In memory of Dr. Andreas Höfert

A piece of good news out of the Eurozone

| Tags: Andreas Höfert

Amid all the uncertainties still surrounding the Russia-Ukraine conflict over Crimea, one piece of news barely made it into the media last week and in fact was almost ignored by the broader public. The long-announced European banking union is finally taking shape and could well be adopted by the European Parliament over the next couple of weeks, before the European elections take place on 22–25 May.

At the height of the euro crisis in mid-2012, European politicians started to think about this banking union and even adopted an ambitious agenda to implement it by the end of that year. It ended up taking them a while longer but, given the usual political lags, the time between decision and implementation is exceptionally short.

All the details haven’t been communicated yet. However, the banking union will encompass a Single Supervisory Mechanism (SSM) scheduled to start in November, as well as – elements still debated as of a couple of weeks ago – a Single Resolution Mechanism (SRM) and a Single Resolution Fund (SRF). The SRF will be funded over the next eight years through financial sector contributions that will ultimately total EUR 55bn. Just two years after its creation, 60% of SRF funds will be “mutualized,” meaning that 60% of what Spanish banks pay into the fund could be used to solve the issues of an ailing German bank.

Why is this news so important? There are two reasons: one related to the longer-term resolution of the euro crisis, the other to current Eurozone growth prospects. The euro courted crisis right from the start because the Eurozone lacked the institutions and other forms of support usually required for an optimal currency area.

What’s needed, in addition to a common central bank, are:

1) A form of fiscal federalism and coordination to mitigate structural imbalances (which arise due to regional disparities in wealth and economic prospects) through fiscal equalizations i.e. transfers from the richer to the poorer regions.

2) A way of harmonizing labor and social laws and institutions to level the playing field in terms of competitiveness and prevent structural imbalances from becoming too large.

3) The aforementioned banking union, because if you define the common central bank of a currency area as the lender of last resort, you need to ensure that financial intermediaries of the different regions abide by a common set of rules and regulations. Otherwise, moral hazard issues will likely undermine the entire financial sector and thwart fair competition.

While the Eurozone remains eons away from acquiring the first two pillars of long-term stability, at least the third one now appears within reach.

The banking union will also help to solve a short-term problem. While the six major economies of the Eurozone are all growing again, one factor could undermine their recovery. Bank lending continues to fall. According to European Central Bank statistics, credit to entities other than governments declined by 2.2% in January 2014 compared with the previous year. This is also reflected in the growth rate of broad money M3, which nearly stagnated in January.

While the drop in lending activity stems partly from a reluctance to borrow, it also arises from the mistrust within the European banking sector, whose members refuse to lend to their counterparts in other countries. This refusal can be traced to the 18 different sets of rules and regulations that make it difficult to assess the soundness of the various financial intermediaries. Here, also, the banking union can help. The SSM will standardize the rules and regulations, create transparency and engender trust among the financial intermediaries. Hence it may contribute to putting the current growth dynamics of the Eurozone on a stronger foundation.