Why the Euro Area Needs a Banking Union
The worst appears to be past for the euro area. The region is slowly heading out of recession. Fears that the single currency might break up have largely abated. But things are a long way from normal. One example is the way in which Europe's single market in banking has weakened under the stress of the financial crisis.
Before the crisis, European banks were increasingly operating across borders, lending and expanding outside their home markets. The system was becoming more integrated with more sharing of financial risk across countries.
The crisis has led to an unwinding of this process. Banks have pulled back from foreign ventures and sold foreign assets to focus on domestic balance sheets. Pressure from national regulators on banks to strengthen their balance sheets and lend more at home has played an important role in this process.
The European banking system has become more national in character. Some commentators have talked of a Balkanisation of Europe's banks – the antithesis of the EU's dream of an integrated, pan-European financial system.
* Many of the banks which have re-focused on their home markets have ended up holding large quantities of their own government's bonds. This has transmitted the debt problems of the so-called peripheral euro area nations straight into their own banks. Coupled with deep recessions in these countries, and rising levels of non-performing loans, peripheral nation banks have faced considerable stress.
One result has been a divergence in the costs of borrowing from the more stressed, peripheral-European banks and from those in safer, core countries.
In Germany, for instance, a corporate can borrow one million euro for a year at an interest rate of 1.8%. Given that German inflation is running at 1.2% this gives a real cost of borrowing of just 0.6%.
By contrast, in Cyprus borrowing costs are 6.2% and the price level is declining – over the last year prices have fallen by 1.6%. This gives a real cost of borrowing for Cypriot businesses of 7.8%, thirteen times as high as in Germany.
The real cost of borrowing in Greece is 7.9%, in Portugal 5.0% and in Spain 2.4%. Even these data do not capture the real extent of the difficulties facing corporates in the periphery of the euro area since they say nothing about the availability of credit or the terms on which it is provided.
It is a measure of the Balkanisation of banking in Europe that the spread between interest rates in euro area countries with the lowest and highest borrowing costs has risen from around 1.0% six years ago to over 4.0% today.
The inability of the European Central Bank to transmit very low interest rates to the periphery of the euro area has blunted the effectiveness of monetary stimulus. In the euro area today, the weakest economies, those with the greatest need of low interest rates, face the highest borrowing costs. The strongest economies, such as Germany, have the lowest borrowing costs.
High borrowing costs and a shortage of credit have led corporates in the peripheral nations to pay down debt on a massive scale.
Between 2011 and 2012 alone, the stock of debt held by non-financial corporates in Spain fell by 16%, in Greece by 10.7%, in Portugal by 7.4% and Ireland by 4.5%.
This is not what the architects of the single currency intended. The EU responded last year by launching plans for a euro area banking union. Its aim is to break the link between weak sovereign bonds and weak banks and to build trust in banks across the region. The ECB wants to give the same confidence to a depositor in a Greek or Portuguese bank as is enjoyed by a depositor in a German bank.
A European banking union would have three elements: to make the ECB the supervisor of euro area banks; to create new powers and capital to restructure failed banks and to set up a euro wide bank deposit guarantee to guard against bank runs.
The US offers a model of how this could work. As in the euro area, US states and local government run their own fiscal policy and have their own borrowing costs. But because the federal government regulates banks and guarantees bank deposits, a depositor in New York has the same degree of security as a depositor in Los Angeles. As a result, the varying solvency of state and city governments does cause huge variations in the cost of borrowing for US corporates across America.
Progress in creating a European banking union has been slow not least because the richer nations worry that they might have to pay to bail out depositors and banks in other countries.
America's current system of federal bank supervision and deposit insurance was put in place in the 1930s to prevent a repeat of the disastrous bank runs and bank failures of the Great Depression. In the same way the euro crisis has revealed big gaps in the architecture of Europe's single currency. Filling those gaps is vital for the creation of a durable and stable monetary union in Europe.