The new European banking union arrangements represent a landmark in European integration which will fundamentally change the financial sector in the European Union. It will make a systemic banking crisis less likely and will help bring down financing costs in the euro periphery, contributing to an economic recovery in Europe. However, the current form of the proposed banking agreement is not sufficient to provide a proper framework to deal with new systemic crisis, nor will it level the playing field between banks in different eurozone countries. It therefore falls short of the objectives policy makers had set for a banking union. 

According to this policy brief by ECFR Senior Policy Fellow Sebastian Dullien, the main advantage of banking union will be that, for the first time, all major banks in participating countries will have to report to a single supervisory agency (the European Central Bank). This will end both regulatory ring-fencing, under which national regulators have in the past prohibited banks under their supervision from moving liquidity and capital to banks in other euro countries. It will also stop regulatory arbitrage whereby financial institutions have shifted certain activities to member states where rules were less strictly enforced.

Professor Dullien says the financial system in Europe will be much more stable. “This is a huge step forward in protecting taxpayers’ money – especially as, in the past, the indirect costs of banking crises due to lost output and tax revenue have often been much higher than direct costs of bailing out banks.”

In addition, as there now will be common rules for “bailing in” private capital in banks that get into trouble, there is no reason to fear that single large banks in some member states will be helped more generously than competitors in other member states. 

All this will contribute to level a playing field once again between banks in different eurozone countries and will especially help reduce the financing costs of financial institutions in the euro-periphery. It will encourage lending to businesses in Europe.

However Professor Dullien also spots a number of weaknesses in the proposal. First he fears that the planned Single Resolution Fund (SRF) will prove insufficient in the case of a major crisis, despite banks’ higher capital requirements. Second, the fact that the rules allow single member states to use “extraordinary public financial support” under certain circumstances means that banking crises could still be dealt with differently in different countries. Here, the danger remains that “the poor bail-in while the rich bail-out”, meaning that countries with a more solid fiscal position might be more generous in their financial support. Investors might anticipate such a scenario and demand lower yields for investments in banks in countries with comparatively low public-debt-to-GDP-ratios, providing cheaper capital to those countries versus higher debt countries.

“These shortcomings limit the extent to which banking union can level the playing field in the European market for financial services”, says Professor Dullien. “While the improvement will be significant, it will not be complete.” 

In order to complete banking union and resolve the remaining issues, the author proposes to federalise more fully the process of bank resolution and bailouts, by pushing for the following reforms:

• The power to take a decision on extraordinary public financial support should be moved to European level, jointly decided upon by the European Commission, the Council and the European Parliament
• Extraordinary public financial support should be financed by the Single Resolution Fund which should be given access to a credit-line to the European Stability Mechanism (ESM)

The review process, already part of the compromise Bank Recovery and Resolution Directive, can be used to push for these changes.