Saving the Euro Zone, One Bank at a Time

Its very name makes eyes glaze over, and its details are so technical that only the wonkiest of financial wonks really grasp them in full. But efforts to forge a European banking union are, in fact, critically important. If European Union countries get it right, it’ll potentially correct what some economists are calling a “birth defect” of the euro zone and perhaps put an end to the recent years of lurching from crisis to crisis. But politically it’s a minefield, and forging compromises between the sharply diverging interests of the various E.U. governments could take time and a lot more patience.

Indeed, the E.U. summit in Brussels that ended on Friday exposed deep divisions over what a banking union actually involves and how and when it should be put into effect. Most notably, there was a clash between French President François Hollande and German Chancellor Angela Merkel before and at the conclusion of the meeting, when both briefed their national press and contradicted each other. Hollande declared that a legal framework would be in place for a new pan-European banking supervisor to be operational at the start of 2013; Merkel, who faces strong domestic opposition to the prospect of German money bailing out reckless banks in other European countries, poured cold water on that interpretation, saying it’s more important to get the details right than to rush ahead.

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So what actually is this banking union supposed to do? And why is it so important that even the International Monetary Fund says that establishing one would “go a long way toward ending the crisis”?

The short answer is that a significant part of the euro zone’s problems originated with banking meltdowns that in turn sparked the sovereign-debt crisis that has been the focus of financial market speculation. That was the case in Ireland, where the government nationalized Anglo Irish Bank in January 2009 to prevent its collapse and then had to inject billions of additional euros into the bank, putting its own national finances in critical condition. It’s also the case in Spain, where the spectacular failure of several caja savings-and-loan institutions has brought disrepute on the Spanish central bank and pushed the government of Mariano Rajoy to the brink of requesting a formal E.U. bailout. (Indeed, the three most severely hit cajas — Bankia, Novagalicia and CatalunyaCaixa — have together incurred capital losses exceeding 50 billion euros, or about 5% of Spanish gross domestic product.)

Tally up all the aid in all the countries, and the total figures are stunning. Between October 2008 and October 2011, according to the European Commission, European countries have mobilized 4.5 trillion euros in public support and guarantees to their banks. At fault is the reckless lending of the banks themselves, which in many countries fueled property-market bubbles. But national banking supervisors in Europe have on the whole been far too accommodating to the problems of their biggest banks, and far too slow — certainly much slower than the U.S. — to push them to clean up their bad-loan portfolios.

This is not just limited to banks in countries on the European periphery, such as Greece or Spain. On Friday, Moody’s issued a tough report on German banks, which it said faced a likely erosion of already weak revenues and profits over the next 12 to 18 months. “High balance-sheet leverage and low preprovision profits will make it difficult for many German banks to cope with major [unforeseen] losses,” Moody’s warned.

(MORE: Amid His U.N. Visit, François Hollande Is Haunted by French Economic Woes)

So far, so uncontroversial. All 27 E.U. nations agree on the need in principle for a banking union. The politics start getting difficult over the issues of how to define it, whom to put in charge of it and when to implement it.

Most interpretations foresee three pillars to this banking union: a single pan-European supervisory mechanism, a deposit-guarantee scheme similar to the Federal Deposit Insurance Corporation in the U.S. and a “resolution” mechanism that would restructure or liquidate failing banks in an orderly fashion, thereby breaking the link between bank failure and sovereign-debt crisis. So far, only the first of these three pillars, that of a supervisory authority, has been discussed in detail. The prevailing belief is that the European Central Bank should take on this function. But how quickly it should do so is a hotly contested point.

For the moment, the ECB is flying blind. It is the de facto lender of last resort to European banks, but it doesn’t have either the full data about their activities or the legal ability to intervene in regulating them. Luis Garicano, of the London School of Economics, who has dissected Spain’s banking and sovereign-debt woes, says that whatever the rules put in place, “the supervisor must be able and willing to stand up to politicians.” (Again, the U.S. may be a guide. The Federal Reserve has some clearly defined responsibilities for the banking sector, built up over decades.)

Some economists agree with Merkel that it makes no sense to rush any of this. Charles Wyplosz, a professor of international economics at the Graduate Institute in Geneva, argues that “a partial banking union is no better than no banking union at all, and possibly worse.”

(MORE: Spain Plays Cat and Mouse over Bailout)

The political pressure is high and rising because, this being the E.U., everything is interlinked. Spain, for example, wants to receive up to 60 billion euros in bailout funds for its banks. That money should in theory come from the 700 billion-euro European Stability Mechanism fund that has recently been set up. But until a new banking supervisory system is in place, the money can only be given to national treasuries if they have officially requested a formal sovereign bailout — and won’t flow directly to banks.

The politics quickly become murky. The governments of Germany, the Netherlands and Finland have already signaled that they don’t think existing bank debt should be covered by the new banking union. After a meeting outside Helsinki, the Finnish capital, in late September, the three nations ruled out including “legacy assets” in the new arrangement. France, on the other hand, is adamant that money should start to flow to beleaguered euro-zone banks as soon as possible and certainly by 2013.

Meanwhile, one still unanswered question is how a future banking union would affect banks and national regulators in the 10 E.U. nations that are not part of the euro zone, notably Britain. In principle, Prime Minister David Cameron is welcoming the introduction of a banking union, but on the condition that it only affects euro-zone countries and doesn’t interfere with the free flow of goods and services within Europe. But that creates a big possible dilemma down the road for European banking regulators if they start to worry about a British bank’s troubles spilling over to the rest of Europe.

The political horse trading will now take place behind closed doors ahead of the next meeting of E.U. leaders, in mid-December in Brussels, which is aiming to come up with a compromise package. In the run-up to that meeting, the discussions may be wonkish, but they’ll be no less intense because of that, given what’s at stake.

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