On banking union, speak the truth

Charles Wyplosz 17 September 2012

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The European Commission has produced an interesting proposal on EZ banking union (Commission 2012). Despite its many shortcomings, it is a good start. And now finance ministers have started to deconstruct the proposal. Part of the deconstruction comes from the ministers’ shameful capture by national bank lobbies, but not all. The proposal includes some clumsy features. But rather than watering it down, the project should be strengthened.

For that to happen, the ECB, which is at the origin of the project, should tell the truth about why a single supervisor is needed – the Eurozone needs a lender of last resort.

The EC’s proposal has one major merit. It unambiguously calls for a single Eurozone bank supervisor and for the ECB to undertake this task. The survival of national supervisors has always been a major flaw of the Maastricht Treaty, as explained long ago by Begg et al. (1998). 

Contrary to current assertions, the absolute need for a single supervisor is not related to possible interventions by the European Stability Mechanism (ESM). The logic is much simpler and much more compelling, but hardly ever mentioned.

The real reason for lenders of last resort

The dark little secret is that banking systems always need a lender in last resort for the rare but critical instances when one or more banks go bust. There is absolutely nothing new here. The definitive statement on the issue was made by Bagehot (1873). He, and countless policymakers, commissions and scholars since then, made it clear that this role can only be fulfilled by a central bank. The reason is simple: the sums that need to be mobilised in a matter of hours are not available elsewhere.

  • Even if the ESM resources ever grow to €500 billion, they will be massively insufficient to deal with the major banks in the Eurozone.

Deutsche Bank, for example, has assets of over €2 trillion – about 80% of Germany GDP (Deutsche Bank 2011).

  • To make matter worse, modern banks are deeply interconnected, which raises the odds that several banks will tank together; arguments about the role of the ESM are a fig leaf to conceal that unavoidable fact that the ECB will have to do the job.

The Irish experience shows what happens in a system without a lender of last resort.

  • Because the ECB stayed on the sidelines, the Irish bank rescue bankrupted the Irish government in 2010.
  • The coming Spanish rescue stands to bankrupt the Spanish government.

That, of course, is why the issue of a banking union arose at this juncture.

The argument against constructive ambiguity

Central banks typically want to maintain constructive ambiguity about their role as lender in last resort. They want to avoid any commitment that could encourage banks to bet on a rescue.

This was never a very convincing argument – not even a clever trick to reduce the inherent moral hazard.

  • The massive rescues that we have witnessed since 2008 in the US, UK, EZ, and Switzerland have now removed the fig leaf.
  • Central banks are lenders of last resort, whether they want it or not.

They need a deal with the relevant government to make sure that the costs will be borne ultimately by the government, not by the central bank, but they cannot and should not refuse to act when an emergency arises.

In order to act appropriately (how much money is needed and under which conditions), they must have at any time an intimate knowledge of the exact situation of every single bank in their areas. This is why it makes sense to give the supervision task to central banks, as many countries do.

Eurozone birth defect

This logic was ignored when the single currency was under preparation. The ‘oversight’ however was deliberate, resulting from pressure by both banks and national supervisors each acting for their own shameful reasons.

  • Supervisors saw themselves as protectors of their banks and banks greatly valued this arrangement.
  • Captured governments went along, with a view to protecting national champions.

Obviously, they still do. They use the pretext that the ESM is possibly too small for the task, which is correct, to argue that much more time is needed to study the issue.

When politicians ask for more time, you know that they want to kill the project. They should not be given this pretext. The ECB, which must be commended for having put the issue on the front burner, now must debunk the ESM pretext. It must accept to state that it is the EZ banking system’s lender of last resort and explain that it can only deliver if it is the area’s single supervisor.

The ECB must do more

The ECB must plug two more gaping holes of the commission’s proposal.

  • First, the ECB needs an arrangement with member governments on who will bear the costs.

This is likely to involve some single deposit insurance agency financed by all member countries and some cost sharing rule.

  • Second, the costs must be guaranteed to be small, possibly even negative (many governments make money from bank rescues as they buy low and sell high).

When money is injected into a failing bank, the bank must be made to carry most of the costs. Following the nearly cost-free bank rescue in Sweden in 1992, we know how to do it. Switzerland followed this logic in its rescue of UBS in 2008 and it now appears that the Swiss taxpayers will make a profit on that operation.

  • For the cost of bank rescue to be kept small, the resolution authority has to avoid capture by special interests that will seek to socialise losses and privatise gains.

Given the huge amounts involved, capture is guaranteed. Indeed, that the commission did not dare venture into this territory is telltale evidence that the national governments are captured.

Taxpayers of the EZ should unite in disgust. They can only count on the ECB to state forcefully that we need a single EZ resolution authority that can be trusted to not transfer massive resources from taxpayers to failed banks.

EU solution for an EZ problem?

Finally non-EZ countries are revolting because they are dragged into this business. They are right. They have their own central banks that can act as lender in last resort and therefore have no need for ECB intervention. The commission is making a grave mistake when it proposed an EU solution for a EZ problem. Even though there are some technical difficulties involved, this should be easy to solve because there are few private interests at stake.

References

Bagehot, Walter (1873), Lombard Street, Henry S King and Co.

Begg, David, Paul de Grauwe, Francesco Giavazzi, Harald Uhlig and Charles Wyplosz (1998) "The ECB: Safe at Any Speed?, Monitoring the European Central Bank 1", CEPR.

Deutsche Bank (2011). Financial data supplement, October

European Commission (2012). “Vice-President Rehn's remarks at the Eurogroup Press Conference”, September.

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Topics:  EU institutions

Tags:  ECB, EZ crisis, EZ banking union

Professor of International Economics, Graduate Institute, Geneva; Director, International Centre for Money and Banking Studies; CEPR Research Fellow