Mending Broken Bonds: The Past, Present, and Future of Euro Area Banking

By Johann Benson, Transatlantic Economy Analyst

While speaking in Shanghai recently, European Central Bank (ECB) President Mario Draghi summed up the current state of affairs in the Eurozone: “…the most salient feature of this new reality is financial fragmentation across euro area countries.” This remark comes on the heels of the latest Bank of International Settlements (BIS) report, which showed further decreases in cross-border interbank lending within the Eurozone during the fourth quarter of 2012.


Meanwhile, after enthusiastically committing to a banking union in June of last year, EU leaders now appear more reserved about the prospects of reaching agreement on further financial integration. Despite their reservations, recent events show that the euro area will find it very difficult to address future crises and reach its full potential without a banking union.


The Eurozone: a victim of its own success


To a certain degree, it was the success of the euro that created many of the common currency area’s current problems. Notably, from 1999 to 2008 the euro appreciated 36% against the U.S. dollar. During this same period, the Chinese economy experienced double-digit growth rates. The confluence of these two factors turned out to be a double-edged sword for the euro area as a whole. Chinese demand for machinery and higher-end goods was a boon to German exports, which were relatively unaffected by euro appreciation. However, cheap Chinese exports were often in competition with the manufactured goods of the periphery, causing a 20-25% decrease in exports as the euro appreciated. Nonetheless, with bond yields similar to those in the euro area’s more competitive economies – and the easy credit that those low yields made available – countries in the periphery saw little reason for concern. Nor did their Eurozone compatriots.


The euro effect


From the inception of the common currency, it was clear that membership had its privileges. The vast majority of lending to the periphery of the EU came from banks in the core of the Eurozone, especially Germany and France. By contrast, most investors outside of the euro area lent primarily to banks in Germany or France. Thus, much as foreign banks helped fund the sub-prime bubble in the U.S., non-EU banks – via the intermediation of German and French banks – likely played an indirect role in the real estate bubbles that built up in Spain and Ireland.


In short, the advent of the euro caused not only bond yields in the euro area to converge, but also perspectives…until the onset of sovereign debt problems. The current crisis has now laid bare the fact that much of the previous financial integration was illusory, at least in regard to the periphery. The lessons that can be drawn from this period, however, are not only lessons of failure, but also of success. The story that needs to be told is twofold.


The banking buffer of Central and Eastern Europe


Rather than acting as a channel for contagion, cross-border banking in Central and Eastern Europe actually mitigated the effects of the 2007-2008 financial crisis. This is because the financial integration that took place in Central and Eastern EU countries was of a fundamentally different nature from that of the Eurozone periphery. A great deal of the cross-border lending that took place was “inter-office;” that is, between banks of the European core countries and their subsidiaries in the emerging markets further east. In fact, foreign-owned banks provide 90% of credit to non-bank residents in the newest EU member nations.


Consequently, during the global financial crisis that ensued after the events of August 2007, the countries of Central and Eastern Europe did not experience the capital flight that many Asian countries suffered when the Asian financial crisis hit in the summer of 1997. This is largely because foreign banks, through their retail operations, were locked into long-term loans in the region, preventing much of the “home bias” in lending that is so prevalent at the moment. The lesson is clear: greater financial integration would enhance the Eurozone’s ability to withstand such crises.


The benefits and limitations of a banking union


It is generally agreed that, to be fully viable, a European banking union would have to include all of the following:


  1. Standardized regulations across national borders and a central monitoring authority

  2. A common insurance fund, guaranteeing uniform levels of deposit protection

  3. A joint rescue fund and a procedural framework for resolving troubled banks


Until now the focus has always been on bank balance sheets at the national level. Consequently, EU-wide systemic risks went unnoticed – resulting in the now well-documented overexposure of European banks to U.S. financial markets. A banking union with central oversight of banks would remove the fragmented supervision that is now in place, allowing for a more complete picture of the financial situation across the entire euro area and the easier recognition of systemic threats.

A banking union, of course, will not prevent the emergence of asset bubbles, such as in the Spanish housing market. This we know simply by looking at what happened in the U.S. in the run-up to the financial crisis. However, an EU-wide guarantee of bank deposits (up to an agreed upon limit) would help prevent capital flight from banks and countries experiencing financial difficulties (and therefore in need of greater access to funds).


Nonetheless, as has been oft-noted, a banking union without a mechanism for resolving failed banks would be incomplete. Resolving failed banks needs to be done at the Eurozone-level, similar to the burden sharing scheme that was recently implemented in the Nordic and Baltic countries. Without a Eurozone-based resolution arrangement, the risk of financial contagion spreading from troubled banks to troubled sovereigns, and vice versa, would remain largely unaccounted for, severely reducing the effectiveness of other centralized measures.


Last but certainly not least, a banking union is all the more important for the euro area economy because of its heavy reliance on banks for access to capital. According to European Banking Federation figures, about 75% of corporate financing in the EU is provided by banks, while this figure is a mere 30% in the United States. At the same time, despite efforts to promote European unity, the home bias of Eurozone banks is, ironically, particularly acute when compared to non-EU banks.


The road ahead


The most recent ECB survey of European banks revealed that “borrowers’ risk and macroeconomic uncertainty remain the main concerns of euro area banks in setting their lending policies.” While a banking union would not eliminate macroeconomic uncertainty, it would create a more uniform environment for assessing risk and erect the necessary framework for building long-term confidence – confidence that is rooted in institutions and not just enthusiasm.


At the moment, however, the greatest obstacle to a banking union and further financial integration is national politics. Germany, in particular, appears increasingly reluctant to take on the bulk of responsibility for what many believe would be future bailouts of the periphery. While this reaction, given the current circumstances, is understandable, it is also short-sighted. It is precisely a euro area banking union that would facilitate the faster recognition of growing problems, and allow for them to be dealt with while they are still easily manageable.


Aside from political hurdles, there are also legal issues that stand in the way of a banking union. Nonetheless, it has always been in the spirit of the EU to forge ahead, growing and expanding first, and then solving problems as they arise. The problems of the common currency have never been more apparent, nor have the steps needed to prepare its financial sector for the future and fulfill its potential. 

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