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Let euro banks stand on their own feet

In Wednesday’s Free Lunch, I revisited the debate on fiscal union in the eurozone with a series of reasons why a system of fiscal transfers between its members is not a necessary condition for the sustainability of the single currency. Today I want to home in on one particular aspect of this debate. This is the question of whether Europe’s banking union — which sets common rules and supervision for large banks — also needs a “thin” fiscal union to function, in the form of common fiscal resources to back up banks under stress.

Part of the blueprint for the finished banking union has long involved two fiscal elements, one explicit and one implicit. The explicit fiscal element is the “common fiscal backstop” — a common fund able to inject capital into failing banks being resolved under the banking union’s new rules. The implicit fiscal element is in the projected but contested common insurance scheme for bank depositors.

Take the latter first. The argument for a common fiscal backstop for banks in trouble is a holdover from the habit of providing a national fiscal backstop — the expectation that governments would bail out “their” banks. That expectation is what brought the eurozone debt crisis to Ireland and Spain, both of whose governments had been models of fiscal probity in the euro’s first decade. The banking union is meant to end this by requiring banks’ investors, including their bondholders, to cover a bank’s losses if necessary to have sufficient equity to operate.

Those who want a common fiscal backstop have not let go of the older conviction that governments must step in to stop banks from being restructured with debt to investors being written down. But by holding on to this old, bad, habit, they are guilty of a contradiction. The requirement to write down creditors of failing banks means that a fiscal backstop is no longer necessary. This is why I wrote in a recent column that banking union is a substitute for fiscal union. Or conversely, one can only argue for a common fiscal backstop to bail out banks if one is unwilling to fully use the new “bail-in” rules to their full potential. That is to say, if one is trying to backtrack on the commitment to banking union and the healthy move to a world where banks can be restructured.

There is a possible retort to this: some bank liabilities have to be kept inviolate, namely the deposits of ordinary savers and small business people. That is because for the sake of basic economic functioning there has to be some way to keep modest savings and transactional capital in safe and liquid form. This is why all modern countries arrange for systems of deposit insurance or deposit guarantees — up to €100,000 in the EU. If these are in any way to be guaranteed across national borders, and ultimately be the responsibility of governments, this will amount to cross-border fiscal commitments, hence an implicit “thin” fiscal union.

Note in passing that an argument for deposit insurance does not work as an argument for a fiscal bailout fund for claims on banks that are not intended to be covered by deposit insurance. Even if there were a strong case for a common deposit insurance scheme and the thin fiscal union it would involve, this does not rescue the case for a common fiscal bailout fund. But even the case for a common deposit insurance scheme is weaker than it is often made out to be.

The point of deposit insurance is to make bank deposits, up the insured amount, available to depositors even during the failure of the bank at which they are held, or during a run where everyone wants to withdraw their deposits at once no matter how healthy the bank. This is, above all, a matter of liquidity — how to honour eligible withdrawals faster than it takes to manage, salvage or liquidate the failing banks’ assets. Are deposit insurance schemes fit for this purpose?

Such guarantees were introduced in the New Deal era of the US in an environment where almost all banks were small “unit banks” with a single branch. In such a world, a modest deposit insurance fund can cover any conceivable amount of withdrawals at any particular bank. But no sensibly sized deposit insurance fund would conceivably be large enough to deal with a run on today’s large banks, or a systemic banking crisis. The failure of the Icelandic deposit insurance scheme in 2008 is a case in point.

Not only is there reason to doubt the ability of deposit insurance to do the job it is meant to do; but a superior alternative exists in the form of central banks. Having unlimited liquidity, central banks can always lend liquid funds in the last resort to redeem insured deposits. To make this safe, banks can be required — instead of taking part in deposit insurance schemes — to always have sufficient assets to back liquidity from the central bank. The central bank, in turn, should precommit to issuing such liquidity on clearly stated terms in advance of any crisis, as Mervyn King has proposed (succinctly summarised in Michael Lewis’s review of King’s book).

There is a parallel with the broader, unpersuasive, case for fiscal union here. Many saw the sovereign debt crisis as demonstrating the need for fiscal transfers when it really demonstrated the need for debt restructuring. Similarly, many see banking union as creating a new need for fiscal resource pooling. In reality, it makes it easier to do without.

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