Monday, August 20, 2012

Banking union and the financial architecture of the Eurozone: A retrospective

by Xavier Vives


August 20, 2012

Does Europe need a banking union? This column argues that banking union is necessary but not sufficient for monetary union to survive. To cope with sovereign risk more political and fiscal integration is needed.

The Eurozone crisis has brutally exposed the inadequacy of institutional financial arrangements in the Eurozone. Modalities of banking union are being discussed now and the late June 2012 Eurozone summit agreed to give the ECB supervisory powers and, once this common supervisor is in place, it will allow direct capital injections into banks using the European Stability Mechanism. The European Commission will release a more concrete proposal on 11 September.

Other necessary elements of a banking union are a common Resolution Agency (RA) of troubled banks and a common Deposit Insurance Fund (DIF). Indeed, the central bank is the liquidity authority but it cannot be at the same time the solvency authority since bank restructuring may have fiscal consequences. The fact that a monetary union needed common stability and regulatory facilities is not news. This was pointed out, for example, by Folkerts-Landau and Garber (1994) as well as in an early CEPR report (Chiappori et al. 1991), and several authors, academic networks, and think tanks have insisted overtime on the issue. Twenty years ago I proposed the following architecture:

1) The ESCB (European System of Central Banks) should perform a Lender of Last Resort function if the stability of the European financial and payment system is to be preserved.

2) The Lender of Last Resort function of the ESCB needs to have associated supervisory powers, although, perhaps, the ESCB need not have them in the exclusive.

3) The concern for a potential misuse of the Lender of Last Resort facility by a ESCB with supervisory powers is legitimate but not overwhelming. Indeed:

4) A potentially optimal structure could be for the ECB to have authority in liquidity matters while another European agency has authority over solvency matters (and perhaps deposit insurance). In this arrangement both agencies would have supervisory powers but the ECB would have the primacy." (Vives 1992)


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