Most observers have realized by now that a core problem of the Eurocrisis is the close interconnection between banking and sovereign fragility. The ongoing sovereign debt crisis in Europe continues to put strains on banks’ balance sheets — full of government bonds — while continuous bank fragility increases (contingent and more and more real) government liabilities. Rather than disentangling the sovereign debt and bank crises, recent policy decisions have tied the two even closer together. The use of the additional liquidity provided by the European Central Bank (ECB) through longer-term refinancing operations by some banks to stock up on government bonds has also tied the fate of sovereigns and banks closer together. Similarly, the initial plan to use European Financial Stability Facility (EFSF) or European Stability Mechanism (ESM) resources to recapitalize Spanish banks via a loan to the Spanish government bank support agency (FROB) would have exacerbated the Spanish sovereign debt crisis rather than helped to alleviate it, as such a loan would have added another heavy burden to the Spanish debt-to-GDP ratio. These short-term stresses come on top of doubts about the long-term sustainability of the EU Single Market in banking without a regulatory and supervisory framework that matches the geographic perimeter of banks’ activities.
The debate on the supervisory structure of banking in Europe and bank restructuring in the current crisis constitute two dimensions of the same problem, as we argue in the following. Specifically, the EU Single Market in banking is only sustainable with a supra-national regulatory authority that has supervisory and resolution powers and the resources to actually intervene and resolve. To address current banking fragility across many of the Southern Eurozone countries, a European Resolution Authority is needed — which in turn could be the basis for the supra-national regulatory authority.
A long-term reform agenda…
The lesson of the recent crisis is that a stable EU Single Market in banking is not possible with national supervision, something also referred to as the financial trilemma (Schoenmaker, 2011). One could of course argue that the problems of Spain (and Ireland) are due to local banks engaging in a classic real estate lending binge. This is true, but the problem would only remain local if the failure of mid-sized local banks did not endanger the stability of the entire euro area banking system. Large cross-border Spanish banks and indeed banks elsewhere have considerable exposure to these banks (and the Spanish economy in general). Failures of the Spanish local banks could thus set in motion a domino chain affecting the entire euro area banking system. In addition, national supervision of cross-border banks gives rise to distortions, as shown by Beck, Todorov and Wagner (2012) as home country supervisors might intervene too early or too late into a weak bank. Finally, the recent experience across Europe has shown political and regulatory capture of national supervisors resulting in underestimates of losses and delayed intervention. The recent case of the Spanish bank Bankia is telling in this context, as is the case of German Landesbanken earlier in the crisis.
The three of us have therefore — in different combinations and with different co-authors — repeatedly called for a supranational framework for the supervision of large pan-European banks (Allen et al, 2011 ; Schoenmaker and Gros, 2012; Schoenmaker, 2012). While different institutional solutions are possible, a European-level framework for deposit insurance and bank resolution is critical in order to enable swift and effective intervention into failing (cross-border) banks, reduce uncertainty and strengthen market discipline. Critically, a central resolution authority needs the necessary resources to resolve large cross-border banks in an efficient manner. That is why a combination of the resolution authority with a deposit insurance scheme for cross-border banks might be necessary (Schoenmaker and Gros, 2012). Industry-based funding for such a scheme is also called for to reduce concerns of moral hazard, where the downside risk of banks’ risk-taking is borne by taxpayers. Since deposit insurance, even if financed by banks themselves, always faces limitations in case of systemic bank failure, however, a back-stop by national governments, possibly through a European institution, such as the EFSF and the new ESM, is necessary. This is especially important in the early phases as the fund is being built up.
…but short-term needs
While the institutional reforms outlined above are necessary for the long-term sustainability of the Eurozone and the EU Single Market in Banking, the Eurozone is facing immediate needs in fighting the ongoing crisis. There is still a significant capital shortfall in many European banks, not yet fully recognized. As just one example, Acharya, Schoenmaker and Steffens (2011) calculate a recapitalization need of 200 to 500 billion Euros. The increasing weight of sovereign debt on bank balance sheets weighs down banks, especially in the periphery.
To turn the European banking system from a source of fragility into a source of strength, bold steps are needed. We call for the establishment of a temporary European Resolution Authority, for which the ECB could make staff and offices available. This Resolution Authority would sort out fragile banks across Europe, both small and large. Strongly capitalized banks would go ahead, while weak banks would be either recapitalized or (partly) liquidated. Where possible, banks should be recapitalized through the market; if this is not feasible, the Resolution Authority would recapitalize by taking an equity stake in the bank (by straight equity or hybrid securities). It is important that the Resolution Authority would also receive the upside if the banks were getting on the right track, with even a possibility to make gains as happened in previous crises. In addition, the use of debt-equity swaps should be considered, as well as restrictions on dividend and possibly salary payments. The Resolution Authority, however, would need a fiscal backstop from the EFSF/ESM to gain the necessary credibility not only with the banks it is tasked to restructure, but also with the markets. Addressing the restructuring needs of Europe’s banks on the European level has the additional advantage that it will also reduce political pressure and interference at the national level and enable a more transparent and cost-effective process. It is important to note that this restructuring and recapitalization exercise does not and should not imply the bailout of equity and junior debt holders, as recently alleged by a group of German economists around Hans-Werner Sinn.
Restructuring and recapitalizing banks across Europe will not only help disentangle sovereign and bank fragility, but also would help Europe grow out of the crisis by turning the financial sector from a drag on sovereigns’ balance sheets to a motor for private sector growth. Such a European Resolution Authority is thus not only a crisis resolution tool, but also a critical part of the growth compact that is currently so high on the political agenda.
The decision of the most recent European summit to allow direct recapitalization of Spanish banks with European funds rather than through the Spanish government, and to initiate a move toward a banking union are a step in the right direction. Stronger and more immediate action, however, is needed.
Acharya, Viral, Dirk Schoenmaker, and Sascha Steffens. 2011. How Much Capital Do European Banks Need? Some Estimates. VoxEU, 22 November.
Allen, Franklin, Thorsten Beck, Elena Carletti, Philip Lane, Dirk Schoenmaker, and Wolf Wagner. 2011. Cross-border Banking in Europe: Implications for Financial Stability and Macroeconomic Policies. CEPR, London.
Beck, Thorsten, Radomir Todorov, and Wolf Wagner. 2012. Supervising Cross-Border Banks: Theory, Evidence and Policy. Tilburg University. Mimeo.
Beck, Thorsten, Daniel Gros, and Dirk Schoenmaker. 2012. Banking Union Instead of Eurobonds – disentangling sovereign and banking crises . VoxEU.org June 24.
Schoenmaker, Dirk. 2011. Financial Trilemma. Economics Letters 111: 57-59.
Schoenmaker, D. 2012. Banking Supervision and Resolution: The European Dimension. Law and Financial Markets Review 6: 52-60.
Schoenmaker, Dirk, and Daniel Gros. 2012. A European Deposit Insurance and Resolution Fund . DSF Policy Paper No. 21. Duisenberg School of Finance, Amsterdam.
_____________________________This blog builds on a recent Vox column  by the same authors (Beck, Gros and Schoenmaker, 2012).