'No guarantees' banking union will work

A mechanism to avoid bank runs and resolve cross-border insolvencies is worth considering but there is no certainty that the EU's banking union plan will be fair to taxpayers

Following last week's meetings in Cyprus, the European Commission announced its proposal to centralise the supervision of all banks in the eurozone. The future stability of the entire European financial system may soon be the responsibility of the European Central Bank.

Under this proposal, the ECB would get additional powers to impose limits on risk-taking on over 6,000 banks in the euro area, as well as deciding which banks to rescue and which to close down. The commission wants the banking union in place as early as possible: if it is not vetoed next December, then the ECB should immediately take over the supervision of banks in need of state aid, and take on all banks by January of 2014.

To understand how a banking union may affect European and British banks, let us consider briefly two elementary principles of financial stability regulation. First, regulation must reduce, or even eliminate, the risks of bank runs. Bank runs must be avoided because they are inherently inefficient: the uncoordinated actions of creditors to stop lending before others only anticipate the insolvency and liquidation of the bank. Second, the regulatory framework must also be fair, by ensuring that the costs of eliminating runs are borne by the banks' shareholders.

Typically, the most effective instruments to mitigate the probability of bank runs are deposit guarantees, such as the Federal Deposit Insurance Corporation in the United States, and liquidity support for the bank's distressed assets. Additionally, providing a clear, unified framework to solve conflicts between the lenders and shareholders of distressed banks can further reduce the risks of runs. Essentially, a shorter more predictable path towards recovery of their loans will make creditors less prone to run. But deposit insurance or asset buy-back programmes can fail the fairness principle if they are funded by taxpayers. Therefore the key question is: how does the commission's proposal incorporate these principles?

The proposal focuses on defining the scope of the ECB supervision. While it remains unclear whether the ECB will take on the formidable task of regulating all banks instead of only the largest ones, the good news is that the proposal acknowledges the need for common parameters to apply its resolutions.

The proposal lacks a description of the parameters that will be used to decide between bailing out and closing down a bank. It is important to determine these parameters because the obvious candidates, such as the bank's size and its potential for contagion, are likely to make the European banking market more concentrated and less competitive. Indeed, size or contagion risk-based criteria will incentivise banks to grow so as to become too big to fail, giving already large banks an advantage over smaller banks. And the proposal is also silent about the creation of a European deposit insurance facility. However, this omission could be intentional as it may be too soon to discuss the costs of bail-out funds after the recent ECB bond-buying programme.

More worryingly, it seems that the banking union would leave the final decision on cross-border crisis resolutions to the local regulators, while only acting as a coordinator. Such a structure is unlikely to prevent the cases of many Icelandic banks and Fortis from happening again. In these cases, the distorted incentives of local regulators, or the lack of coordination between sovereign regulators and foreign creditors created more uncertainty and delays.

Finally, it is quite apparent that the ECB would set limits to leverage all across the board. On one hand, this policy could complement well the use of emergency bail-out funds by reducing the implied moral hazard costs. On the other hand, limits to leverage incentivise bankers to continuously invent financial products that achieve higher leverage while technically complying.

As lenders to European Union banks, British banks are likely to benefit from a unified framework that aims at quick conflict resolution. But being the most diversified in the EU, British banks could get the least benefit from the liquidity guarantees and should demand more transparency regarding who will ultimately fund the bail-outs. The City of London may worry that the new supervisor could rule against the United Kingdom's interest too often through its increased powers to resolve cross-border. But the alternative of leaving too much power in the hands of local regulators would defeat the purpose of providing clear and effective cross-border resolutions.

Systemic crises are extremely costly, and any mechanism aiming at avoiding runs, and solving cross-border insolvencies quickly is worth serious consideration. There is no guarantee yet that the proposal presented by the commission can achieve these objectives while being fair to the taxpayer.

Enrique Schroth works out of the finance faculty at Cass Business School in the United Kingdom