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Why the Pan-European Banking Union is Overhyped

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A consistent theme throughout Europe's debt crisis has been for European politicians to over promise and under deliver. Thus, In the case of a European banking union, it would be wise for market participants to expect nothing else. The European Stability Mechanism was said to be the end-all be-all of financial firewalls designed to prevent contagion, and yet Spain is currently requesting 100 billion euros to recapitalize its banks and only three of seventeen nations have ratified the ESM proposal.

Germany's Chancellor Angela Merkel was adamant last year that no nation would leave the euro. Still, the future of Greece in the currency union is set to be tested on Sunday when Greece holds its election. With these lessons in mind, a European banking union deserves a real debate.

There are lots of benefits to a pan-European banking union. Rather than having individual domestic regulators, there would be one European bank regulator that would be able to monitor cross-border capital flows, provide deposit insurance, and make the financial system more transparent. Also, due to the fact that many banks are extremely large relative to their nation's GDPs, a pan-European banking union would make backstopping and potentially even bailing out the banks easier and faster. For example, France's GDP is approximately 3.5 trillion euros whereas the assets of its two biggest banks are nearly 90% of its GDP. Currently, there is no institution capable (legally) of implementing and monitoring bailouts, and having a banking union would create such an institution. This way, the governments can backstop the banks, as there would be sufficient size (in terms of GDP) to match the asset bases.

However, there are drawbacks to such an idea. First, the expediency of the process is a concern. Writing the legislation, passing it through all seventeen national parliaments, and implementing the measures could take years to do. Thus, it could not provide help for the banks now, which they need. Any plan would have to include some form of a temporary watch-dog until the union is established. The best solution would be to give the ECB these powers until the nations can ratify the plan. If this happens, the ECB would be free to recapitalize the banks, and since it can print money, it would not stretch fiscal finances any further. In this scenario, the ECB would have to step up and verbally declare a back-stop of all euro-denominated deposits. This would limit capital flight, insure deposits, and give the banks the capital they need cheaply.

The ECB has been reluctant to take the lead in this crisis, so this would be a monumental shift for the bank. A Greek exit or failure to form a government, followed by a interest rate spiral in Spain and Italy, would probably prompt further Securities Market Program (SMP) purchases. The crisis would have to shift to the core nations, mainly France or Germany, before the ECB accepts this role.

A banking union is a good idea and could provide the necessary support systems to prevent future crises. However, it would take too long to implement to help now. More money may be needed from Germany to backstop the banks, although German politicians remain reluctant to commit any more spending, having passed a law to ban additional bailouts. It may come down to the actions of the ECB to keep the Eurozone intact.

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