Growth Prospect and Risks Involved in the European Banking Union Project - Term Paper Example

The European Banking Union Project Executive Summary All the while, Greece had increased public expenditurenearly ten times and Ireland had indulged in massive property development, presently taking route to further debt. Italian borrowers owed lump sum amounts to the French banks putting the external debt at risk. If Italy failed to finance itself the French economy would come under pressure thereby transferring the pressure to the French creditors. It could take the form of financial contagion. In this paper we would look at the different opinions of the member states of the European Union and their views on the growth prospect and risks involved in the European Banking Union Project. Introduction The European Union consisting of twenty-seven countries is going through a turbulent phase of financial crisis that has developed in 2008. Often referred to as the European sovereign debt crisis, it was propelled by the rising debt levels, both private and government, around the world. The European System of Central Banks (ESCB) consisting of the European Central Bank (ECB) and the national central banks of the twenty-seven countries of the European Union serve as the monetary authority of the Euro zone. The Euro zone consists of particularly those seventeen countries that use Euro as their legal currency and is a part of the European Union. During the period of 2000 to 2007 there was a significant global rise in savings which was available for investment. It created an easy credit facility as well as helped the formation of a powerful real-estate bubble. When these bubbles burst, the property price fell hugely while the liabilities owed to global investors remained at their full price. The high-risk lending and borrowing practices had started taking its toll. Debate over the failure of the European Central Bank The ESCB is managed by the decision making bodies of the ECB which has adopted the authority of monetary policy of the Euro area with the objective of maintaining price stability. To fulfill this objective the ECB’s primary task is to set the key interest rates for the Euro zone (The role of the European Central Bank, 2012). The primary cause cited for the sovereign debt crisis is that ECB has failed to notice the huge housing bubbles that became the driving soul of the economies of countries like Spain and Ireland. On one hand it allowed these bubbles to grow dangerously while on the other hand it was extremely cautious in its quantitative easing policy (The European Central Bank: The Main Cause of the Debt Crisis). The European Union Banking Project: The Proposal The European Union leaders have come forward to propose a remedy for the current financial crisis. The European Council of 28th and 29th June, 2012 has agreed to deepen the economic and monetary integration. The leaders have discussed a report titled Towards a Genuine Economic and Monetary Union, prepared by the President of the European Council in close collaboration with the President of the European Commission, the Chair of the Euro group and the President of the European Central Bank. The Commission has proposed to design a single banking supervision mechanism in the Euro area. In 2008 when the financial crisis spread to Europe, there were 27 different banking regulatory systems based on the separate national rules. The proposal is not aimed at changing the rule making for the single market (with its ‘four freedoms’ namely, freedom of movement of goods, services, and the factors of production i.e. labour and capital) existing amongst the 27 countries, but the way in which the banks in the Euro area would be supervised. Although coordination pre-existed by way of the framing of the monetary policies for all these banks by the ECB, it was rather informal and was not sufficient to face the financial sector crisis of this nature. A full-fledged banking union has become necessary that would lead to pooled monetary responsibilities and better financial integration (Towards a Banking Union). Discussions on the pros and cons of the proposal The proposal presented by the European Commission president, José Manuel Barroso, is to have a single supervisor for the Euro zone as soon as possible. According to the proposal; all the national bank regulators of the more than 6000 banks of the Euro zone would continue to function but would be under the ultimate supervision of the ECB. One of the elements of the debt crisis addressed by the proposal is the transfer of debts from the feeble banks to the sovereign administration. Once the banks had extended loans to borrowers without judging their credibility, sometimes they failed to recover the loan amounts. In critical cases it so happened that the banks had to be bailed out by the respective government or the ECB. The money had not to be re-paid and the banks used them to give further loans in order to maintain their position in the market. Once more they would be unsuccessful in recovering the loans and would ask for bailout. Thus a vicious circle of loans-loss-bailout-loan-further loss came into existence. Such has occurred in Ireland and recently in Spain where the governments’ own finance weakened in order to support the teetering banking sectors (Chaffin). Although substantial reforms have been made to the Economic and Monetary Union (EMU) the close financial as well as economic integration of the euro area has increased the chances of ‘cross-border spill-over effects’ in an event of bank crisis involving international debt. A genuine Economic and Monetary Union will include the main pillars of the Banking Union, i.e., a single rule book for all financial organizations in the single market, to strengthen deposit guarantee schemes, to establish national resolution funds and legislation. However the communiqué was not very clear about the issues pertaining to deposit insurance, bank resolution law and recapitalization devices. Apparently, although all the banks are to be supervised by a central body, for deposit insurance purposes nationality of each bank will be maintained. This paves way for a situation of dichotomy and bias towards any particular bank depending upon its economic condition. This might result in a chaotic situation. Besides, once the banks in the Euro area gets accepted into the system the European Stability Mechanism (ESM) (established on 27th September, 2012 as a firewall against possible bank failure in the Euro zone), it will be entrusted with the power to recapitalize a bank following the regular decision. This is targeted at breaking the vicious circle existing between the banks and the sovereign governments. However it has to be acknowledged that a good resolution mechanism (deposit payment made to the central bank and withdrawal of the bank’s license or change of ownership in case of bank failure) that actively plays its part to save a situation of unviable bank shall be good enough to break the links connecting the banks and the governments without intervention of ESM. Also, as long as the banks put on their national character such links cannot be broken totally (What Does European Banking Union Mean). In response to the proposal of establishing a banking union, several countries have showed their concern or fear. Such a method of unifying the monetary responsibilities of all the banks in the European Union is going to have a far-reaching effect on the growth of the economies. Germany, for example, is not willing to cede control of its entire banking sector. It wants that presently the new regulators should take control only of the biggest banks of the region, the smaller ones to be brought under the shade later on considering the fact that the smaller public sector banks follow a lower-risk business model and it is doubtful whether they can compete with the bigger banks under the uniform regime of the banking union. German Finance Minister Wolfgang Schäuble has argued in favor of a national supervision of small banks (Stevens and Henning). By agreeing to the new ECB regulation, all the banks including the smaller savings and co-operative banks will have to submit to the uniform deposit insurance system. This would provide support to the more unstable banks at the cost of the comparatively safer ones. Until now the state owned Landesbanks and the savings banks have been insuring each other’s deposit with unlimited guarantee. With the onset of the new regime, the guarantees would be limited to €100,000 or $129,000 (Stevens and Henning). Such debates regarding private and public-sector banks are also taking place in other countries like France and Austria. But Germany with 1,885 financial institutions being home to twice the number of banks than any other nation in the euro zone creates the major concern. The UK government also wants to stay out of the European Banking Union. It will not allow its banks to be supervised by the ECB. Financial Banking Chairman Adair Turner has stated that it felt like “being made captain of the Titanic after we’d hit the iceberg, but before we’d actually sunk” when he had been appointed the chairman of the FSA one week after the Lehman Brothers collapsed in 2008 (Mohinsky). The proposal of forming a banking union within the European Central Bank is due to be established by January 2013. But this plan has to be judged properly and must not be rushed through as said by the German Chancellor, Angela Merkel. The thought that is bugging some of the countries, particularly the ones with a healthy financial sector, is, the question of exposing themselves to the risk arising from integration of all the teetering banks across the European Union. The countries like the Czech Republic that do not belong to the Euro zone are naturally loathe to such a proposal since they have a quite healthy and highly capitalized financial sector. It can be induced that if they are to join the banking union they would be falling under the supervision of the ECB and the deposit insurance scheme covering all the banks. This would imply that a portion of the losses incurred by other banks and the burden of the debt being borne by other governments would be transferred to the Czechs. This would affect their economy adversely by bringing in a slowdown. Hence they have decided to veto against the proposal in case it is put to vote in its current shape. Sweden, like the Czechs, has also not complied with the proposal on the ground that their banks or taxpayers cannot be made to foot the bill for the others. In 1990s a financial crisis arose in the Czech Republic and Sweden that was handled by these countries without any external debt (Czech PM: EU banking union plan not acceptable in current shape) hence in the current scenario they do not want to submit themselves to the union that includes some of the worst affected and inconsistent countries of the European Union. The question of economic growth addressed and the risks involved The question of economic growth that arises inevitably out of the proposal of formation of the European Banking Union does not have a definite solution. It is bound to affect some of the economies negatively, especially those that have not been too significantly affected in the crisis. But it in the current scenario where five of Europe’s countries, namely, Greece, Portugal, Ireland, Italy and Spain are engulfed by the debt-shark, an immediate responsive action has to be taken. Before the crisis, the ECB was operating based purely on a monetarist concept looking solely after consumer price inflation. Therefore the necessity of a stronger authority to oversee all the banks in the European Union can be felt. Nonetheless, the European debt crisis has strong political implications. Within the member countries the financial austerity has lead to public protests as in Greece and Spain (Kenny) Amongst the member countries political tension is created, as it has happened between the fiscally sound countries like Germany and the higher debt countries like Greece. Greece, Ireland and Portugal have received a series of bailouts from the International Monetary Fund and European Central Bank. But bailouts cannot be the permanent cure to the problem since it is difficult to save bigger countries like Italy and Spain through the same means. Greece has been pushed to cut spending and raise its tax rates. But higher tax rates will lead to lesser disposable income and eventually lesser consumption. Thus output will fall and per capita income will drop leading to slackening of growth rate. The absolute amount of revenue collected will be ultimately lesser than before and the funds available for the country to meet their debts will be reduced. The policy-makers are faced with a difficult choice: whether to keep the currency union together along with all the challenges to be entailed or to allow Greece to exit from the Euro zone. If Greece exits from the Euro zone, it will lose the monetary efficiency gain that it used to enjoy using the Euro as its only legal unit of exchange while being in the Euro zone. On the other hand, although the economic stability loss for Greece may be reduced on leaving the zone, the fact that the country would stay in the European Union and face the same single market, might offset a portion of the reduction in stability loss. The single market of the European Union is one of the greatest achievements of the European integration. In fact the creation of the banking union is on the preset that it would not in any way hinder the unity and integrity of the single market. The “four freedoms” of the single market, namely the freedom of goods, services, capital and labor are subject to equivalent rules across the European Union. The commitment of the leaders towards the establishment of a banking union is supposed to work for an efficient handling of the debt ridden government and the troubled banks. There are two positive reasons behind this. Keeping aside the bank resolution system, the single resolution to be followed by the banking union will weaken the link between the governments and the troubled banks in way of governing the banks’ resolution and co-coordinating amongst them. In case of any cross-border failure the union can address it with the needed speed and credibility. If any bank gets into some difficulties, it is important for the public to have the confidence that the bank will be restructured or closed and the tax-payers’ cost will be minimized. Secondly, with a supervisory single rulebook, in the long run, the European single market in the banking sector will expectedly become more effective. Different supervisory handbooks followed by the member countries taking part in the single decision-making instrument would increase the risk of fragmenting the single market (Communication From The Commission To the European Parliament And The Council). Conclusion – why is it worth the risk Across the Euro zone, government debt averages to almost 90 percent of the annual economic output which is 60 percent above the limit of the fiscal rules of the region (while using statistical data provide exact reference). In this slack economy, growth is pitted against ‘heightened risk aversion’ as said by European Central Bank President Mario Draghi. Individual consumers as well as companies are focusing on improving their finances by cutting debts (explain the relation between debt and investment). In such a situation when growth is already under threat, whether formation of the European Banking Union will hinder economic growth further to a great extent, it is not yet fully researched on. It is not a single-ended issue and one side will get affected while easing out the problem on the other side. Yet, since we have already faced the need to create a central supervisory system, the leaders should take the necessary steps to move “towards a banking union, which was missing in the monetary union” (France bank chief urges European banking union) as said by the Bank of France Governor Christian Noyer. Works Cited Towards a Banking Union, Europa, 2010, November 29, 2012 from http://europa.eu/rapid/press-release_MEMO-12-656_en.htm#PR_metaPressRelease_bottom Communication From The Commission To the European Parliament And The Council, Europa, 2012 retrieved on November 29, 2012 from http://ec.europa.eu/internal_market/finances/docs/committees/reform/20120912-com-2012-510_en.pdf Kenny, Thomas, What is the European Debt Crisis?, About, 2012, November 29, 2012 from http://bonds.about.com/od/advancedbonds/a/What-Is-The-European-Debt-Crisis.htm Czech PM: EU banking union plan not acceptable in current shape, Reuters, 2012, November 29, 2012 from http://www.reuters.com/article/2012/10/17/us-eu-summit-czech-idUSBRE89G0NF20121017 Mohinsky, Ben, U.K. Will Stay Out of European Banking Union, Turner Says, Bloomberg News, 2012, retrieved on November 29 from http://www.bloomberg.com/news/2012-10-11/u-k-will-stay-out-of-european-banking-union-fsa-s-turner-says.html Stevens, Laura and Eyk Henning, Germany Balks at Bank Union, Wall Street Journal, 2012 retrieved on November 29 from http://online.wsj.com/article/SB10000872396390443696604577647750612500694.html What Does European Banking Union Mean, SeekingAlpha, 2012, November 29, 2012 from http://seekingalpha.com/article/940651-what-does-european-banking-union-mean Chaffin, Joshua, Barroso unveils European Banking Union, Financial Times, 2012 November 29, 2012 from http://www.ft.com/intl/cms/s/487af8ac-fcc6-11e1-ba37-00144feabdc0,Authorised=false.html?_i_location=http%3A%2F%2Fwww.ft.com%2Fcms%2Fs%2F0%2F487af8ac-fcc6-11e1-ba37-00144feabdc0.html&_i_referer=#axzz2DPUmBI7j The European Central Bank: The Main Cause of the Debt Crisis, CEPR, 2012, November 29 from http://www.cepr.net/index.php/blogs/beat-the-press/the-european-central-bank-the-main-cause-of-the-debt-crisis France bank chief urges European banking union, (2012) expatica, retrieved on November 29, 2012 from http://www.expatica.com/fr/news/french-news/france-bank-chief-urges-european-banking-union_250548.html Read More