Via Peter Hooper, Chief Economist, Deutsche Bank, from a new report titled  Global Economic Perspectives: The Crux of Banking Union

In order to separate banks from states and end the vicious circle of banking and sovereign debt crises authorities in 2012 decided to build a “Banking Union” in EMU. In Banking Union, banks should be centrally supervised, centrally restructured or resolved, and benefit from common deposit insurance. At its meeting in June 2012, the European Council set the goal to have at least the key parts of Banking Union ready at the beginning of 2013.

  • Developments since then have been disappointing. It is taking longer than expected to set up a Single Supervisory Mechanism (SSM), and it is proving more difficult to establish a Single Resolution Mechanism (without which the SSM would end up as a paper tiger). Common deposit insurance has been postponed indefinitely.
  • At the heart of the difficulties is disagreement on who should finally foot the bill for banking crises. The authorities are discovering that separating banks and states at the national level only reunites them at the euro area level.
  • In this note we argue that the reasons for the encountered difficulties lie in the nature of fractional reserve banking. If banks are to be truly separate from states, this model would have to be changed. We show how this could be done, but we are not very optimistic that governments will agree on changes to fractional reserve banking, because they rely on this banking model for having access to cheap credit.

European Banking Union Bank Balance Sheets

European Banking Union Economic Forecast

European Banking Union GDP Growth

The Crux of European Banking Union

  • In order to separate banks from states and end the vicious circle of banking and sovereign debt crises authorities in 2012 decided to build a “Banking Union” in EMU. In Banking Union, banks should be centrally supervised, centrally restructured or resolved, and benefit from common deposit insurance. At its meeting in June 2012, the European Council set the goal to have at least the key parts of Banking Union ready at the beginning of 2013.
  • Developments since then have been disappointing. It is taking longer than expected to set up a Single Supervisory Mechanism (SSM), and it is proving more difficult to establish a Single Resolution Mechanism (without which the SSM would end up as a paper tiger). Common deposit insurance has been postponed indefinitely.
  • At the heart of the difficulties is disagreement on who should finally foot the bill for banking crises. The authorities are discovering that separating banks and states at the national level only reunites them at the euro area level.
  • In this note we argue that the reasons for the encountered difficulties lie in the nature of fractional reserve banking. If banks are to be truly separate from states, this model would have to be changed. We show how this could be done, but we are not very optimistic that governments will agree on changes to fractional reserve banking, because they rely on this banking model for obtaining cheap credit.

Banking Union Introduction

Banks have played a central role in the crisis of EMU. In some countries, they have recklessly lent to private households for the purchase of existing or newly built houses (e.g., Ireland and Spain). In other countries they have liberally lent to governments that were unable to balance their budgets (e.g., Greece and Portugal). Since the introduction of the euro eliminated exchange rate risk, banks could lend freely across borders and finance very large current account imbalances within the euro area. When the global credit bubble burst, bad private sector loans by banks triggered massive government support that pushed states to the verge of or into insolvency. At the same time, illiquid or insolvent states threatened the existence of banks that had accumulated large exposures to these entities.

Efforts To Stop Banking Union

Against this background, it seemed only logical when in 2012 efforts got under way to separate banks from states by creating a so-called Banking Union. In Banking Union, banks should be centrally supervised, centrally restructured or resolved, and benefit from common deposit insurance. At its meeting in June 2012, the European Council set the goal to have at least the key parts of Banking Union ready at the beginning of 2013.

Developments since then have been disappointing. It is taking longer than expected to set up a Single Supervisory Mechanism (SSM), and it is proving more difficult to establish a Single Resolution Mechanism (without which the SSM would end up as a paper tiger). Common deposit insurance has been postponed indefinitely. At the heart of the difficulties is disagreement on who should finally foot the bill for banking crises. The authorities are discovering that separating banks and states at the national level only reunites them at the euro area level. We shall argue in this note that the reason for this lies in the nature of fractional reserve banking. If banks are to be truly separate from states, this model would have to be changed. We show how this could be done, but we are not very optimistic that governments will agree on changes to fractional reserve banking, because they rely on this banking model for having access to cheap credit.

Banking Union – The Problem With Fractional Reserve Banking

Students of economics generally learn fairly early in the curriculum that banks keep only a fraction of their deposits and lend on the rest. They get acquainted with the money multiplier and are told that fractional reserve banking allows banks to create their own money (“inside money”), which they promise to exchange into legal tender (“outside” or central bank money) any time the depositor wishes to do so. However, since economic history is rarely part of the core curriculum, only few are taught that it was fractional reserve banking that led to the creation of central banks as lenders of last resort. Until the beginning of the financial crisis, even fewer were taught that fractional reserve banking also requires the state to back the banking system in times of systemic solvency crises. Fractional reserve banking was established as the predominant business model for the industry in the 14th century in northern Italy, and it took until the middle of the 17th century, when the Swedish Rijksbank was created, for central banks to emerge as lenders of last resort. It took until the early 1930s, when the Roosevelt administration established the Federal Deposit Insurance Corporation, until it was recognised that fractional reserve banking also required backing by a public institution in a systemic solvency crisis.

The reasons for the need of a central bank and a state to back banks in times of crises are quite simple:

  • Banks creating (inside) money through credit extension need a central bank as a supplier of central bank (outside) money when the public suddenly wants to exchange inside against outside money. The central bank then acts as a lender of last resort to avoid a liquidity crisis. To prevent the central bank from funding banks that have made bad lending decisions, the 19th century British economist Walter Bagehot
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