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Can Banking Plan Aid Eurozone?

Interviewee: Domenico Lombardi, Senior Fellow, Global Economy and Development, Brookings Institution
Author: Christopher Alessi
July 12, 2012

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Eurozone leaders are pushing ahead with plans for a single banking authority (WSJ) situated in the European Central Bank, a first step toward developing a eurozone banking union. The new banking supervisor would be able to activate the permanent euro rescue fund--the European Stability Mechanism--to directly recapitalize struggling eurozone banks, rather than channeling funds through national treasuries and adding to a country's debt burden, says the Brookings Institution's Domenico Lombardi. This new banking oversight system could prove vital for Spain, which is expected to receive a €100 billion ($1.23 billion) EU bailout to rescue its flailing financial sector. "As the Europeans set in motion this framework over the next few months, the remaining part of this 100 billion could be channeled through this innovative mechanism," Lombardi notes.

Can you give an overview of European plans for a new eurozone banking union, which was tentatively agreed to at a leaders' summit last month?

Clearly, to have a full-fledged banking union, you need to achieve quite a close fiscal union.

It was decided that the European Commission will present proposals for a single supervisory mechanism. Such proposals will be presented by the end of the summer. Then member states will have an opportunity to assess those proposals and finally will make a decision at the European summit that will take place by the end of the year.

We should expect a single supervisory mechanism that will [directly] involve the European Central Bank or an agency controlled by the European Central Bank. This mechanism will be able to activate the European Stability Mechanism for recapitalizing banks under stress directly, rather than going through the treasury of the relevant country, as is currently the case. And the idea is, through these measures, to establish an embryonic banking union. Clearly, to have a full-fledged banking union, you need to achieve quite a close fiscal union. In the end, resources to cap banks under stress will have to come from taxpayers--and therefore, having [in the future] a euro area-wide deposit insurance mechanism [would be] tantamount to having a fiscal union.

How would this single banking authority operate?

The single supervisory authority will be responsible for implementing banking and financial supervision based on the commonly agreed commitments of Basel 2.5 and Basel 3.0, commitments the European Union has already taken. The single supervisory mechanism will be regulating the financial institutions based on this [Basel] international framework.

The idea is that if there is a single supervisory mechanism--with that the possibility of reinforcing banks in distress--then capital flows within the euro area could resume.

The reason why a single supervisory mechanism is by far a superior choice to having national supervisory mechanisms [is that] the reason to have a monetary union was and still is to improve cross-border financial allocations. What we have noticed since the start of the euro crisis is that these financial flows have [been] repatriated. Capital flows have been nationalized, in that their investment has become national in scope and, in a sense, the monetary union is not applying to banking and capital flows within the euro area. The idea is that if there is a single supervisory mechanism--and with that the possibility of reinforcing banks in distress--then capital flows within the euro area could resume.

The EU recently agreed to provide Spain with a 100 billion bailout to recapitalize its banks. How will this new supervisory authority affect that agreement?

A first part of this 100 billion will be channeled through the Spanish deposit insurance mechanism and will be guaranteed by the Spanish treasury. So the first part, 30 billion, will be channeled according to the current model of essentially intervening at the central level, not intervening directly to cap [Spanish banks]. But as the Europeans set in motion this framework over the next few months, the remaining part of this 100 billion could be channeled through this innovative mechanism [directly from the ESM to Spanish financial institutions].

A timely and massive intervention to reinforce and stabilize the Spanish financial sector is key to bolstering confidence in the markets.

Will Spain be forced to request a full-fledged bailout from the EU to rein in its sovereign debt?

The vulnerability in Spain arises from a shaky financial sector. Spain doesn't really have a big debt-to-GDP ratio, compared to Italy; however, there's a substantial uncertainty in the markets that if there's no intervention in the financial sector, the Spanish treasury will eventually have to take the liabilities off the financial sector. And this is why a timely and massive intervention to reinforce and stabilize the Spanish financial sector is key to bolstering confidence in the markets--and to break this vicious circle of [the] financial sector under stress that leads to added strains on the sovereign.

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