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A Banking Union Backwards

Published on , , Zagreb, Twitter: @AdelinaMarini
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Every now and then you will hear politicians, economists and central bankers that there is nothing more important for the survival of the eurozone than the establishment of a banking union. Nonetheless, progress in its construction is very slow and hesitant. According to Thomas Mayer, senior adviser at Deutsche Bank and a senior fellow at the Goethe University Frankfurt, the reason for that slow tempo is the fight which government should be a payer of last resort when banks collapse due to bad loans in the past. In his analysis for the Centre for European Policy Studies (CEPS), Mr Mayer proposes for the sake of overcoming the current deadlock, the construction of the union to start backwards because if things are left in the same spirit, we will hardly witness a full fledged banking union.

The order of stages in building the banking union, as agreed at European level, is a single banking supervision first, which was relatively quickly agreed. The next step is again a single mechanism for bank resolution which, however, was surrounded by controversy even before the beginning of that stage and is expected that it will rule over the entire first part of the upcoming political season. The analyst proposes construction to be reversed and start with the third step - deposit insurance - and only then to move forward with resolution and end with supervision.

Thomas Mayer outlines his idea in much detail about how exactly should the insurance of deposits look like to allow determining which assests could participate in a possible bail-in. According to him, the change of the method of construction of the banking union will lead to a serious change of the way the banks and governments act. The banks will no longer be able to extend credit and create book money at will. Instead, they will undertake the dual role of a safe keeper of risk assets, meaning central bank money for deposit savers, and of a mediator between investor-savers and entrepreneurs.

With this scenario it is possible the banks to raise the interest rates on loans, but then savers will realise that bank deposits bear a credit risk unless they are entirely supported by central bank reserves. Mr Mayer believes that there is a wide-spread misconception that bank deposits in the current reserve banking system  (when the bank holds only a part of the deposits as a reserve and the rest uses for investments or loans) are completely safe and can be converted into central bank money at any time. This, practically, is a subsidy to bank lending rates for the government, the analyst is convinced.

And governments, for their part, will no longer be able to rely on banks to finance their debt and will have to obtain funding from the capital markets. The costs for that will increase for them, too, because they will no longer be viewed as offering risk-free assets and therefore they will no longer be able to profit from preferential treatment. Thus, an end will be put to the subsidies to government borrowing as a result of special regulatory treatment.

In conclusion, the author points out that the banking union can be built in three steps. The first is to introduce deposit insurance in the euro area by demanding banks to support the fully insured deposits with central bank reserves. This will be the only secure asset in the euro area where governments do not have control over the money printing machine. All bank liabilities can be involved in covering losses in a hierarchical order introduced through a common bank resolution regime as a second step. In order to help banks get rid of government bonds, the ECB could buy these bonds out by replacing the risk claims of banks on governments with risk-free claims of banks on the ECB as a third step. Governments and the ECB could agree to use future seigniorage income to pay down the government debt held by the ECB.

What the German expert proposes is a serious revolution in banking as he insists on the establishment of a banking regime that will be able to work without government assistance. It is no accident, then, that Mr Mayer has titled his proposal "A Copernican Turn", a metaphor introduced by German philosopher Immanuel Kant and symbolising radical change.

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