The Big Idea That Won’t Fix Europe's Banks

Europe's banks have had a rough year: Their stock prices have fallen so low that some observers wonder whether they are viable in their current form.

Yet the most commonly proposed solution -- a true banking union -- is also deeply flawed.

The euro area's banking system faces numerous difficulties. These include economic growth that seems to be permanently slow, a common currency that punishes low-productivity countries, low or negative interest rates that are undermining profitability and new bail-in rules that impose losses on creditors precisely when the economy is most vulnerable.

The malaise has led to renewed calls to complete a project the euro area began in 2012: a banking union, in which member states would take joint responsibility for overseeing financial institutions, salvaging unhealthy ones and insuring depositors -- much as the Federal Deposit Insurance Corporation does for banks in U.S. states. The idea is that by sharing risks, the member states would protect weaker economies from the kind of financial crises that tend to hurt everyone.

The project, however, hasn't made much progress -- and not due to lack of foresight. Rather, a banking union tends to evolve into some form of fiscal union, in which one country's taxpayers may be called upon to help another's. That's unpopular, and pretty much impossible to sell to voters in the wealthier euro area countries.

Imagine a pan-European version of the FDIC, with countries or banks paying into a fund that insures deposits throughout the euro area. By making depositors indifferent to the risks banks take on, the guarantee would eventually spread to other parts of the economy. A financially troubled government, for example, could easily pressure banks to buy its securities -- effectively relying on the insurance to support its fiscally questionable behavior. If the government ultimately defaulted, other countries' taxpayers would be responsible for making the depositors whole -- not quite the same as a fiscal union, but pretty close.

Experience suggests this is entirely possible. Around the time of the 2011 sovereign-debt crisis, European banks were very heavily loaded with government securities, in part because fiscally weak domestic governments had encouraged it. Some commentators compared this arrangement to two drunks leaning against each other, with no lamppost in sight. The incentives for such a dangerous dependence would be stronger yet if bank deposits were guaranteed at the euro area level.

Governments could also take advantage of deposit insurance more directly, through state-owned banks. Suppose Portugal expanded the operations of the government-owned Caixa Geral de Depósitos, the largest bank in the country, to attract deposits and invest the money in infrastructure and other state projects. By insuring the deposits, the EU authority would in essence be guaranteeing a bond issue of the Portuguese government, even though the funds would be channeled through a bank. This wouldn't be a fiscal guarantee of the entire Portuguese government budget, but it could prop up spending at the margin.

The more Machiavellian amongst us might see banking union as a useful way to achieve a fiscal union surreptitiously. The Brexit vote, however, showed where such thinking can lead. Among the Leave campaign's most popular points was the claim that Britain was sending the EU 350 million pounds a week -- and that wasn’t even true. Imagine the possible furor if voters learned that large transfers were actually institutionalized through the banking system.

So if a banking union is a non-starter, what will happen? Individual governments will probably have to take on the burden of propping up banks, with repercussions for state finances. Italy, which seems to have by far the largest bank problem, can still borrow money at negative nominal interest rates. So it can issue government bonds to bail out financial institutions -- an outcome that would probably be more palatable for German taxpayers and voters. Whatever EU rules this may violate can almost certainly be bent: When Spain and Portugal recently ran over their allotted deficit targets, they incurred only a symbolic fine of zero euros. That too is a kind of fiscal transfer, involving pride rather than money. Whether it is small or large remains to be seen.

Expect European pride to take a further hit as government deficits grow and the can gets kicked just a wee bit further down the road.