Should the 'outs' join the European banking union?

Highlights For political reasons, European Union member states’ opinions on joining banking union range from outright refusal to active consideration. The main stance is to wait and see how the banking union develops. The wait-and-see positions are often motivated by the consideration that joining banking union might imply joining the euro. However, in the long term, banking union’s ultimate rationale is linked to cross-border banking in the single market, which goes beyond the single currency. This Policy Contribution documents the banking linkages between the nine ‘outs’ and 19 ‘ins’ of the banking union. We find that some of the major banks based in Sweden and Denmark have substantial banking claims across the Nordic and Baltic regions. We also find large banking claims from banks based in the banking union on central and eastern Europe. The United Kingdom has a special position, with London as both a global and European financial centre. We find that the out countries could profit from joining banking union, because it would provide a stable arrangement for managing financial stability. Banking union allows for an integrated approach towards supervision (avoiding ring fencing of activities and therefore a higher cost of funding) and resolution (avoiding coordination failure). On the other hand, countries can preserve sovereignty over their banking systems outside the banking union. 1. Introduction Banking union, which consists of the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM), was a reply to one of the root-causes of the European debt crisis - the sovereign-banking loop. The vicious circle linking the solvency of euro-area countries to the solvency of their banks contributed to the crisis. The sovereign-bank loop works two ways. First, banks hold on their balance sheets large amounts of the bonds of their own governments (Merler and Pisani-Ferry, 2012; Battistini et al, 2014). Consequently, a deterioration of a government’s credit rating would automatically undermine the solvency of that country’s banks. Second, a weakening of a country’s banking system could have implications for the government’s budget because of the potential for a government-financed bank bailout, and because of lower tax revenues resulting from the subsequent economic downturn (Angeloni and Wolff, 2012)1. The euro area fell victim to the sovereign-bank loop because national central banks have given up control over the currency in which their debts are issued, putting the European Central Bank (ECB) in charge. To break the loop, a June 2012 summit of euro-area heads of state and government2 decided to move the responsibility for banking supervision to the euro-area level as a pre-condition for direct bank recapitalisation by the European Stability Mechanism (ESM)3. Moreover, the ECB was substantially exposed to banks because it was forced to provide them with liquidity without having supervisory control. If ex-post rescues are organised at European level, ex-ante supervision should also be moved to European level to minimise the need for such rescues (Goodhart and Schoenmaker, 2009). The essence of banking union is therefore supervision and resolution of banks at supranational level. While euro-area members have been included in all elements of the banking union by default, the SSM also allows non-euro area EU members to participate. For these countries, an important strategic question is if and when they should join part or all of banking union. On this question, opinions differ (Figure 1). Sweden declared in 2014 that it will not join banking union in the foreseeable future, and has not since changed its view substantially4, remaining the United Kingdom's main ally on this issue. By contrast, Denmark's government said in April 2015 that it wants to become part of the banking union, because it views it as being in the interests of its financial sector (Ostergaard and Larsen, 2015)5. In central and eastern Europe, the Czech Republic remains sceptical about eventual participation in the banking union, and Hungary and Poland have also adopted wait-and-see approaches6. Bulgaria and Romania are more positive about joining banking union. In July 2014, Bulgaria said it would seek to join banking union after poor supervision led to the collapse of its fourth biggest lender7. Romania too has embraced the idea of joining banking union from early on (Isarescu, 2013). [infogram id="new_map___all_of_europe" prefix="SEh" format="interactive" title="new map - All of Europe"] These wait-and-see positions are often motivated by the consideration that joining banking union might imply joining the euro. However, we argue that in the long-term, banking union’s ultimate rationale is more linked to cross-border banking in the single market, which goes beyond the single currency. Therefore, the debate about whether to opt in to banking union is not necessarily a debate about joining the full package, eg joining both the euro and banking union.