a negative feedback loop, with the problems of one feeding on those of the other. to break out of this loop, elements of a banking union are currently being discussed. these elements need to be considered together and seen in the light of the trade - off between insurance and incentives. the first element of the banking reform is the creation of a single supervisory mechanism involving the ecb. besides the obvious coordination and information benefits for supervising banking in a financially integrated area, and given the risk of regulatory capture when the supervisor and the supervised are too close to each other, partially transferring supervisory authority up one level can be seen as a commitment not to renegotiate. it limits regulatory forbearance ( a form of insurance ) and serves as an incentive for sound risk management in the banking sector. it also ensures the singleness of banks ’ liabilities in the euro area, congruent with the single monetary policy. within the ecb, there should be a strict separation between the single supervisory mechanism and monetary policy, as a way to safeguard incentives when liquidity is extended. to quote bagehot once again : “ any aid to a present bad bank is the surest mode of preventing the establishment of a future good bank. ” 1991 ; and d. diamond and r. rajan, “ liquidity risk, liquidity creation, and financial fragility : a theory of banking, ” journal of political economy, 2001. see w. bagehot ( 1873 ), lombard street : a description of the money market, henry s. king and co. see t. sargent and n. wallace, “ some unpleasant monetarist arithmetic ”, federal reserve bank of minneapolis quarterly review, fall 1981, pp. 1 – 17. see w. bagehot ( 1873 ), op. cit. bis central bankers ’ speeches once incentives are upheld, it is possible and desirable to provide insurance. incentive - compatible insurance must, however, be partial. and that is why it is important to add other elements to complement the single supervisory mechanism. one such element is a european resolution mechanism. since a bank ’ s debt should not be insured in full, it should, and in fact will, be possible for banks to fail. since the beginning of the financial crisis in august 2007, the federal deposit insurance corporation ( fdic ) lists 466 cases in which banks in the united states failed. given the special role of banks as intermediaries, the failure of one bank

stop driving altogether if we had to fully pay for the consequences of an accident. insurance improves ex post efficiency. mark twain is credited with saying that : “ a banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain ”. he describes a world that is not ex - post efficient. let ’ s now take an ex ante perspective. carrying an umbrella does not encourage rain, but why drive carefully if we never bear the negative consequences of careless driving? insurance may well encourage imprudent driving. in other words, insurance hurts incentives, that is, it reduces ex ante efficiency. the way to manage the trade - off between ex ante and ex post efficiency is through partial insurance. we are usually not fully insured against car accidents. there is a deductible, a sum that we have to pay out of our own pocket if we file an insurance claim – in finance speak : we bear the “ first loss ”. moreover, our insurance depends on the car we drive, our past record of insurance claims and also on whether it can be shown that we were negligent or not. in other words, insurance companies worry about the behaviour that insurance induces. the trade - off between ex ante and ex post efficiency is apparent from the fact that if the deductible is too high, it may discourage insurance and therefore driving altogether. if, on the other hand, the deductible is too low, then drivers may become imprudent again. the same trade - off can be found in other policy domains – say, for example health care co - payments –, and, as i will argue next, in the relationship between outside investors and inside users of funds. 2. the case of sovereign debt : insurance and incentives to some extent, a borrower ’ s income and hence his ability to repay debt is subject to forces outside his control. a bank, for example, cannot perfectly control its cash flow, which depends on what its competitors do and on general economic conditions, among other factors. similarly, a country cannot perfectly control the business cycle ; its income also depends on worldwide conditions that matter for its imports and exports. at any moment in time, there can be mismatch between a borrower ’ s income and his expenditures. without access to capital markets, without the ability to borrow, banks would have to cut lending and countries would have to limit the provision