Stress Tests Are Not Enough to Fix the Banks

The situation in Europe has developed from a financial and banking crisis into a sovereign debt crisis, and from there to an institutional crisis, as the European Union’s collective inability to make effective decisions becomes an ever larger part of the problem. These three components of the predicament feed each other; they also threaten international financial stability.

The banking component can no longer be separated from sovereign and institutional developments. This is why today's publication of stress tests results, while useful, is unlikely to be the game-changer it could have been two years ago. The London-based European Banking Authority (EBA) has led the tests with a firmer hand than many anticipated. But even with these disclosures, individual member states remain in charge of ensuring that the weaker banks raise the capital they need, or are properly sold or restructured if they cannot. On past experience, many will be reluctant to do so, allowing Europe’s banking system to remain fragile.

In this, the stress tests exemplify the frustrating and unstable hybrid that is European financial integration. Financial services in the European Union are more integrated than in any comparable set of countries, with related economic benefits. But in most of the euro area, cross-border bank ownership remains limited: Only 5 percent to 13 percent of banking assets in France, Germany, Italy, the Netherlands, and Spain are foreign-owned, so market power and systemic risk are concentrated.

The pre-crisis momentum was towards more integration, with a slow dismantling of regulatory barriers, and pan-European banking groups gradually emerging from cross-border acquisitions. But the resurgence of sovereign risks has partly reversed this trend. In many member states, EU financial integration was not advanced enough to prevent renationalization of credit conditions, even though the effect has been muted by the European Central Bank’s (ECB) exceptional liquidity provision. Crisis-induced bank mergers have tended to be intra-country rather than cross-border, as between HBOS and Lloyds, Dresdner and Commerzbank, or Spanish savings banks (Fortis Belgium is the exception). In the United Kingdom, the Vickers Commission has made regulatory proposals that are compelling but that sit awkwardly with the EU’s single market framework.

The crisis has revealed that the EU banking market cannot be truly integrated as long as banks are implicitly guaranteed by fiscally sovereign national governments. Even in the United States, market integration has been slow and protracted, from the first nationally chartered banks during the American Civil War to the creation of the Fed, the New Deal’s overhaul and, finally, the Reagan-era dismantling of barriers to interstate banking. In the less-than-federal European Union, the crisis creates a real risk of harmful financial disintegration along national lines. To prevent it, the European Union must go beyond the publication of stress test results. It must partly sever the link between governments and banking systems, deeply embedded as it is in political economy and history, and establish the institutional basis for a credible EU-level banking policy. Fast-moving developments on sovereign debt may force quicker decisions than had been envisaged even recently.

European leaders should ask the European financial stabilization facility (EFSF) to guarantee explicitly all the euro area’s national deposit guarantee schemes, thus countering the risk of bank runs in countries facing sovereign debt restructuring. The EBA, after its competent handling of the stress tests, should be granted direct supervisory and resolution authority over pan-European banking groups, either by EU decision or unilaterally by countries that are home to the largest such groups, including Austria, France, Germany, Italy, Spain, and Sweden. This should also allow it to facilitate cross-border acquisitions of undercapitalized banks and negotiate the multilateral provision of taxpayer support in extreme cases (as happened for Dexia in 2008). The governance of the EBA should also be amended, with a new executive board as exists at the ECB to properly represent and defend the common European interest.

Decisions taken in the coming months will determine, among other things, whether the legacy of this crisis is an integrated European banking system or a move back towards fragmentation. The steps proposed here on banking would not replace urgent necessary actions on the sovereign and institutional fronts, but they are a necessary building block for a comprehensive solution. In Europe too, united we stand or divided we fall.