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The European financial crisis is almost six years old. By now, it has too many strands to be reduced to a one-dimensional narrative. It is also part of a wider international sequence of financial turmoil. Its early phases were sparked by the US property market downturn and loss of confidence in US mortgage-based securities in mid-2007, and later by the shockwaves following the collapse of Lehman Brothers in September 2008. Inside Europe, different drivers of the crisis have been identified, including inadequate fiscal policies, structural rigidities and low productivity performance, and regional macroeconomic imbalances.
Today I want to focus on one such driver which, in my reading, has been a central connecting thread of the crisis and bears some uniquely European characteristics. I am referring to the mismatch between, on the one hand, financial market integration, which is very much about banking as banks dominate credit intermediation in Europe; and, on the other hand, the fragmented nature of banking policy in Europe, which until now has remained principally in the hands of national authorities. This mismatch between market structures and institutional arrangements has resulted in a powerful and often under-recognized impact on the propensity of national authorities to view the competition among banks in Europe as a proxy for a competition among member states and their respective national interests, and to act accordingly in the execution of their banking policies and especially in bank supervision.
This attitude can be labelled “banking nationalism” by analogy with “economic nationalism,” an expression which has become commonly used to refer to government supporting or protecting domestic corporate actors perceived as “national champions,” or undermining foreign such actors seen as champions of competing national interests, usually in contexts which involve an element of cross-border economic competition. Banking nationalism is often more potent than other forms of economic nationalism, because of the dense webs of relationships between banking sectors and governments. These include (but are not limited to) explicit guarantees of segments of banks’ activities and banking regulation to protect financial stability, as well as the role of banks in financing the national economy in general, and government operations in particular.
These webs of relationships, and banking nationalism itself, are by no means unique to Europe. While they are never identical from one country to another, they exist in all developed and emerging economies. What is unique to the European Union is their coexistence with a legal framework that bans financial barriers between member states and creates a seamlessly integrated supranational financial market, at least in principle—developments earlier this year in Cyprus having shown that the abolition of national financial borders is less absolute and irreversible than had been previously assumed by many.
In my analysis, the mismatch between European market integration and national banking policy and the resulting impact of banking nationalism have played a central role both in the buildup of financial risk in Europe prior to the crisis, and in the inability to resolve this crisis so far. I will conclude by briefly reflecting on the current initiatives to chart a path towards European banking union.
The Run-up to the Crisis
Before the crisis, banking nationalism and its interaction with the drive towards a single financial market should be assigned a significant, though not exclusive, share of responsibility in two developments that have greatly contributed to the fragility of the European financial system. The first of these is the excessive buildup of leverage in European banks, and the second is the comparatively stunted growth of non-bank finance.
As is well known, the “abolition of obstacles to freedom of movement for capital” across borders in Europe was included as one of the missions of the European Community in the 1957 Treaty of Rome, alongside parallel freedoms for persons and services, and the elimination of customs duties and creation of a single market for goods. But that treaty’s chapter on capital also provided for considerable prudential exceptions. Until the late 1980s, Community policies to integrate Europe’s financial markets had remained comparatively timid, and financial systems had remained predominantly national.
The late 1980s and 1990s brought four changes which radically transformed this context and materialized the promise of a single financial market. First, a 1988 directive mandated the abolition of capital controls. Second, the Maastricht Treaty enshrined this obligation in primary legislation, and further paved the way for the creation of the euro which came into existence in 1999. Third, the excommunist candidate countries for EU membership in Central and Eastern Europe gradually privatized most of their financial institutions, and in most cases accepted their purchase by Western European banking groups; cross-border bank consolidation also gathered pace inside Western Europe, particularly at the subregional level, such as in the Benelux and in Scandinavia. Fourth, from 1999 onwards the European Commission developed a more assertive competition policy to prevent member states from erecting barriers against such cross-border banking consolidation or otherwise distorting the European market, e.g., though the provision of state guarantees to selected banks. These steps brought Europe much closer to a united banking and financial market, and created the perception of an unstoppable trend towards cross-border integration.
The sea change of market environment prompted banks to position themselves for what most thought was an inevitable incoming consolidation wave. To achieve this, banks sought size, and found it mainly through domestic acquisitions and financial leverage. In a different context, supervisors might have prevented these strategies. Authorities might have frowned on domestic consolidation which not only distracted bank executives from their risk-management duties, but also led to dangerously high levels of market concentration at least in some European member states. On the contrary, the creation of large national banking champions was viewed positively in most cases, as it made it more likely that domestic banks would act as acquirers rather than targets in future cross-border consolidations.
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