Is Europe’s banking union flawed?

Howard Davies, former Chairman of Britain’s Financial Services Authority, Deputy Governor of the Bank of England, and Director of the London School of Economics, is a professor at Sciences Po in Paris.

PARIS – The European Union is now the proud owner of a Nobel Peace Prize. When the choice alighted on Barack Obama three years ago, the Norwegian Nobel Committee was criticized for honoring someone whose achievements were still to come. The Committee took that criticism to heart, and this time decorated an institution with a proud past, but a clouded future.

The eurozone is distinct from the EU of course, but it is the Union’s most ambitious undertaking to date, and it is still struggling to equip itself with the structures needed to bolster a currency union. A common fiscal policy remains a distant dream, as does a genuine political union.

But Europe’s policymakers claim to be making progress toward a so-called “banking union,” which means collective banking supervision, rather than a merger of banks themselves. In September, the European Commission announced a plan to make the European Central Bank the supervisor of all 6,000 of Europe’s banks.

The reaction among national politicians, central banks, and banks themselves was not universally favorable. The Germans want the ECB to focus only on large systemic banks, and leave smaller savings banks (like those that invested heavily in subprime mortgages) to national authorities. The United Kingdom and Sweden argue that they cannot be made subservient to a central bank of which they are, at best, semi-detached members.

The case for a pan-European supervisor is widely accepted, especially as the European Banking Authority (the EU’s banking regulator) proved feeble in carrying out financial stress tests: the first tests were so weak that even Spain’s now-bankrupt savings banks could pass with flying colors. Europe must break the vicious circle linking distressed sovereign borrowers with banks that are obliged, or at least encouraged, to buy their bonds, which in turn provide the funding for bank rescues.

But the method chosen by the Commission to implement a banking union is fatally flawed.  Moreover, according to a leaked opinion from the EU Council’s chief legal adviser, the proposed reform is illegal, because, according to the Financial Times (which received the leak), it goes “beyond the powers permitted under law to change governance rules at the European Central Bank.”

Throughout the crisis, European leaders have tried to respond to the gaps in the monetary union without proposing a new treaty, because they fear that any new treaty proposing more centralization of authority in Brussels would be rejected, either by national parliaments or by voters in a referendum. So they have tried to proceed by intergovernmental agreement, or by using existing treaty provisions.

In the case of the banking union, they plan to use Article 127(6) of the Lisbon Treaty which allows the European Council to grant authority to the ECB to perform specific tasks concerning “policies relating to the prudential supervision” of certain financial institutions in the Union. That is a thin legal basis for establishing a pan-European supervisor with direct responsibility for individual institutions, and it was clearly not intended for that purpose. Indeed, Germany agreed to the wording only on the understanding that the ECB could not be a direct supervisor.

The consequences of choosing this inadequate, if expedient, route are serious. For starters, the existing treaty cannot be used to create a single European resolution authority, leaving an awkward interface between the ECB and national authorities. Nor can it be used to establish a European deposit protection scheme, which is arguably the most urgent requirement, to stem the outflow of deposits from southern European banks.

There will also be potentially dangerous consequences for the ECB itself. The use of the Lisbon Treaty clause means that the ECB must be given these additional responsibilities. But it is impossible to create a separate bank-supervision entity within the ECB, as has been done in France, for example, with the Prudential Control Authority, or in the UK with the new Prudential Regulatory Authority, which has its own board and accountability arrangements within the Bank of England.

The importance of these structures is that they insulate the central bank’s monetary-policy independence from corruption by the tighter accountability requirements that inevitably come with banking supervision. Because supervisors’ decisions affect individuals’ property rights – and their actions or omissions can put taxpayers on the hook to bail out banks – governments, parliaments, and the courts are bound to hold the watchdogs on a tight leash.

That is why Germany’s Bundesbank, which always guarded its monetary-policy independence so assiduously, has once again found itself in the rejectionist camp, expressing severe doubts about the route that the Commission plans to take. This time, they are right.

There are other serious issues, too. According to the Commission’s model, the European Banking Authority will remain in place, and is charged with producing a single rulebook for all 27 EU member states. But, while its work is carried out under the normal qualified majority voting system, the 17 eurozone countries will have a single supervisor, so will have a block vote. The Commission is trying to find ways to protect the rights of the non-eurozone countries. But the very complexity of what is proposed shows just how inadequate the scheme is.

Non-Europeans, in particular, may find the entire topic impenetrably abstruse. But it illustrates a simple point: Europe is trying to achieve a stronger federal model that responds to the weaknesses revealed by the eurozone crisis. But it is doing so without addressing the crucial need to bring its citizens along. Indeed, the devices that the EU is adopting are designed specifically to avoid having to consult them.

The proposed construction of a banking union reveals this fundamental flaw at the heart of the European project today. It is difficult to be optimistic about the success of an initiative built on such flimsy legal foundations, and lacking democratic legitimacy. Europe’s banks and their customers deserve better.

The opinions expressed here are those of the author, not necessarily those of the World Economic Forum. Published in collaboration with Project Syndicate.

Image: A sculpture  of the Euro currency sign is seen in front of the ECB headquarters in Frankfurt. REUTERS/Alex Domanski