European banking union will be no friend of vibrant financial services

Roland Vaubel
WOLFGANG Schäuble, the German finance minister, recently said that “we can only achieve political union if we have a crisis”. His idea is to exploit the Eurozone’s sovereign debt problems to confer additional powers on the EU. And his most recent project is the “single supervisory mechanism” – otherwise known as banking union. EU finance ministers are meeting this week to thrash out the details.

The argument goes that, if Europe directly finances the recapitalisation of Greek and Spanish banks, these institutions should fall under the supervision of a single authority. Schäuble asserts that national regulators lack the incentive to be strict, and that a European supervisor is needed to prevent moral hazard. But he is wrong, and the UK is wrong to be sympathetic.

Firstly, the incentive to be strict depends almost entirely on the price of bail-out loans. A lender of last resort ought to lend at a penalty. The problem here is not national regulators but the European Stability Mechanism (ESM) – the body meant to provide financial stability in Europe. If the ESM charged punitive rates of interest, instead of subsidising loans, moral hazard would disappear.

Secondly, proponents of banking union suggest that national bank supervision creates a vicious circle due to regulatory capture. According to this story, banks persuade regulators to be lax in exchange for promising to buy government bonds at low interest rates. When a banking crisis causes a budgetary crisis, therefore, the collapse of bond prices feeds back to bank balance sheets, thus aggravating the banking crisis. European bank supervision, it is said, would prevent regulatory capture and interrupt this cycle.

But this justification is also unconvincing. The budgetary problems of most southern Eurozone countries were not caused by a need to support banking. Greece, Portugal and Italy did not have to bail out banks during the financial crisis. Moreover, regulatory capture may be stronger on a European level. By shifting lobbying upwards, interest groups can escape the attention of voters – their rivals in influencing policy. One recent study concluded that “the EU is now more lobbying-oriented than any single European country.”

Most importantly, you don’t need European banking supervision to eliminate this vicious circle. If regulators are inducing banks to hold excessive amounts of government debt, this could be stopped through a rule that limits the share of government debt that can be held in a bank’s portfolios.

Some justify banking union by referencing the failure of national regulators during the financial crisis. It’s true that they did fail to foresee it. But so did the European Commission – even though it’s responsible for the EU’s internal market. And although multinational banks did pose a problem for regulators, these issues have been handled effectively through bilateral cooperation between them. Would 27 EU members, or a majority among them, have known better?

Perhaps the strongest justification for European supervision is that policies in one country cause external effects in others. But, the internal effects of bank failure are much greater than those outside. A national regulator has a stronger interest in adequate supervision than a European authority deciding by majority vote. It follows that supervisory control should primarily rest with the national supervisory authority. National authorities tend to be better informed and have better incentives.

Most perniciously, banking union advocates suggest that there should be a level playing field in banking regulation. But there are key reasons not to impose equal conditions on all markets. National banking systems differ, and consequently have different needs. Regulatory competition generates peer pressure and encourages innovation. Further, decentralised supervision helps to diversify regulatory risk.

There is a real danger that Europe will create a level playing field with a very high level of regulation. If decisions are taken by the majority – as is currently the case across much of the EU – the majority of highly-regulated member states have an incentive to impose their regulations on the minority of less regulated member states to reduce the competitiveness of the latter. This is the so-called “strategy of raising rivals’ costs”. A banking union would be no friend of a vibrant market in financial services.

Roland Vaubel is professor of economics at the University of Mannheim.