All hail the banking union

Eurozone leaders emerged from their latest all-nighter with a plan that sent the markets into paroxyms of relief: The German and French stock markets were up more than 4 percent Friday. The key heralded result was a commitment to move toward a banking union. This was taken as a critical concession by German Chancellor Angela Merkel and a key move toward resolving the crisis.

As the good folks at Foreign Policy have helpfully documented, this is not the first time European summiteers have stepped out, bleary-eyed, and announced there would be economic peace in our time. It’s roughly the 20th. I warned before about celebrating any European plan to have a plan, and that’s what this is. But how good is the plan? Is it a significant step toward solving the euro crisis?

The most striking move was the promise of a banking union. The European Central Bank would be given new regulatory powers over eurozone banks and European bailout funds could be sent directly to ailing banks to support them, without adding to national indebtedness. It would be nice to be able to dissect the details of how this new scheme will operate, but there aren’t any yet. The bailout funds cannot be tapped until the ECB is empowered, and that will take at least a few months.

In theory, a move to bolster Europe’s ailing banks could help. As the 2008 financial crisis aptly demonstrated, the financial sector provides the lifeblood of an economy; cut it off and the economy turns distinctly blue. Europe’s economies are notably more dependent on bank finance than the U.S. economy and the banks of the troubled economies on the periphery have had trouble raising funds and retaining deposits. A move to bolster them could potentially stop a direct drain on the funds of impoverished sovereigns and move toward restoring normal functioning and growth in those economies.

There has been a clamor for such moves, partly on the well-established theory that banking panics can be self-fulfilling. The normal operation of banks is risky. If everyone tries to get their money at once, even a healthy bank will succumb. This is the rationale behind deposit insurance. Let all those small savers know their money is secure, restore calm, and the insurance may never even need to pay out.

So that’s the hope. If the eurozone banking troubles are just the result of unfounded panic, a new backstop could restore calm. If there are a limited number of banks troubled by past lending into now-burst real estate bubbles, a well-funded cleanup could set things aright.

But the potential problems are enormous. Here are five sets of questions facing the new European banking union plan:

1. Politics of operation. In the story above, banks are just going about their ordinary business when an unfounded panic attack strikes customers. But banks can make choices about how much risk to take on. Riskier projects can offer higher returns. This is why the bailout has been coupled with regulation; Chancellor Merkel does not want a situation in which "Heads Bankia wins, tails Brussels loses." Bank regulation is difficult in ordinary circumstances (banks are big and complicated and even they may not realize the risks they are running). The situation is even more complex when you have close relationships between banks and politicians and bank lending is used to further political or industrial policy ends. Will Germany or France tolerate that kind of interference from the ECB?

2. Back door fiscal union? One of the risky behaviors that European banks have recently engaged in has been lending to the governments of Greece, Spain, and Italy. If the banks are allowed to keep purchasing government bonds, then direct lending to the banks looks like a back-door fiscal union, only without controls on government spending, a point made by James Mackintosh of the Financial Times. That would also beg the question of where the money will come from, since the summit proposed no new resources and existing ones would not cover those countries’ needs. If a new bank regulator cuts off the flow of funds from the banks to the governments, that raises the question of who will be left to lend to the governments. When bond buyers disappear, interest rates soar.

3. Politics of resolution. All of the political questions apply even more strongly when it appears a bailout has failed. Who decides to pull the plug? Will powerful governments let national champion banks be disassembled by eurozone technocrats? Who decides how the losses are allocated? There are already lawsuits from small Spanish shareholders who claim they were misled into funding Spanish banks. If such shareholders or bondholders are wiped out – normal in a bankruptcy – that can have an economic and psychological impact.

4. What about London? Britain is not in the eurozone, of course, but London is the financial center of Europe. The EU is supposed to have a single market in financial services. Omitting Britain entirely would be like saying that we would regulate finance in the United States, except in New York. But on what grounds could the ECB hold sway over behavior in London?

5. Which risk are you insuring against? In the standard deposit insurance story, some banks get unlucky with their loans and their depositors are rescued. Europe’s problem is that there is another sort of risk lurking: euro departure. Imagine two Greek depositors, one of whom keeps his money in his Athens bank, the other who moves her money to Frankfurt. If Greece were to leave the euro, our two depositors would have drastically different experiences. He would be much worse off than she would be, since his savings would be in depreciated drachmas. Would deposit insurance compensate him? It is hard to believe it would, particularly when one hears Europeans talk about how a departure would be an unacceptable violation of European law. Even if Europe were tempted toward forgiveness and inclined to reimburse such losses, the cost would be enormous. This would be covering virtually all bank deposits in a departing country, not just an unlucky few. The latest summit did not propose any new funds, much less the trillions of euros this could cost. If you do not insure against this risk, then insuring against the lesser, idiosyncratic bank risk is completely futile. If you do insure against this risk, the promise has to be credible to do any good.

In sum: another European summit; a burst of euphoria; a plan to have a plan; and many questions left unanswered. Eurozone leaders have expressed their good intentions, but in mid-crisis it is the seemingly-obscure particulars of banking practice that will determine whether or not the markets’ relief was merited.