The EU will regret terminating a banking union

The EU has effectively buried the idea of a banking union. It is a decision that will have profound economic consequences for the eurozone. It kills the last chance of a resolution that could have ended the depression in the eurozone periphery. In the brave new world of the EU's resolution regime, all risks will be shared between various categories of bank creditors, which are mostly domestic institutions, and the banks' home states.

The European Council, the gathering of EU heads of government, has long become silent on the ceremonious pledge, made in June 2012, to break the link between sovereigns and the banks. Last week's agreement did not break it. It has not even been diluted. It has been reconfirmed.

But has the European Stability Mechanism, designed to provide assistance to members of the eurozone, not been given the right to recapitalise banks directly - up to a total of €60bn? Yes, it has, but there is a catch. For each euro the ESM uses to recapitalise a bank, it has to post two euros as collateral to maintain its own credit rating. If the ESM were to use the entire pot of €60bn, its total available free lending capacity would shrink to some €200bn - not enough to meet the obligations it is likely to face in the next few years. The way the €60bn bank recapitalisation facility is constructed, the eurozone finance ministers will have a strong incentive not to use it as a bank recapitalisation fund at all. My conclusion is that the €60bn is there not to be used. And, as I argued last week, the losses of the banking system are so large that this amount would hardly make a difference anyway.

In theory, a bail-in rule should shift some of the financial burden away from the bank's home state. But this only works to the extent that some of those shareholders and bondholders are foreigners. The trouble is that the banks have become more national since the crisis. They are the buyers of last resort of their home countries' national debt.

In return, the governments backstop their domestic banks. Most of their creditors are domestic. It therefore matters little whether the Spanish state bails out its banks or whether mostly Spanish bondholders get bailed in. The bottom line is that all the risk remains in Spain. As such, it is a liability of the Spanish state in the final consequence.

The debt ratio that matters as a guide to the country's overall solvency is not the much-quoted ratio of net public debt to gross domestic product but total external debt, public and private sector combined.

In the case of Spain this was almost 170 per cent of GDP at the end of 2012, according to the latest data of the World Bank. For Spain, a banking union that cuts the link between the state and banks would have been a necessary, and possibly even sufficient, guarantee for sustainable membership of a monetary union. However, that would hold true only as long as the political support for fiscal adjustment and economic reforms remains in place. Without that guarantee, I cannot see how that is possible.

When policy makers last year portrayed banking union as a less onerous step than a fiscal union, it was already clear that they were either not serious about the project or at least not serious about it as an instrument of crisis resolution. As the reality about the new regime sinks in, the doubts about the viability of the monetary union could quickly resurface.

In normal times, even the unsustainable can last surprisingly long. But that is not necessarily the case in times when the banking systems of several large European states are under water.

The situation in Italy is different from Spain in some important respects. Italy's banks are not sitting on mountains of bad mortgage debt. Italy has a lower gross external debt position, at 124 per cent of GDP. But the problem in Italy is a vicious circle of a credit crunch, a recession, and a public sector with little fiscal room for manoeuvre to fix an undercapitalised banking system. The new government's focus on a petty scheme to reduce youth unemployment when its real problem is a liquidity crunch is unbelievably misguided. With the rise in global market interest rates, the country is getting closer to an ESM programme, which would then trigger bond purchases by the European Central Bank. But the ECB cannot recapitalise the Italian banks. Nor can the Italian state. Nor can the ESM. According to Mediobanca, an Italian investment bank, the degree to which Italy can tap private wealth as a source of new funds is limited, since wealth taxes are already relatively high. So even Italy's sustainability in the eurozone is not assured in the absence of a joint-liability banking union.

How could it have come to this? It was my reading of the political situation a year ago that a majority in the European Council was quite serious about a proper banking union to be followed by a fiscal union in the future. Germany had yet to be persuaded. Then came the ECB's celebrated backstop last summer. And that killed it. The politicians no longer saw a need for policies that would be a hard sell back home.

There is a still project with the name of banking union but it will be irrelevant to this crisis. That leaves the ECB. The central bank can do a lot but it cannot fix the banks.

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