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As the institutional order of the eurozone currently holds, the Euro area’s banking system is not integrated, as is its monetary policy. In particular, bank supervision, regulation and recapitalization rests in the hands of member-states. Yet it is clear, from economic/monetary theory and from the events of the eurocrisis that this setting engenders vicious cycles.
When a local bank in the eurozone requires capital, it will eventually seek funds from its respective state, provided that no access to capital markets is allowed at any sensible price; which is the case for many of Europe’s zombie banks. As soon as a bankrupt bank asks for the support of a quasi-bankrupt state, in the midst of a recession, then everything seems set for a destructive, self-fulfilling prophecy.
Take for example the current events in Spain and Cyprus. Ahead of the capital adequacy test on June 30, both governments are called to recapitalize their banks, some of which are on the verge of collapse. However the states themselves are in a precarious position, as their fiscal finances have been deteriorating, courtesy of the ongoing recession, the increasing (structural) unemployment and the red tape and bungling of the EU.
So what is now happening, is that a bankrupt bank, say Bankia in Spain, and Laiki bank in Cyprus, requires fresh capital to keep its operations going. Given that no serious investor would ever put her money in these complete basket cases, the banks eventually seek the assistance of their respective state, in exchange for partial nationalization (in exchange for equity). Yet the harsh reality is that the governments of Spain and Cyprus have no money either, nor can they find it easily these days, with Spain having to pay rates persistently above 6%, which are high enough to knock the country out of the bond markets; while Cyprus has been shut out of the markets for several months now, with interest rates being around the usurious level of 14%.
As events have been shaped throughout the crisis, to abstain from recapitalizing the banks will probably have far-reaching repercussions, not excluding the possibility of a complete financial meltdown. Even if we were to assume that non-intervention in the banking system would save funds for the state, the resulting financial crisis would have been enough to diminish economic activity further, thus again bringing the state in a troublesome position; only this time it would be at a much more suboptimal situation, since the state would be bankrupt, the economy crippled and the banking system completely wiped out (whether the cocktail of expensive bailouts, inane austerity, ad hoc recapitalizations and months/years of dithering, has been a prudent approach is another issue – I say it has been disastrous and is part of the problem).
As such, irrational and absurd as that might sound, the governments are in a sense forced to bail out their banks, in exchange for the sustainability of their own fiscal position. To put it in a metaphor, it is as if two persons are drowning and they try to stay afloat by means of holding on to each other. This is catastrophic for both. Eventually a European fund is required to provide a backstop, now the EFSF, soon the ESM.
Within the context of this article, I do not want to touch upon the recapitalizations per se. What I wish to point out is that the markets were already well aware that banks would eventually seek help from their governments, given that no banking union exists in the eurozone, no cross-border deposit guarantees and no common fund for recapitalizations. Because of this structural flaw (and not of some metaphysical laziness of the Southerners), the monetary union is found in the unpleasant position whereby a euro deposited in say a Spanish or a Cypriot bank, has lower expected value than a euro deposited in a German bank; thus all the capital flights, the financial stress, the disintegrating pressures on the euro and the striking asymmetries in bonds yields across member-states (see also German interest rates: That which is seen and that which is not seen).
Hence when news came out or will come out about a crippled bank, markets started doubting the capacity of the respective government to meet its obligations, since they knew that the cost of saving the bank would ultimately fall on the government. As markets avert from investing in the government’s bonds, interest rates go up; and as interest rates rise, the pressures increase, eventually fulfilling the cyclical prophecy that leads to state bailouts and further disintegration.
Spain and Cyprus will sooner or later come to the need of a bailout mechanism of some kind, even though they would have avoided it in the context of a proper monetary union. All this smoldering mess, would never exist had the eurozone featured a genuine banking union that would have prevented the formation of these negative feedback loops, since local banks and EU member-states would not be in such a near-symbiotic relationship. Recapitalizations that occur in the absence of a banking union, may only exacerbate the problem instead of mitigating it.
With time running out for European policy-makers, it is essential to provide a brake to these feedback loops. The sectarianization of the eurozone’s banking system can no longer be afforded. A banking union, or at least steps towards that direction are of cardinal importance in order to escape from this policy-made morass, otherwise the euro will soon belong to history, with tragic results on the entire global economy.