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First the Governance, Then the Guarantees

The European Commission’s plan to establish a single supervisory mechanism (SSM) for all banks in the euro area has received a mixed reception. The ambitions regarding the coverage (all banks) and time path (first phase starting in January 2013) have met with strong German resistance. Quick initiatives to complement the SSM with a joint deposit guarantee scheme and a euro area bank resolution fund also seem unlikely due to German opposition.

These setbacks have disappointed many economists. A consensus in the economics profession is that the euro area needs a real banking union. In addition to standardized regulation and centralized supervision, such a banking union would also provide for European risk-sharing. Proper risk-sharing is deemed an essential ingredient to break the vicious link between banks and sovereigns in the euro area.

I agree with this line of reasoning, but I also think that sequencing matters. A prudent path towards banking union needs to start with a real transfer of decision rights to the European level, before any pan-European guarantees are extended. Doing it the other way around risks repeating the Greek debacle, where European control over fiscal policy was tightened only after the huge exposures to Greek debt had been built up.

How should we rate the commission’s proposal on the transfer of decision rights? Are we getting a European supervisor with real teeth, which can put an end to the too cosy relationships between bankers, local supervisors and politicians? Or will real power still rest with the national supervisors?

On paper, the proposal looks impressive. On the basis of article 127(6) of the Treaty of Lisbon, the commission wants to transfer important supervisory tasks to the ECB. The ECB will also be granted far-reaching powers, e.g. to collect information or to inspect individual banks. The need to operate within the confines of the Treaty of Lisbon, while understandable to maintain momentum, sometimes produces an awkward outcome. For example, the ECB will be entrusted with the main supervisory tasks, yet national supervisors will retain “overall responsibility” regarding banking supervision. The question how national supervisors can bear this responsibility when the ECB is in charge of granting banking licenses, is not answered.

Yet this is not the main drawback. In my view, the most dangerous flaw relates to the governance of the SSM and, more specifically, to the composition of the new banking supervisory board within the ECB. The commission proposes a board consisting of 17 representatives of the national supervisors, a chairman, a vice-chairman and four other members. Out of 23 members, a large majority thus originates from the national supervisors. While this may help to reduce the opposition of national supervisors to the SSM, the commission takes the risk that in this way the current talking shop of supervisors will be internalized within the ECB. How will this work, in a board of which 17 members do not appreciate ECB interference in their daily national supervisory activities? My guess is that these 17 members will collude to prevent the ECB from ever using its full powers. This would castrate the European supervisor at birth and thwart the whole idea of disentangling banks, local supervisors and politicians by means of an objective outside supervisor.

As long as supervisory power effectively remains in the hands of national supervisors, as in the governance structure currently proposed by the commission, risk-sharing through European deposit guarantee schemes or resolution funds is a dangerous and naive dream.

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Otaviano Canuto

Otaviano Canuto is Senior Advisor on BRICS Economies in the Development Economics Department, World Bank, a new position established by President Kim to bring a fresh research focus to this increasingly critical area. He also has an extensive academic background, serving as Professor of Economics at the University of Sao Paulo and University of Campinas (UNICAMP) in Brazil.

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