Completing the banking union is an urgent project facing the EU, given the eurozone’s continued vulnerability to idiosyncratic liquidity shocks to national banking systems. The proposed changes to the European deposit insurance scheme (EDIS) under consideration by the European Commission could open the way to a satisfactory compromise between the twin needs to reduce legacy risks in banks’ balance sheets and to provide greater risk-sharing and a fiscal backstop for both the Resolution and the EDIS Funds – while continuing to exclude any sharing of past losses. With such a compromise, financial fragmentation would likely recede rapidly, leading to a larger role by private capital in cushioning real and financial idiosyncratic shocks.

EDIS could move forward immediately by providing in its early phase that the European Stability Mechanism would provide a liquidity line to national deposit guarantee schemes that had exhausted their funds, with no sharing of losses. Meanwhile, risk-reduction would accelerate through the stronger policies already established by the Single Supervisory Mechanism for the reduction of non-performing loans and a fresh approach to the reduction of banks’ sovereign exposures, based on a modified version of the large exposure prudential policy. Direct risk-weighting of national sovereigns would be excluded.

The ultimate anchor of a stable banking union would be credible policies to reduce excessive sovereign debt-to-GDP ratios. This paper argues that a combination of a strengthened debt rule in the Stability and Growth Pact and a market discipline mechanism entailing the obligation to issue junior bonds, subject to restructuring, for the countries violating the common budgetary rules, could offer a suitable way forward to restore the credibility of the Pact. It also argues that effective policy coordination within the eurozone also requires greater symmetry of policy obligations by the member states, which may be built into the European Semester through an appropriate revision of the macroeconomic imbalance procedure.

Read the document