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Safeguarding the euro – balancing market discipline with certainty

A lot has been achieved in terms of institution building to turn the Eurozone into a sustainable currency union. The Eurozone Crisis, however, has shown that the Eurozone is still not a properly functioning currency union. This column, first posted 12 February 2016, points to three areas of further reform to achieve such a goal. These include the disentanglement of sovereigns and banks, completion of a banking union, and an institutional convergence for a fully integrated financial system.  

Editor’s note: Originally published on 12 February 2016, this is a chapter from the eBook How to fix Europe’s monetary union: Views of leading economists.  

A lot has been achieved over the past years in terms of institution building to turn the Eurozone into a sustainable currency union. The Greek crisis of 2015, however, has also shown that the institutional framework is not sufficiently strong yet. While there is the feeling that the worst of the crisis is over and that the Eurozone is much better equipped to confront future shocks, the Eurozone seems still far away from a properly functioning currency union.

A long-term sustainable monetary union has to combine a minimum degree of market discipline with a minimum degree of certainty to achieve market-based risk sharing. The former is to force markets participants to price their claims according to risk. The latter is to hedge against catastrophic risk, realising that government has a comparative advantage in providing certainty but also regulatory discipline. Ultimately, the right balance of market discipline and providing certainty is up for discussion – at this stage I will only argue that a healthy portion of both is needed.

Lots of progress has been made in the area of market and regulatory discipline, including bail-in rules for banks, the Comprehensive Assessment of banks as entry point for the SMM and actual bail-ins of junior bondholders in bank failures and restructurings across the Eurozone. It seems, however, that not as much progress has been made on institutionalising certainty – the certainty of stable banks and of re-denomination risk is currently borne primarily and almost exclusively by the ECB, summarised in the famous words: Whatever it takes.

This column points to three areas of further reform needs to achieve a more appropriate balance of market discipline and certainty:

  • Completely disentangle sovereigns and banks;
  • Complete the banking union; and
  • Institutional convergence for a fully integrated financial system


Disentangling sovereigns and banks

It seems almost obvious that there will be another stand-off between creditors and the Greek government in the near future. The critical problem is if this stand-off will put into question yet again the Greek membership in the Eurozone or whether it will rather resemble the Puerto Rican stand-off between government and its creditors. One big difference is that in Puerto Rico private sector creditors sit on the other side of the table, though their political influence is strong enough to influence the actions of the federal government in Washington DC. As – or even more – important is, however, that the solvency and liquidity of Puerto Rican banks does not depend on the solvency or liquidity of Puerto Rico’s government, unlike in the case of Greece. Only when Greek depositors can be completely confident that their euros will be safe – in the form of euros – in Greek banks whatever happens to their government’s solvency and liquidity position, they will NOT run on the banks at the slightest sign of fiscal policy trouble. The task is thus to separate governments and banks, in reality and in perception. It is almost too obvious to state – and so I will not focus on this – that continuous talk about a Grexit will undermine this task, but there are other important steps to be taken.

First, ‘europeanise’ Greek banks; i.e. there should be no influence of the Greek government authorities or the Greek central bank over the domestic Greek banks. The recent ouster of the CEO of one of the major Greek banks clearly shows that this has not been achieved yet. Even the impression of a link between government and banks, however, will put in question the solvency and liquidity of Greek banks, if and when the Greek government gets into trouble.

Second, the ECB should not be part of the Troika and thus creditor of the Greek government, as it faces a clear conflict of interest by: being a lender to the Greek government; supervising the banks that hold Greek government bonds; and having the task to keep Greece within the Eurozone. This conflict of interest came clearly to light during the recent stand-off in July when the ECB had to decide on a daily basis whether to extend liquidity support for the Greek banks or not, based on (in)solvency assumptions of the Greek banking system, which in turn depends on assumptions about the solvency of the Greek government.

Third, regulatory safeguards have to be strengthened to disentangle governments and banks. This would require putting concentration limits on government bonds of any government, similar to single borrower exposure limits. In the long run, the development of non-bank financial institutions will help by diversifying the holdings of government bonds across a large array of investors.

Fourth, it would be good to revive the idea of synthetic Eurobonds as collateral instrument for ECB refinancing purposes, built out of portfolios of individual countries’ government bonds (e.g. Brunnermeier et al. 2011, Beck et al. 2011), which would per construction limit the exposure of Eurozone banks to their government’s debt.

Finally, there is the broader question of the sustainability of large government debts across several Eurozone countries (Eichengreen and Panizza 2016), an issue beyond the financial sector and requiring a political solution.

Completing the banking union

As much as the current banking union structure is beyond even the most ambitious dreams of economists in 2008/9, several important elements of a fully functioning banking union have been missed, including a purely supra-national European bank resolution and a proper funding mechanism. The bank resolution mechanism is still a mix of national and Eurozone-wide decision processes, especially when funding decisions are involved. This can be clearly seen in practice in recent controversies about bank resolutions in Italy and Portugal; another sign that national governments and national banking systems are still closely linked. In addition, the funding still seems somewhat limited. While De Groen and Gros (2015) compute that the targeted fund might have been enough to solve the failures during the Global and Eurozone crises, it seems rather on the limited side. Most importantly, a public backstop is missing, even though first attempts at possible liquidity extension to the Resolution Fund during crisis times are being discussed. The ECB would have to play a significant role in such a public backstop mechanism (either directly or indirectly by serving as backstop to, for example, the ESM). The fact that the ECB is being pushed indirectly into such a role, by taking on a greater and greater role in crisis management beyond monetary policy, under the headline ‘whatever it takes’, is rather ironic and politically counter-productive. Finally, plans for linking the deposit insurance schemes across the Eurozone are important to provide the necessary certainty that the safety of deposits does not depend on the solvency position of national governments.

A second issue is the creation of a truly European banking system. This does not imply the absence of local banks; it rather implies cutting the unhealthy entrenched relationships between dominating local banks, supervisors and politicians. Such links can be seen across the Eurozone – from politically motivated recapitalisation decisions for German savings banks (Behn et al. 2014) and close connections between cajas and local politicians in Spain (Garicano 2012) to the Greek government recently leaning on a large Greek bank to fire its CEO. There is no immediate solution to this problem and it will never be solved completely. The supervision of the systemically most important banks in the Eurozone is an important step.

One important issue is the regulatory perimeter. The brief of the SSM seems to be limited to regulated banks and cannot be easily – i.e. without further European-level legislation – be extended to bank-like or non-bank financial institutions seen as systemically important. This puts the regulator at a disadvantage as financial intermediaries shift risk towards outside of the regulatory perimeter. Second, what is the role of the SSM in macro-prudential regulation and its relationship with the ESRB (which covers the whole European Union and not just SSM members)? While the SSM can use macro-prudential tool covered under the CRR and CRD IV, it cannot use other macro-prudential tools, which will remain exclusively under national authority (Sapir 2014). Given that not only micro- but also macro-prudential decisions have externalities beyond national borders, this seems another gap in the banking union. The ESRB, which does not have any formal powers beyond issuing warnings and recommendations, cannot completely fill this gap.

Finally, what is the relationship with non-Eurozone countries, both those that will join the SSM and those that will not? The critical difference for non-Eurozone members of the SSM would be an asymmetry in their financial safety net, with lender of last resort and resolution funding strictly on the national level, although solutions such as access to liquidity lines might be considered (Zettelmeyer et al. 2012). Cooperation with the Bank of England, which will stay out of the SSM for the near future will be critical, given the importance of London as financial centre. Ultimately, tailor-made solutions are necessary for arrangements with European countries outside the Eurozone (Beck and Wagner 2016).

By reducing banking nationalism within the EU, carefully designed regulatory reforms in banking can thus also contribute to the recently advocated Capital Markets Union. Ultimately, however, the banking union will not be able to stand alone without further integration along other policy dimensions, most prominently fiscal policy. From an optimistic viewpoint, banking union might open the door to such reforms; from a pessimistic viewpoint, further reforms might be prevented by the lack of a fiscal union.

Aiming for institutional convergence

Analysts of the Eurozone often point to the risk sharing elements within the US – another large currency union with divergent sub-national economies – as comparison point for the Eurozone. One important element in the US are integrated financial markets. It is more: there is strong empirical evidence that the banking market integration in the 1970s and 80s in the US led to higher consumption smoothing and risk sharing across US states (Acharya et al. 2011). Capital markets in the US have been integrated for a longer time, given the common contractual and governance tradition and framework.

A Single European Market in Banking as well as a Capital Market Union rely on convergence in the underlying contractual and informational institutions. A lot of progress has been made in the regulatory area for the banking system within the Eurozone (in the form of the above discussed banking union). Plans to create a Eurozone-wide credit registry are under way and will also help both for stability and competition purposes. Other plans for strengthening regulatory institutions and clearing systems are very welcome to foster the integration of capital markets across Europe and help the development of other non-bank components of the financial system. The necessary institution building for integrated capital markets, on the other hand, is more difficult to undertake, given that legal codes, including contract and insolvency laws, are historically grown and entrenched. Similarly, the institutions to apply and execute these laws (courts, registries, legal profession etc.) have developed over generations and centuries. A convergence process in the legal framework is thus a much longer-term process than regulatory convergence. However, it is never too early to start on this.

Political constraints

One major obstacle is the diverging interests of Eurozone members and non-Eurozone members of the EU. Some of the above initiatives, such as the Capital Market Union, are on the EU rather than Eurozone level. The cost-benefit calculus of undertaking deep institutional reforms, however, is a different one for the Eurozone and non-Eurozone members. The question will therefore be whether further integration has to be limited to the Eurozone resulting in an integration process of two speeds. From the viewpoint of the Eurozone, there is the trade-off between maximising integration to maximise the survival chances of the Euro versus minimising the risk of losing the rest of the EU.

A second major risk is that reform fatigue within the EU and the Eurozone has been replaced with outright antagonism against any further integration and even attempts to regain national sovereignty. The current refugee crisis and resulting controversy about the Schengen zone (seemingly completely unrelated to anything discussed above) can have very negative spill-over effects in this context. These are not easy times for attempts to strengthen the Eurozone further!


Acharya, V J Imbs and J Sturgess (2011), “The Efficiency of Capital Allocation: Do Bank Regulations Matter?” Review of Finance 15, 135-72.

Beck, T, H Uhlig and W Wagner (2011), “Insulating the Financial Sector from the European Debt Crisis: Eurobonds without Public Guarantees”, VoxEU.org, 17 September.

Beck, T and W Wagner (2016), “Supranational Supervision: How Much and For Whom?”, International Journal of Central Banking.

Behn, M, R Haselmann, T Kick and V Vig (2014), “The Political Economy of Bank Bail-Out”, Mimeo.

Brunnermeier, M, L Garicano, P R Lane, M Pagano, R Reis, T Santos, D Thesmar, S Van Nieuwerburgh, and D Vayanos (2011), “ESBies: a realistic reform of Europe’s nancial architecture”, VoxEU.org, 25 October.

Eichengreen, B and U Panizza (2016), “A Surplus of Ambition: Can Europe Rely on Large Primary Surpluses to Solve its Debt Problem?”, Economic Policy.

Garicano, L (2012), “Five Lessons from the Spanish Caja Debacle for a new Euro-wide Supervisior”, VoxEU.org 16 October.

Gros, D and W Pieter de Groen (2015), “The Single Resolution Fund: How much is needed”, VoxEU.org, 15 December.

Sapir, A (2014), “Europe’s Macroprudential policy framework in light of the banking union”, in Dirk Schoenmaker, (ed.): Macroprudentialism, VoxEU eBook.

Zettelmeyer, J, E Berglöf and R De Haas (2012), “Banking union: the view from emerging Europe”, in Beck, T. (ed.) Banking Union for Europe – risks and challenges, VoxEU eBook.

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