Europe heading toward new financial crisis

Europe faces a predicament. Even as it struggles to contain the COVID-19 pandemic, it’s setting itself up for another crisis — this one financial. To ensure the viability of the common currency at the heart of the European project, the EU’s leaders will have to cooperate in ways they’ve so far resisted.

Adopting the single currency has yielded great benefits, from frictionless trade to improved global competitiveness. But the euro also obliged member states to relinquish the independent monetary policies that can help backstop national debts and financial systems.

One result is that distress at banks presents a heightened threat to individual governments’ finances, and vice versa — the so-called “doom loop” that played out in spectacular fashion during the early 2010s, when the euro area nearly broke apart.

In 2012, European leaders agreed on what should have been a big part of the solution. They envisaged a full banking union, in which governments would take joint responsibility for supervising financial institutions — and, most important, for dismantling or recapitalizing banks when necessary, and for making depositors whole. Progress has been excruciatingly slow.

Although the European Central Bank now oversees the region’s largest banks, individual governments still bear the cost of rescues, as bailouts in Italy and Germany have demonstrated. Mutual deposit insurance remains no more than a proposal.

The pandemic has aggravated the problem, with governments taking on ever more debt in their efforts to provide economic relief. The International Monetary Fund estimates that general government debt in the euro area will exceed 98 percent of gross domestic product by the end of 2021, up from 84 percent at the end of 2019. Worse, individual countries’ obligations are accumulating on the balance sheets of their banks. At the end of February, Italian banks’ holdings of Italian government debt amounted to 124 percent of their capital and loss reserves, rendering them extremely vulnerable in the event of fiscal distress.

Aside from the financial risks they present, these sovereign exposures make banking union harder to achieve politically. Northern countries such as Germany, for example, don’t want to sign on to mutual deposit insurance if it means subsidizing Italian banks’ excessive holdings of Italian public debt. Governments of heavily indebted countries, for their part, worry that restrictions on banks’ holdings could render them unable to borrow when they have to.

There’s a way forward. To nudge banks toward diversification, the ECB could designate a “safe portfolio” of government debt, corresponding to member states’ shares of the region’s GDP (an idea originally proposed by German Finance Minister Olaf Scholz, and elaborated by Luis Garicano, an economist and member of the European Parliament). Any divergence would entail an increase in capital requirements.

They should undertake a major upgrade of the Single Resolution Board, providing it with the powers and resources required to take over and liquidate or recapitalize banks anywhere in the euro area, and to compensate depositors — much as the Federal Deposit Insurance Corporation does in the U.S. To make a mutual insurance fund more politically palatable, it could initially be designed to kick in only as a backstop to national funds.

With increasing urgency, the same logic applies to severing the link between the health of banks and the solvency of national governments.