Academic journal article Contemporary Economic Policy

Preserving Financial Stability: A Dilemma for the European Union

Academic journal article Contemporary Economic Policy

Preserving Financial Stability: A Dilemma for the European Union

Article excerpt

Financial institutions are now crossing national borders within the EU. In balancing member states' desires for sovereignty against the effectiveness of the financial safety net, banks are currently all chartered by Member States and the safety net remains largely the responsibility of individual national governments. The paper questions whether minimally harmonized national safety nets and reliance on voluntary cooperation can keep EU banks safe and sound and prevent financial contagion. The paper examines a number of proposed remedies and recommends enhancing market discipline and adopting a system of prompt corrective action and least-cost resolution to minimize the incidence of bailouts. (JEL F36, G18, G21)

I. INTRODUCTION

A union of states faces conflicting interests and objectives when its financial institutions move across its members' borders. The union encounters challenges when it creates a safety net aimed to diminish financial problems and remedy weaknesses that can spill over and lead to contagious financial crises. This paper focuses on the difficulties that have arisen in the EU as it attempts to balance members' desires to retain sovereignty against the efficacy of its safety net.

The United States has adopted a dual banking system to effect this balance, which, however, remains subject to continuing tensions. It allows banks to choose between a federal/national charter with federal prudential supervision or a state charter with both state and federal supervision. Banking crises prompted it to make lending of last resort, deposit insurance, and bank resolution federal responsibilities long before banks crossed state lines in large numbers. (1) The EU, in contrast, has courted a single market for financial services across its 25 member countries by allowing banks chartered in one member state to branch in any other member and/or to establish subsidiaries with the host country's permission. At present, while legally permitted, there are no banks with EU charters and there is no unified system for bank regulation, Supervision, emergency liquidity assistance, or failure resolution, all of which remain almost entirely the responsibility of each member's national government.

Achieving a balance between member sovereignty and safety net effectiveness is becoming increasingly difficult in the EU as the European financial system integrates (European Central Bank [ECB], 2005). (2) Integration has been slower in banking, and particularly in retail banking, than in other sectors of the financial system, yet it is happening. Home country credit institutions (banks) dominated in most of the 15 pre-enlargement members of the EU from 1997 through 2004, and there were relatively insignificant cross-border activities-four EU-15 countries still derived 10% or less of their bank assets from banks headquartered in other parts of the European Economic Area (EEA) at the end of 2004 (Figure 1). (3) Yet cross-border assets have risen in Austria, Denmark, Greece, Finland, the Netherlands, and portugal and were higher elsewhere in the EU. In addition, the accession of 10 new EU Member States in May 2004 changed the union's cross-border banking picture because most new Member States had much higher percentages of assets from other EEA countries.

[FIGURE 1 OMITTED]

In recent years, moreover, newspapers have reported several attempts by banks domiciled in one EU country to acquire banks in another EU-15 member country giving added impetus to cross-border issues. Spain's Santander Central Hispano purchased the UK's Abbey National in 2004. The acquisition by Italy's UniCredio of HVB--Germany's third largest publicly traded bank, which also owns 75% of the Bank of Austria--was approved by the EU in October 2005. By fall 2005, after much difficulty, the Netherlands's ABN Amro had been allowed to acquire Italy's Antonveneta. EU banks are currently bidding to acquire a major Romanian bank prior to Romania's planned accession to the EU in 2007. …

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