EZ banking union with a sovereign virus

By Daniel Gros

The doom-loop between banks and the national governments played a dominant role in the Eurozone crisis for Ireland and Cyprus. A Eurozone banking union is usually viewed as the solution. This column argues that the doom-loop cannot be undone as long as banks hold oversized amounts of their government’s debt. A simple solution would be to apply the general rule that banks are prohibited from holding more than a quarter of their capital in government bonds of any single sovereign.

The purpose of the proposed banking union is to de-link banks from their sovereigns.

• Putting the ECB in charge of supervision and creating a common resolution mechanism should help.

But this is not enough.

• European banks hold too much government debt of their own governments to really sever the sovereign-bank link.

Until the link is broken, the Eurozone will continue to be vulnerable to disruptive, self-reinforcing feedbacks of the type that brought the Eurozone to the brink of collapse in 2011-12.

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