Introduction and motivation

The euro area started as a pure 'monetary union'. It is now in the process of also becoming a 'banking union' (BU). EU leaders have argued that even this step is not enough. In September 2012, close to the peak of the euro crisis, a joint report by the four Presidents of the European Union (the Presidents of the European Commission, the European Council, the Eurogroup and the European Central Bank), entitled "Genuine Economic and Monetary Union", argued that much more was needed (Belke, 2013; Begg, 2014). The four Presidents argued in essence that the establishment of a banking union should also be seen as a first step towards further integration. According to their report, a fiscal union would be the next logical step. Moreover, a fiscal union was held to imply the need for a political union.

There is surprisingly little analytical support, however, for the claim that a banking union needs to lead to a fiscal union (Belke, 2013 and 2013a). The key argument most often heard is simply the observation that the euro area has only a very limited central budget (at least compared with other monetary unions), and that therefore there are almost no fiscal transfers to smooth asymmetric shocks. By contrast, the US, which is similar in size to the euro area, does have a substantial federal fiscal budget. The US experience is thus usually taken as a model of what is needed for a sustainable monetary union.

This study contributes to this debate by illustrating how the 'banking union' of the US provides very tangible insurance against local financial shocks, without major involvement of the 'fiscal union', which undoubtedly also exists in the US.

The transatlantic financial crisis which started in 2007-08 and led to the Great Recession provides a key episode in assessing the importance of mechanisms to absorb regional shocks. The financial shocks quickly became regional in the euro area after 2009-10 when the financial systems of some countries almost collapsed and their sovereigns lost market access, e.g. Ireland, Portugal and Greece. It is often overlooked that the origins of the crisis in the US were also rather concentrated at the regional level. The housing boom was very concentrated in the US. The increase in housing prices varied enormously from state to state and only a few states (Arizona, Nevada, Florida and California) tended to account for most of the sub-prime lending, overbuilding and thus the subsequent economic distress and losses from delinquent mortgages.

However, the US experienced 'only' a system-wide crisis in 2007-09. There was no specific crisis involving only those states where the real estate excesses had been most marked (Nevada, Florida and California). The main thrust of this study is that the US was better equipped to deal with these regional shocks because it is a fully fledged banking union.

The euro area officially has a banking union, but most observers would agree that it is incomplete if one starts with the three 'canonical' elements of a banking union (IMF, 2013a and b):

1) Common supervision. This has been achieved since the ECB, under the heading of the Single Supervisory Mechanism (SSM), has become the ultimate supervisor for all banks in the euro area, and the direct supervisor of about 130 of the largest banks accounting for about two-thirds of banking assets.

2) A common mechanism to resolve banks. This has also been achieved with the creation of the Single Resolution Mechanism (SRM), which will be able to rely on a common fund, i.e. the Single Resolution Fund (SRF), after a transition period. The SRM will cover all banks in the euro area (and in those other EU countries wishing to join the SSM).

3) Common deposit insurance. No agreement has been reached on this point. It remains to be seen how important this lacuna will become.

By contrast, the US has had all three elements in place at least since 1933. The US thus qualifies as having had a banking union for over 80 years. (But one should also not forget that the US monetary union survived almost a century and a half without being a banking union.)

The central theme of this study is that the consequences of the US banking union could be seen during the financial crisis. A simple comparison of the fate of two different members of a large monetary union, after they were hit by a financial crisis, offers a powerful illustration of the importance of an integrated banking system. Ireland and Nevada, in fact, provide an almost ideal test case. These two entities share several important characteristics. For example, they both have similar populations as well as comparable GDP/GSP (gross domestic product/gross state product), and they both experienced an exceptionally strong housing boom. But when the boom turned to bust, the US states did not experience any local financial crisis (nor did any state government have to be bailed out).

We find that the key difference between Nevada and Ireland is that banking problems in the US are handled at the federal level (the US is a banking union), whereas in the euro area, responsibility for banking losses remains national. Moreover, we also find that large banks with a wide footprint can also help to absorb regional shocks (at the cost of transmitting them to the entire system).

This book is organised as follows. The next chapter presents some case studies of the stabilisation properties of a banking union. Chapter 3 then analyses the role of 'foreign-owned banks' as a sort of 'private banking union'. Chapter 4 looks at the institutions that paid for the shock absorption provided by the official US federal banking-related institutions: the Federal Deposit Insurance Corporation (FDIC) and government-sponsored enterprises (GSEs), commonly known as Fannie Mae and Freddie Mac. Chapter 5 speculates on the extent to which European banking union as currently planned could provide comparably strong protection against regional...