In their summit statement of June 29, 2012, the heads of state and government of the euro area issued a declaration widely interpreted by investors as the founding act of a European banking union, about which European policymakers have been talking increasingly vocally in the past two months or so. Their commitment remains little more than a promise, with multiple caveats. But Europe’s leaders will now renege on this promise at their peril. The general perception is that an irreversible step has been made, with vast consequences that will unfold only gradually.

“We affirm that it is imperative to break the vicious circle between banks and sovereigns,” the heads of state and government declared. “The [European] Commission will present proposals on the basis of Article 127(6) [of the Treaty on the Functioning of the European Union] for a single supervisory mechanism shortly. We ask the [European] Council to consider these proposals as a matter of urgency by the end of 2012. When an effective single supervisory mechanism is established, involving the ECB [European Central Bank], for banks in the euro area the ESM [European Stability Mechanism] could, following a regular decision, have the possibility to recapitalize banks directly.”

The key commitment in this clumsily worded half paragraph is less the “single supervisory mechanism,” which can be interpreted in multiple ways, than the direct involvement of the ESM under a clear deadline of end-2012, meaning that the euro area fund would intervene into individual banks without having to rely on national authorities as intermediaries.

As German Chancellor Angela Merkel has made clear on recent occasions, funding cannot be envisaged without what she calls “control.” Therefore, the ESM will need to control those banks it would recapitalize, a process that the summit statement further describes as either “institution-specific, sector-specific or [presumably national] economy-wide.” Such banking institutions, sectors, or economies would presumably be irreversibly transferred under the policy framework of the banking union, in accordance with the objective to “break the vicious circle between banks and sovereigns.” This presupposes the existence of an operational capability to assess the financial position of the relevant bank(s) to prepare the recapitalization, which may itself include an array of instruments from subordinated debt to voting common equity. In other words, the statement implies the buildup of a euro area resolution authority.

Some policymakers talk about bank recapitalization as if it were some sort of automatic, mechanical process, but it is nothing of the sort: One needs only to think of the convoluted sagas of WestLB, Hypo Real Estate, Fortis, Dexia, or Anglo Irish Bank to realize each case will require time-intensive efforts and difficult and lengthy legal and financial judgments. We do not know exactly how many large European banks are insolvent, but the number is more likely to be in the double digits than single.

In a paper coauthored with my Bruegel colleagues Jean Pisani-Ferry, André Sapir, and Guntram Wolff, I argue that the capital assessment, recapitalization, and restructuring process would be best achieved through a temporary structure or task force, akin to the US auto industry task force in 2009 or, in the banking sector, the Swedish Bank Support Authority of the early 1990s. The motivation for establishing such a temporary framework is twofold: First, it can be set up more rapidly than a permanent institution, which would be hobbled by complex questions of governance and checks and balances. Second, the restructuring task is a thankless one that will win few friends, and it may exceed the strength of permanent institutions that must continuously care about cultivating future relationships. This framework was first proposed jointly by Adam S. Posen and me in a 2009 policy brief, months before the beginning of the euro crisis but at a time when the European banking sector was already suffering from systemic fragility. In that piece we suggested as a further reference the Treuhandanstalt (or Treuhand), which—in spite of doing a more than decent job of restructuring and selling the former German Democratic Republic state-owned enterprises in the early 1990s—gained the gratitude of neither Eastern Germans, who thought it liquidated their industry, nor Western Germans, who thought it wasted their taxes. The Treuhand’s first head, Detlev Rohwedder, was assassinated in Berlin in 1991.

Policymakers will need to carefully consider the links between this resolution authority and its immediate partners. Among the partners are the ESM (which will provide public money for recapitalizations along with individual national treasuries), and the ECB, and national central banks ( which extend liquidity under the Eurosystem’s Long-Term Refinancing Operations and, in some countries, national Emergency Liquidity Assistance). The London-based European Banking Authority (EBA) could serve as another partner, though it can only be a peripheral player given the United Kingdom’s refusal to join a European banking union, even though it has crisis management competence under legislation adopted in 2010.

As for the “single supervisory mechanism,” one should not underestimate the complexity of the process of creating one. Here the summit statement raises a risk of paralysis. It mentions the establishment of that supervisory mechanism as a precondition for direct ESM intervention. One possible way of overcoming that precondition might be in the form of an early political agreement on the type of joint supervision as a sufficient milestone to unlock ESM intervention, even though the buildup of an actual supervisory capability could take many more months or perhaps years.

An immediate and much-debated question is the extent to which the “single supervisory mechanism” will be vested in the ECB, as the reference to Article 127(6) appears to suggest. That article of the Treaty reads: “The Council (…) may unanimously (…) confer specific tasks upon the European Central Bank concerning policies relating to the prudential supervision of credit institutions and other financial institutions with the exception of insurance undertakings.”

Intriguingly, the European Council Conclusions, published on June 29 a few hours after the Euro Area Summit Statement, only refer to Article 127, which might suggest a less exclusive focus on the ECB (or perhaps only a typing omission). In any case, more debate is likely on the respective merits of the supervisor being inside or outside the ECB, even though the ECB can be expected to assume an anchoring role for all institutions of the future banking union. There are multiple arguments on both sides of the debate over the central bank’s role. Here again, as long as the United Kingdom and other member states stay resolutely outside of the banking union, the EBA cannot assume the role of single supervisor even if it retains important functions in the preparation of new banking rules that would continue to apply to the entire European Union. Specific arguments include:

These arguments should be discussed actively so that the political decision on the creation of the single supervisor can be made rapidly, triggering direct ESM intervention as early as the late summer. Time is limited: Policymakers should not mistake the positive market reactions to their summit statement as an unconditional endorsement. Volatility is likely to remain in the markets. Rapid movement from promises to actions, including disbursements, is necessary to avoid further episodes of market dislocation.

In addition to major political issues, the legal challenges are also daunting and serious. One is the current legal basis and mandate of the ESM, which might require revision. Another is that the resolution authority (or task force, if this model is chosen) will need to be empowered by national legislation in all relevant member states. It should have the power to impose losses on creditors, in order to ensure that taxpayers are not the only ones to share the burden of restructuring. This is intrinsically controversial, and furthermore might play out differently under different national legal systems. Finally, if the political decision is made to open the banking union to non-euro area member states (such as Poland or Denmark), a single supervisor will have to coexist uneasily with (most likely) various deposit insurance systems in the different currency areas.

Moreover, depending on the next steps of crisis management, retail depositors might need to be further reassured. In some risk scenarios, the ESM could offer an explicit and unconditional guarantee on national deposit insurance systems. Such a step, however, would further strain the ESM both legally and financially even though it might be needed to reestablish public trust in deposits. In the medium term, the euro area will need an at least partly federal deposit insurance system as a necessary component of the banking union. This inevitably raises the issue of further fiscal union, because no deposit insurance can be fully funded without one. A credit line must be accompanied by a fiscal authority to ensure its credibility.

Ultimately, a European banking union cannot be considered in isolation from the other necessary “building blocks” to make the euro area policy framework sustainable—namely fiscal union and a “political union” to strengthen democratic accountability and federal executive decision-making capacity. It is conceivable that not all of these implications have been taken into consideration by all euro area leaders as they agreed on the summit statement shortly before 4 a.m. on last Friday. But they should not regret their move towards banking union, which is needed if the euro crisis is to be eventually resolved. Now, there is no turning back.

Originally published on the author's blog. 

The views expressed in this article are the authors' own and do not necessarily reflect Fair Observer’s editorial policy.