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BIS Backs Banking Union to Ease Euro Zone Crisis

Creating a banking union for the euro zone could break the fever gripping the shared currency and help put the euro on a viable long-term footing.

LONDON - Creating a banking union for the euro zone could break the fever gripping the shared currency and buy time for governments to put the euro on a viable long-term footing, the Bank for International Settlements said on Sunday.

The endorsement by the BIS, a global forum for central banks, will add momentum to proposals for a single supervisor for big euro area banks, pan-European deposit insurance and a fund to wind down cross-border lenders in trouble.

The ideas will be discussed at a European Union summit in Brussels on June 28/29, the 19th such meeting to try to quell the euro zone's 2-1/2-year-old debt and banking crisis.

The crisis is complicated by the interdependence of heavily indebted governments and the banks that help to finance them by buying their bonds. Germany, the EU's paymaster, is opposed to asking its taxpayers to backstop other countries' banks.

"If adopted, these measures will break the adverse feedback between the banks and the sovereign and other destructive links that are making the crisis so severe," the BIS, based in Basel, Switzerland, said in its annual report.

Common banking rules would shore up confidence in the euro because depositors would no longer have a reason to flee lenders they fear might fail, the BIS said. Greek banks have lost about 30 percent of their deposits since the start of 2010.

"With day-to-day normality attained through a unified currency and banking system, leaders will have the time they need to finish building the broader institutional framework that the monetary union needs for its long-term viability," the report said.

It said recent banking union proposals offered quick progress because they would operate within the existing terms of economic and monetary union.

"The conclusion is hard to escape that a pan-European financial market and a pan-European central bank require a pan-European banking system," the BIS said. "Banks in Europe must become European banks."

If common rules can prise apart banks and their sovereigns, now locked in a fatal embrace that has propelled bond yields in Spain and Italy to unsustainable heights, interbank lending and market funding for governments could revive, the BIS said.

That would let the European Central Bank withdraw from its "unconventional and undesirable role" as an intermediary. The ECB has given euro zone banks more than 1 trillion euros ($1.25 trillion) in two rounds of cheap three-year loans, and speculation is swirling about the need for a third operation.

Unsurprisingly given the BIS's membership, the burden put on central banks to ensure financial stability and support economic growth is the main theme of the annual report.

"Simply put: central banks are being cornered into prolonging monetary stimulus as governments drag their feet and adjustment is delayed," the BIS said.

DON'T PUSH US TOO FAR

The decisive response of monetary policymakers during the global financial crisis probably prevented a repeat of the Great Depression of the 1930s, the BIS said. As central banks worldwide have pumped money into their economies, their assets have more than doubled over the past four years to $18 trillion.

But while low interest rates buy time, they can also lower the incentives for banks to purge their bad loans and for households to reduce their debts.

"One message of the crisis was that central banks could do much to avert a collapse. An even more important lesson is that underlying structural problems must be corrected during the recovery or we risk creating conditions that will lead rapidly to the next crisis," the BIS said.

It painted a gloomy picture of the world economy.

Growth was likely to remain weak for some time, with Ireland, Spain and the United States in particular facing prolonged high unemployment. In emerging markets, rapid credit growth risked sowing the seeds of a new financial crisis in countries including Brazil, Turkey and Thailand, the BIS warned.

If the root causes of financial and economic weakness are not addressed, central banks will come under pressure to do more than they can actually deliver, the report said. That would make it harder to unwind ultra-loose monetary policies and could ultimately threaten their credibility and operational autonomy.

Low inflation expectations suggest this credibility remains intact, but the BIS warned that once confidence in central banks is lost, as it was in the 1970s, it can be hard to regain.

To take pressure off central banks and boost confidence in public finances, governments should waste no time in tackling the "gross underfunding" of pension and health care obligations and an "unmanageably large" public sector, the BIS said.

"In most advanced economies, the fiscal budget excluding interest payments would need 20 consecutive years of surpluses exceeding 2 percent of gross domestic product - starting now - just to bring the debt-to-GDP ratio back to its pre-crisis level," the BIS said. "The question is not whether governments must adjust, but how?"

Yet the euro zone crisis shows that the essential first step before reducing government deficits and private non-financial debt is to create a less risky and less leveraged banking system that functions more clearly in the public interest.

"Only then, when balance sheets across all sectors are repaired, can we hope to move back to a balanced growth path. Only then will virtuous cycles replace the vicious ones now gripping the global economy," the report said. ($1 = 0.7977 euros)

(Editing by Ruth Pitchford)

Copyright 2010 by Reuters. All rights reserved.

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