Bank of Spain Lays Out Plan to Reform EU Economy, and Head off Financial Risks

Fresh off the heels of the European Parliament elections, the Governor of the Bank of Spain, Pablo Hernández de Cos, has urged the EU to complete the Economic and Monetary Union.

According to the Bank of Spain, the best strategy to tackle the imminent challenges confronted by the European economy – including downside risks to economic growth, the proliferation of protectionism, the volatility of emerging markets, the idiosyncrasies associated with EU economies, along with the uncertainty surrounding Brexit – resides in pulling together and taking decided action.

Among other proposals, the Governor of the Bank of Spain, Pablo Hernández de Cos, has called for the  creation of a European Deposit Insurance Scheme (EDIS) – the final pillar for the completion of a fully-fledged EU Banking Union – and a pan-European safe asset. Under the economic structure of the EU, capital and investment are internationally mobile but national factors determine many risks. These proposals would contribute significantly to mitigating the risks of applying national regulation to an international economy, and would better equip the bloc to manage future economic headwinds.

What would a common deposit insurance scheme and a pan-European safe asset mean?

EU member states currently have national deposit insurance schemes. This means that if a Belgian bank goes bankrupt, the Belgian government repays depositors’ funds. This system promotes financial and economic stability – as depositors will not fear putting their money in a bank if they know their deposits are insured. Banks, therefore, are able to make stable loans – which is key to driving local economies and fostering entrepreneurship –  ultimately putting depositors’ savings to work as investment.

In the EU, a problem can arise when money moves freely across borders if banking systems have different perceived levels of risk. If a crisis hits one country and depositors no longer believe that the government will be able to guarantee their deposits, they will be incentivised to withdraw their funds from the banking institution within the troubled economy, and put them into a bank in another more stable EU country. This individually rational behaviour can hurt the crisis country’s banking system, decrease investment in its economy, and bring about the collapse that depositors feared in the first place. Even in normal economic times, countries perceived to be more stable receive greater investment than countries with weaker economies, reinforcing inequalities.

The creation of an EDIS would eliminate the incentive for depositors to take their money out of a troubled banking system. If the EU insured deposits in Greek banks on the same terms as those in German banks, in the case of a sudden crisis affecting the Greek banking system, there would be no reason for people or companies to move those deposits from Greece to Germany. As a result, depositor confidence in a bank would no longer depend on that bank’s location, and the chance of financial instability triggering a full-on bank run would decrease.

A safe asset (also knows as a risk-free asset), on the other hand, is a bond that is guaranteed to repay its principal and interest; in practice, the government debt of stable countries is considered risk-free. Banks use such assets for repurchase agreements – so-called “repos” – where they post bonds as collateral to borrow money short term. This allows savers to lend their cash to the bank for a small quick return, and helps banks raise cash without selling their long term investments.

In the US, Treasury bonds serve this purpose throughout the country. There are only three eurozone countries, however, whose debt has triple-A ratings – Germany, Luxembourg, and the Netherlands. Other countries’ debt is riskier, meaning there is more demand for high grade safe assets than these three countries can supply. Without enough risk-free bonds to post as collateral, banks have a harder time accessing short-term cash, and overall investment in the economy can decrease.

The establishment of a common European bond market would mitigate risks of links between European banks and national governments. Copyright: symbiot /

Moving to a common pan-European safe asset would mean that, instead of nineteen countries issuing their own debt – some riskier than others – one central issuer would provide uniform eurozone bonds. This move would increase the supply of risk-free assets and help banks function more effectively. Furthermore, when a bank holds a large proportion of its home country’s debt, a banking crisis can easily become a fiscal crisis, or vice versa. A eurozone bond market would mitigate risks of links between European banks and national governments.

Can it be done?

These plans have little traction within Germany, the Netherlands, and other countries across Northern Europe. They fear that an EDIS would put them on the hook for repaying deposits in countries such as Italy or Greece, while establishing a common European bond market would raise their borrowing costs above what they pay now. On top of that, many in Northern Europe fear that a European risk-free asset is the first step to pooling debt obligations among eurozone countries with widely disparate debt burdens.

On the other hand, the Bank of Spain’s call for an EDIS and a pan-European safe asset, fit in with the government programme of Spanish Prime Minister Pedro Sanchez, strengthened by his party’s recent wins in national, regional, and European elections.

Italy’s populist coalition and the UK’s imminent departure from the EU provide an opening for Spain to increase its influence at an EU level. Sanchez has common ground with French President Emmanuel Macron, in his push for eurozone integration, and is likely to find allies in countries such as Portugal and Greece. The Bank of Spain’s view is that these steps are necessary for closer European integration. As a Bank official said, “It will not be easy to get the political consensus to move in that direction, but a window of opportunity opens up with a new European political term, and we believe that it is absolutely necessary.”

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Michael Fedynsky

Michael Fedynsky is a freelance writer based in Washington, DC. He is pursuing an MA at Johns Hopkins School of Advanced International Studies (SAIS), where he focuses on the political economy of Europe and Eurasia. He has previously studied and worked in France, Ukraine, Italy, Luxembourg, and the US.

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