The ECB's risky business

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A common currency cannot function if banking systems remain segmented along national lines, as a result the eurozone does not need an 'economic government' but an integrated banking market complete with a common supervisor, argues Daniel Gross.

Daniel Gross is an economist, professor and the director of the Centre for European Policy Studies.

"A central bank always has a crucial role to play in a financial crisis. But the European Central Bank's role within the eurozone nowadays is even more 'central' than that of the Federal Reserve or the Bank of England.

A key difference between the eurozone and the United States is that lending between two banks located in two different member countries is still perceived as carrying quite different risks than 'domestic' lending (between two banks in the same country).

This is not the case in the US, because it has an integrated financial system, and support for banks (deposit insurance or outright bailouts) is administered at the federal level.

As a result, the fact that California might be closer to bankruptcy than some eurozone countries has no influence at all on the credit rating of banks headquartered there, or on their ability to obtain funds on the interbank market. In Europe, by contrast, the fate of all banks depends upon their home governments.

During the credit boom before 2007, enormous cross-border interbank claims built up, because banks trusted one another. Then, in 2008, the interbank market suddenly froze as that trust evaporated. This was a generalised phenomenon, not focussed on particular countries, because it was still assumed at the time that all eurozone governments would be able to bail out their own banks.

Now that the 'southern' eurozone governments' solvency no longer seems assured, distrust has grown along national lines. German banks continue to lend to each other (and to other banks in northern Europe), but they are no longer willing to lend to Italian, Spanish, or other banks in southern Europe.

A sudden withdrawal of interbank funding has the same consequences as a bank run. A bank that suddenly has to repay its interbank debt must cut credit to its own customers or sell off other assets, leading to large losses. This is precisely what happened when the interbank market froze after Lehman Brothers collapsed in 2008."

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Published in partnership with Project Syndicate.