Europe's banking reform a move forward but economists still wary

The European Union does not draw straight lines. Last week's tortuous agreement on a common system for shutting failed banks exemplifies the awkward, often unstable compromises by which Europe advances.

Banking union is the biggest leap forward in EU integration since the launch of the euro single currency in 1999, and one of its main architects wasted no time in trumpeting the momentous landmark.

"I want to underline the speed and the magnitude of this achievement," European Council President Herman Van Rompuy boasted after the deal among finance ministers. "I know it means a huge deal for markets and the financial world."

From next year a single supervisor based in the European Central Bank (ECB) will take direct charge of the EU's 126 biggest banks, with a single resolution board to decide when a bank needs to be broken up or closed, backed by a fund financed by a levy on the financial sector.

In line with the precedent set in the euro zone's bailout of Cyprus in May, the bank's shareholders, creditors and large depositors would all take losses before national and ultimately European resolution funds were tapped.

Yet the complex procedures required to order the winding up of a bank, the multiple decision-makers potentially involved, and the absence of a common public financial backstop have led critics to warn that the wobbly new system will not work, let alone break the "doom loop" between weak banks and weak states.

It will take a decade for contributions levied on banks to fill a resolution fund, and it's not clear whether that fund will be able to borrow on the markets.

What happens, economists ask, if the ECB review of banks' balance sheets and stress test of their ability to withstand financial shocks reveal large capital holes next year, before the fund is in place?

Such criticism, while technically accurate, misses the point. The EU has shown its determination to keep the show on the road through four years of financial and economic crisis.

DRAGHI'S PLEDGE

That resolve was best illustrated by ECB President Mario Draghi's July 2012 pledge to do "whatever it takes" to preserve the euro, ending speculation of a possible break-up.

Those words continue to keep markets calm, even though Draghi's offer to buy the bonds of any euro zone country that accepts an internationally monitored bail-out programme has not been and may never be implemented.

When it came to banking union, the conflicting demands of creditor and debtor states and of members of the euro and non-members, some of which like Britain may opt out while remaining part of the single financial market, made any solution complex.

As so often in the past, when EU countries cannot agree to do something immediately, they set a timetable for doing it in the future, leaving irksome details to be thrashed out later.

So the bank levies paid into the resolution fund will be mutualised at the end of the 10-year phase-in.

Complexity, delay, interim steps and planting flags of intent for the future are all part of the toolkit of the architects and plumbers building and fixing an edifice that is neither a federal state nor just a international organisation.

That's how the single currency was born in the first place - a deliberately incomplete construct to which its founders knew additional features would have to be added over time.

Much of the criticism of the European approach to banking union has been based on comparisons with the US Federal Deposit Insurance Corporation, which underpins American banks with a credit line from the US Treasury.

The EU may eventually reach such a system - possibly after another crisis - but for now its main paymaster, Germany, is not prepared to go that far.

Chancellor Angela Merkel, determined to shield taxpayers from liability for other countries' banks and to avoid censure by the German constitutional court, insisted that the European bank resolution fund should not be given a credit line by the euro zone's bailout fund for states.

RED LINE

Permanent fiscal transfers to weaker EU partners remain a red line for the Germans, who insist that Europe's economic woes can be overcome with stricter enforcement of agreed rules.

As to the practical aspects of the new system, closing a bank may be simpler in practice than it looks in theory, EU regulators say, because it is highly unlikely that any national authority would challenge a recommendation of the single resolution board in an emergency.

In reality, a few telephone calls between the resolution board's chief, the ECB and the European Commission may settle the matter.

If the system doesn't work, it will be fixed, probably at night on a weekend. That's the way Europe works.

On two weekends in May 2010, for instance, EU finance ministers meeting almost around the clock agreed on a rescue for heavily indebted Greece and, when that proved insufficient to calm markets, on the creation of a temporary bail-out fund.

That was eventually followed by a permanent rescue fund with a larger financial firewall, but still subject to unanimous decision-making that gives Germany, and its parliament, but also Finland and Slovakia, a veto over bailouts.

Merkel often cites the Latin term "ultima ratio" - the last resort.

It doesn't look pretty. In design terms, the EU's decision making process produces camels rather than horses.

But the EU keeps moving forward because of the political capital invested in it and the strong awareness of how much each member, especially Germany, stands to lose if the monetary union and the single market were to fall apart.

European officials have long compared European integration to a bicycle which has to keep moving to avoid falling over.

The European bicycle sometimes advances so hesitantly that it zig-zags rather than tracing a straight line. But as last week's banking union deal shows, it is still moving forward.