When a European bank fails, who pays its depositors?

This difficult question is at the center of a stalled effort to unify the European Union’s banking market and its financial system in general.

Currently, the answer to that question is different in each EU country. Some countries have strong deposit-insurance schemes, backed up by solid government finances.

Other countries have weaker banks and wobbly government balance sheets – which could ultimately mean that taxpayers across the EU would have to bail out a failed bank.

European policy makers are trying to come up with a different solution, one that separates the credit risks of a bank from the creditworthiness of its government. Their proposed solution is to share the risk of bank failures across the EU by means of an EU-wide deposit-insurance fund. Private banks across the EU would pay into the fund, using their savers’ deposits and other assets.

This idea is political poison in Germany and other countries with strong regulation and relatively strong government finances. German voters, among others, strongly object to the idea that their savings might be used to pay depositors of failed banks in economically weaker countries.

Does this mean that in this case Germany is blocking an EU unification initiative?

“We always stand in the way when it comes to guaranteeing the stability of the financial system,” said Dr. Joachim Wuermeling, a member of the executive board of the Deutsche Bundesbank, Germany’s central bank, in response to this question.

He spoke at as a member of a panel of experts at a large-scale financial services conference in May. The conference, titled Future Europe, was held simultaneously in Frankfurt, Paris, Amsterdam and London, where local panels were connected by video links. The event was organized by the Frankfurt-based Maleki consultancy and public relations group.

The consensus of the senior bank executives, leading policy makers and national regulators at the conference is that the project to unify the EU’s financial markets has ground to a halt.

That standstill is harming the competitiveness of Europe’s banks and slowing down the EU’s economic growth, the panelists agreed.

Banking union “is a big opportunity, but we have been stuck in a lot of impasses,” Dr. Wuermeling said, noting that the EU must first take steps to reduce the risks that banks will fail in the first place.

“We need to be pan-European and supervise and regulate at the European level,” said Lorenzo Bini Smaghi, chairman of French financial services group Société Générale and a former member of the governing board of the European Central Bank. “We need a fresh start to convince governments that if they only look to their own backyards, this will increase the fragility of the financial system.”

“Putting national responsibility first is not preparing us for the future,” said Roland Boekhout, a member of the Management Board Banking of ING, the Dutch financial services giant. “Of course there is a national interest in people saying that their banks are stronger, or that their [national] guarantee system is better, and this leads to an impasse. National authorities have to give up some of their powers in order to make progress.”

The EU has been trying since the financial crisis of 2008-09 to reduce the risks of bank failures and to sever the link between the creditworthiness of banks and the creditworthiness of their national governments. The EU has also been looking for ways to share the risks of bank failures across the EU within the private sector banking system, rather than relying ultimately on taxpayers.

So far, they have made some progress. Under a project that became known as “Banking Union”, an EU-level body has been monitoring the stability of large banks since 2014. A central fund financed by banks across the EU was set up in 2016 to pay for the costs of restructuring failed banks.

Also, under a separate initiative known as Capital Markets Union, the EU has tried since 2015 to unify EU markets for investments in stocks, bonds and other financial instruments by creating joint trading rules and joint regulatory bodies to protect investors.

But at ground level, where individuals and companies use financial services, there is not much evidence of an EU-wide banking system. Many of the basic elements of a common system are still missing.

“The banking union is far from complete even for simple things,” said Professor Mark Wahrenburg of Goethe University in Frankfurt. “Savers have trouble opening bank accounts across borders, so for example a German saver wishing to open an account in Italy runs into problems. There are many examples of gaps in the single market.”

Beyond plugging those obvious gaps, policy makers have to make major changes in EU rules if banking union is to be politically acceptable in fiscally conservative parts of Europe, such as Germany and the Netherlands.

Since banks tend to hold large quantities of their own governments’ bonds, improving the balance sheets (i.e. the statements of assets, liabilities and capital) of national governments – and thereby boosting the credit quality of those governments’ bonds -- is part of the to-do list. In practice that would mean governments spending less and collecting more in taxes.

“We would have more safe [bank] assets if some countries showed more budget discipline,” commented Dr. Wuermeling of the German central bank.

Beyond that, the EU would need to agree on stricter rules on how banks do business, including how much money they must hold in reserve.

“The risks must be reduced before we consider a common deposit insurance system,” said Dr. Joerg Kukies, State Secretary in the German Finance Ministry. “This implies more attention to requirements for [banks’] reserve capital, and it requires further attention to sovereign debt.”

Ultimately, banking union would rest on a firmer foundation if EU member states were to agree on common tax and spending policies, eliminate tax havens within the EU, simplify the rules for cross-border banking, and strengthen enforcement as well as regulation at the EU level.

It’s a long list, and the EU is not likely to achieve those goals any time soon – particularly against a background of rising nationalist and populist sentiment.

Tax harmonization, for example, has been a stumbling block for decades. “Regarding tax harmonization within the EU, I am very skeptical,” said Friedrich Merz, a prominent politician and currently chairman of the German division of BlackRock, the global American investment management corporation.

“Even within the EU we still have tax havens in Malta, Ireland, the Netherlands and Luxembourg,” Mr. Merz said. “Tax arbitrage is still possible within the EU, even in the area of direct taxation [taxes on income and profits]. We talk big about further harmonization. But as a first step we need to agree to do away with such examples of preferential tax treatment.”

Despite such barriers, experts called for continued efforts to create the necessary conditions for a single EU market in financial services.

Banking union aims to strengthen European banks by giving them access to an EU-wide market, which in turn should improve the financing support they can offer European companies. For individuals, banking union offers the promise of a broader, Europe-wide choice of financial services providers.

“All these technical topics have the ultimate goal of making Europe stronger, making access to finance easier, and contributing to Europe’s world competitiveness,” Dr. Wuermeling concluded.