Isabel Schnabel (center) is a professor of financial economics at Bonn University and a member of the five-strong German Council of Economic Experts | Arne Dedert/EPA German economic adviser: ‘Italy is another argument for reforming now’ Bonn University’s Isabel Schnabel says even small-step eurozone reforms would be better than no deal.

Isabel Schnabel is a professor of financial economics at Bonn University and a member of the five-strong German Council of Economic Experts, an academic body tasked with advising policymakers on matters of economic policy.

Why do experts and governments alike deem the completion of a banking union so crucial at this stage?

At the core of the euro crisis in many countries was the close interaction between the banking sector’s health and the risk of sovereign default, as witnessed by huge bank bailouts and by banks holding a high amount of their own government’s debt. That means that a banking crisis can put the government’s budget at risk — as we saw in Ireland — and that a fiscal crisis, in turn, can be a drain on banks’ balance sheets, leading to what economists call the “doom loop” between sovereigns and banks. To stabilize the euro area and foster the financial integration across countries, we need to end this vicious circle.

The German and French governments seem to have discussed further steps, like a backstop for the bank resolution fund. But will that be enough?

First of all, we must acknowledge that many things have been achieved since the global financial and euro crises. Many far-reaching decisions were taken that make the monetary union stronger today than it was 10 years ago. Creating the single supervisory mechanism for banks across the area was a major step. As was the new resolution mechanism to allow for an orderly winding down of failing banks, which limits the potential cost for taxpayers.

But on the sovereign-bank nexus, the progress has been slow and a number of crucial elements are missing. So an agreement on the backstop — important as it is — would clearly not be enough.

So are governments now ready to go further on contentious issues such as a joint guarantee scheme for bank depositors?

In Germany, the discussion on the European deposit insurance scheme (EDIS) has been poisoned by misleading narratives from the banking industry. They have raised fears about the country’s savers being asked to bail out Italian banks, or others. And this misconception has been hard to fight by those who know better. I think the discussion should instead focus on how to design EDIS in a way that avoids bad incentives.

You co-authored the policy brief put forward by French and German economists in January, which suggested capping the amount of their own government’s debt that banks would be allowed to hold. Is that in your view a reform that should be enacted together with EDIS?

The two must go together because if banks take on too much exposure to their own governments — in Italy or elsewhere — the risk of sovereign default could partly be shifted to the European level through joint deposit insurance. That’s why the group of French and German economists is suggesting what we call sovereign concentration charges, as an incentive for banks to diversify away from their own country. They imply higher capital requirements for banks with high concentration in their sovereign exposures.

In order to break the sovereign-bank vicious circle, all the parties have to overcome their red-line mindset. All these red lines set by Berlin, Paris, Rome or others aren’t compatible. Too many lead to no intersection and no policy action …

Will that be a bad signal if EU leaders can’t agree on these reforms at their June summit?

I don’t share the view that no deal would be better than a small deal. In any case, if we talk about EDIS or sovereign concentration charges, there would have to be long transition phases. It’s not as if those things could be implemented overnight. What’s important is to keep the process going. Even small steps are a success, it shows that there is a willingness to move on with euro area reforms. But even if some reforms are introduced only later, one should agree on a road map now.

Does the new government in Italy and its seemingly anti-euro leanings play into the old German fears?

I’m afraid it does. But you could argue that this is another argument for reforming now. It becomes clear that we shouldn’t wait for the next crisis. The next one could be very harmful, if not destroy the euro altogether. Space for action will be limited, both on the monetary and fiscal side. That said, I’m very worried about the Italian situation.

Even though the two parties have finally watered down their most virulent anti-euro proposals?

Such discussions destroy trust. A construction like the eurozone only partly rests on rules, technical procedures, institutions, etc. It relies on the fact that governments can trust each other at a minimum level. Take that away, and the whole edifice suddenly becomes much more fragile and the willingness to reform shrinks. This certainly does not help with regard to the June summit.

This interview was edited for length and clarity.

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