An effective banking union is essential for the European Union if future euro crises are to be avoided, panellists at the 2013 Brussels Economic Forum agreed. But what will the components of this banking union be, and how will it address banking sector risks?

The EU started work to establish a banking union last year in an attempt to break the ‘vicious circle' between banks and state finances and to avoid the burden of supporting banks falling on taxpayers. Erkki Liikanen, the Governor of the Bank of Finland, hailed the agreement by EU leaders this year giving the European Central Bank (ECB) the responsibility for supervising banks across the euro area and other Member States that opt to join the Single Supervisory Mechanism (SSM).

“That financial stability should be an important objective should be self-evident. The solution has to be a Single Supervisory Mechanism. This needs to power to shut down and wind up non-performing banks,” Liikanen said, adding that the logical follow-up to the SSM was a Single Resolution Mechanism to shore up Europe's banking sector. “Protecting the sovereign from danger from contagion is not the only aim. It should also protect the banks from contagion from sovereigns,” he said.

Maarten Verwey, the European Commission’s Deputy Director-General for Economic and Financial Affairs (ECFIN), said that rapid progress to a fully-fledged banking union is absolutely essential for Europe’s economic health. “We need banking union, and sooner rather than later. It is absolutely important to break the feedback loops between bad banks and weak sovereigns,” he said. After what he called “the momentous step” of creating the Single Supervisory Mechanism, he said the Single Resolution Mechanism was needed so that banks can be resolved in an orderly manner.

Verwey called for ample liquidity for banks, but he insisted it did not mean that taxpayers should pay for this. “Banks should pay – the problems in one bank create instability in the entire sector. This gives strong incentives for the sector to watch out for excesses,” he said.

Claudia Buch, chair in Economics at Otto von Guericke University Magdeburg, said there was an obvious problem of debt overhang that created risk in banking. “Banking union will create a common risk sharing mechanism, which is critical to the proper functioning of the financial system,” she said, before noting an imbalance in the financial markets. “Why did we have so much integration of debt markets but not of equity markets? What would have happened if equity markets were more integrated?”

Jim O’Neill, former Chairman of Goldman Sachs Asset Management (GSAM), highlighted the importance of timing, as the environment changes so fast. “If EMU is to be strengthened, you have to do it now, because when you go further in the future, the natural incentive of players will recede,” he said. O’Neill said it was essential to be clear about what was being regulated. “Not all financial institutions have the same purpose – what an investment bank exists for is not the same as commercial banks. But you need both doing separate things for a healthy economy,” he said. He added the hope that a properly executed banking union could lead to genuine cross-border banking mergers, which have been few in Europe.

Marek Belka, President of the National Bank of Poland warned that there was lukewarm support for banking union in Poland. “If we pool our banks – small, with conservative profiles – with the big banks in Europe with risky profiles, what will happen? How will it deal with small subsidiaries of big banks? With regard to macro-prudential instruments, Mr Belka expressed concern. "Risks show up locally or nationally and we think they should be dealt with locally”, he said. "So will macro-prudential policy remain in national hands or will it be pooled together in Frankfurt?" These concerns, he suggested, could also explain the relative hesitancy of some non-euro area Member States over banking union, but deliberations among these countries continue.