Hugo Dixon

Some European policymakers are talking about a “banking union” for the euro zone as if it was around the corner. Jose Manuel Barroso, the European Commission president, for example, told the Financial Times last week that such a union – which would involve euro-wide supervision, bailouts and deposit insurance for the banking industry – could be achieved next year.

But this is not remotely likely. Parts of the zone’s banking industry are so rotten that taxpayers elsewhere can’t reasonably be asked to bear the burden of bailing them out. A massive cleanup is required first. The crisis in Greece, Spain and other countries may provide the impetus. But even then, as Germany suggests, banking union should proceed in stages.

The appeal of a euro zone banking union is understandable. Governments and lenders are currently roped together in what has been dubbed the sovereign-bank doom loop. Weak banks – for example those in Spain, Ireland and Cyprus – can drag down their governments when they need a bailout. Equally, weak governments, such as Greece’s, can drag down their banks when those are stuffed with their own sovereigns’ bonds. By shifting responsibility for bailouts to the euro zone as a whole, the loop could be cut. Or, at least, that is the hope.

The snag is that banks and their governments are entangled in a tight incestuous relationship. Some of Spain’s cajas, for example, made dubious loans to their directors, as well as financing politicians’ pet projects. And the ex-chairman of Bankia, which has required the mother of all bailouts, was a former finance minister. Conflicts of interest have also been rife in Ireland, Cyprus and Greece. Even supposedly virtuous Germany has suffered from incompetent Landesbanken, controlled by regional governments, whose boards are filled with political appointees.

Bank boards were often useless or worse. But the national supervisors who should have spotted the problems were not much better. And Europe’s initial attempts at cross-border banking supervision have been pathetic. A European-wide stress test in 2010 didn’t even bother to examine Anglo Irish, a cesspit of bad property loans which virtually bankrupted Dublin. Another test in July 2011 concluded that Spain’s banks were only 1.6 billion euros short of capital. Then another last October bumped the number up to 26 billion euros – but didn’t stress the lenders’ property loans. Finally, last weekend’s bailout came up with a hopefully more realistic figure: up to 100 billion euros.

Governments have given the European Banking Authority (EBA) inadequate authority to overrule national supervisors. Meanwhile, the domestic authorities always have an incentive to downplay the capital needs of their banks. So long as lenders are pronounced solvent, they can get liquidity from the European Central Bank. That way, governments can delay putting in any of their own money to bail out their domestic lenders.

Part of the “doom loop” involves banks stocking up on sovereign debt. That link has grown tighter in Italy and Spain in recent months as foreigners have stopped buying bonds, leaving domestic lenders to step into the breach. They got the money from the ECB. If governments really surrendered control of their banks to a tough supranational agency, it would be harder to engineer such a money-go-round.

Yet another problem is that governments are reluctant to inflict losses on bondholders. In Bankia’s case, there were an estimated 12 billion euros of subordinated debt and 8 billion euros of senior debt – or 20 billion euros in total. These have not suffered losses as part of the bailout. But unless there are haircuts for a bank’s own bondholders, is it reasonable to ask the taxpayers of a foreign country to fork out cash to bail out banks and their depositors?

All this means that for banking union to work effectively, there needs to be effective supervision as well as a system to bail in bondholders. Everyone agrees on this. The real debate is largely one of timing. The peripheral countries want a euro-wide system of bailouts and deposit insurance fast, as an answer to the current crisis. Germany is stressing the need to start with supervision.

Berlin is right that the clean-up has to come first. That may, of course, be accelerated by the crisis. Spain’s banking bailout gives the rest of the euro zone a golden opportunity to insist that its system of crony finance is swept away. The same goes for Cyprus, a haven for recycling dubious money from Russia and elsewhere, if it requires a bailout.

But the euro zone will also need to determine who will supervise banks. The EBA is a busted flush. So it would be best way to empower an institution that has credibility. The obvious candidate is the ECB – an idea Germany’s Angela Merkel backed last week. But even that could be problematic: giving the ECB responsibility for supervision as well as monetary policy would concentrate a huge amount of power in a single body. Even it might struggle to monitor banks over such a vast area.

Then, of course, a system for bailing in bondholders needs to be crafted. Although the European Commission this month proposed a plan, it is not supposed to kick in until 2018. Finally, there is the question of how governments in trouble will finance their debts if they can no longer lean on their banks. Nobody yet has a good answer to this.

The banking union train may be about to leave the station. But it will take years to reach its destination.