In 2012 eurozone leaders vowed to break the “doom loop” by which national governments and their banking systems could drag each other down in a financial crisis. This began the long journey towards a banking union in which taxpayers would no longer be on the hook for failing banks.

Had the leaders fully understood what they were signing up for, they may not even have started. The logical destination of breaking the doom loop is to relinquish one of a government’s most attractive powers — the ability to make “its” banks finance its deficits when nobody else is willing. The fear of losing a captive market for sovereign bonds is now turning into a seemingly insurmountable obstacle to progress, notably in one country.

Rome has emerged as the biggest stumbling block to the two big financial reforms of the euro: upgrading the European Stability Mechanism rescue fund for troubled governments, and completing the banking union.

The new ESM treaty is being held up because the Italian opposition, led by Matteo Salvini, is agitating against it on the grounds that it will force losses on Italians who put their savings in government bonds. Rome is holding off on approving the ESM until it can make it politically saleable at home. “Basically they need something to claim victory,” says Lorenzo Codogno, former chief economist of the Italian Treasury. Regional elections at the end of the month do not help.

Rome has let it be known it wants the ESM passed as part of a “package deal” which must include banking union and its ultimate prize of a common deposit insurance scheme. But it is simultaneously resisting demands from counterparts that banks must first be prevented from holding too much of their own country’s debt, or common deposit insurance is out of the question. Again, compromise founders on the fear of making it harder to sell government bonds.

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As Mr Codogno warns, “if Italy blocks ESM on basis that it can get a package deal, that may be a miscalculation and you may get nothing”.

“I doubt that this position will prevail,” says Lucrezia Reichlin, economics professor at London Business School. A regional election win should make it easier for the government to sign off on the ESM revision, she notes.

Still, for banking union to get moving again two concerns must somehow be satisfied at the same time: the need to reduce banks’ exposure to their own sovereign, and debt-laden governments’ fear of not being able to borrow. Italy’s central bank chief, Ignazio Visco, has stated repeatedly that capital charges on banks’ sovereign exposures could be acceptable if, but only if, a common eurozone “safe asset” — a “eurobond” — was introduced at the same time. That solution, however, is anathema to Germany and other northern states.

An intriguing alternative is being promoted by Luis Garicano, an economist and liberal Spanish MEP. Instead of substituting common eurobonds for government bonds, Mr Garicano recommends letting banks treat as risk-free a diversified “safe portfolio” all eurozone government bonds. Under such a system, any Italian bonds that Italy’s banks needed to offload would be bought by banks elsewhere in Europe, because they would diversify away from their country’s debt. It would also encourage investment banks to securitise diversified bundles of bonds.

It is not just high-debt countries’ bonds that would be reshuffled to other jurisdictions under such a system. Among banks supervised by European authorities, seven out of the 15 most exposed to their home governments’ debt are German (and only three are Italian), according to calculations by economist Eric Dor.

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Mr Codogno thinks such a solution “would be acceptable to Italy”. The German finance ministry’s latest initiative on banking union is also compatible with it. Could a “safe portfolio” be the Gordian solution to the banking union knot? It is hard to see what else could.



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