Irish tapes show need for EU bank union

Speaking at last week's EU summit, Irish Prime Minister Enda Kenny described the tapes as "a thunderbolt," adding they "damaged our reputation."

German Chancellor Angela Merkel said it was "simply very hard to swallow for people who go to work normally every day, who earn their money."

The leaked recordings re-open wounds that date back to the 2008-9 financial crisis and, in particular, to the fraught weekend in September 2008 when market-induced panic saw the Irish government become the first in Europe to make the fateful decision to guarantee all liabilities held by its banks.

The move had a domino effect.

It forced other EU governments to follow suit and guarantee their own institutions in order to prevent capital flight as savers rushed to move their money to banks where its safety would be guaranteed.

It created a precedent for states to bail out banks.

When it became clear that Irish banks had severely understated the size of their debts, it also led directly to Ireland's budget deficit reaching 30 percent of GDP and being forced to seek a €67.5 billion bailout in autumn 2010.

Nearly €40 billion of the money was needed to cover losses of Anglo-Irish and the Bank of Ireland.

By August 2011 total funding for six Irish banks by the European Central Bank (ECB) and the Irish Central Bank came to about €150 billion, over 20 times the original sum asked for when Anglo-Irish first got out the begging bowl.

It is a salutary tale about the havoc that can be wrought when one country decides to go it alone.

But the release of the tapes into public consciousness was timed perfectly as far as EU policy making is concerned.

Last week, finance ministers agreed their negotiating mandate on the proposed bank recovery and resolution directive - the EU legislation that will put in place common rules for when a bank requires emergency support or needs to be liquidated.

The 17 members of the eurozone also agreed to allocate up to €60 billion of the European Stability Mechanism (ESM), the eurozone bailout fund, to directly recapitalise ailing banks.

Meanwhile, financial services commissioner Michel Barnier is expected to release his proposal for a single resolution mechanism for the eurozone's banking sector next week.

Buried in last week's EU statements are commitments for ministers to agree on the resolution mechanism amongst themselves by the end of 2013.

It is the same timeframe as they give for agreement with MEPs on the recovery and resolution directive.

It is now looking increasingly likely that the key pieces of banking union legislation will not be finished by next May's European elections.

The newly-agreed supervisory regime, with the ECB having oversight over the bloc's biggest banks, will come into force in mid-2014.

However, supervision was always likely to be the relatively easy bit.

What is trickier, and more politically controversial, is what to do when a bank gets into such difficulties that it must be either propped up or liquidated.

It is now apparent that Berlin is leading the way in scuppering plans for a eurozone banking union, at least until after the federal elections in the autumn.

German intransigence on banking union comes down to a similar rationale to that used by Berlin during the debt crisis - rules to wind down banks must be applied rigidly in all cases, and they will not agree to a common resolution fund which, to German eyes, looks suspiciously like another bailout tool.

Both elements are needed.

Harmonised EU rules, including a hierarchy of creditors to be "bailed in," would finally allow individual banks to fail while safeguarding the overall stability of the sector.

Meanwhile, although resolution and recovery should be about preventing bank collapses rather than emergency tools to help cover the costs of one, there are legitimate reasons for wanting another financial backstop.

With the eurozone's periphery countries mindful of the Cypriot bailout fiasco, and aware that the failure of one or two domestic banks could wipe out any national resolution fund they had in place, it is difficult to imagine any small eurozone country that would not want an EU-level fund.

The financial crisis demonstrated just how dangerously interconnected the European banking system had become.

For example, UK and German banks were highly exposed to Irish debt. Had either Ireland or Greece opted to default rather than receive high interest bailout loans, banks in Germany, France and the UK would have taken big financial hits that they were in no position to absorb.

That threat of contagion still exists.

Cyprus was dragged to its own debt trap-door after its banks lost over €4 billion as part of the haircut on Greek debt held by the private sector.

The Anglo-Irish tapes are a painful reminder of the criminally reckless and negligent practices by a handful of bankers who brought the financial sector to its knees.

But it should also spur politicians to agree on the most important parts of banking union.

Without pan-EU rules on bank resolution, including clear rules on the hierarchy of creditors to be bailed in, and a fund to cover costs, the bloc remains one bank collapse away from a crisis.