(By Mani) As the market is concerned with the potential exit of Greece from the European Union, let's focus on an area that has been ignored by media as well as investors. This is nothing but lack of an integrated banking system in the Euro.
Euro, as a monetary union, lacks an integrated banking system backed by a credible lender of last resort. This plays a crucial role in a monetary union by ensuring that internal imbalances in trade are readily offset by capital flows.
For example, a monetary union like the United Kingdom where the regional imbalances in trade that exist between the component parts of the monetary union are not something that is economically important, partly because of the existence of a functioning fiscal union.
"Those regions with a "trade deficit" towards the rest of the country may be net recipients of fiscal transfers, and that is a capital flow finances the current account imbalance. Partly, however, it is the result of an integrated banking system," UBS economist Paul Donovan wrote in a note to clients.
The Euro area's lack of a pan-monetary union banking system has seen an evolution of capital transfer mechanisms. Initially this was through bank lending from banks in one economy to customers in another economy, creating a country risk to the bank. In reality, it is not that different from a UK bank using deposits in Kent to lend to Yorkshire.
With the advent of the global financial crisis, this mechanism has shifted. Banks are retrenching in the Euro area, and the capital flow of cross border lending that balanced the internal balance of payments has been lost.
Instead, as is well known, an imbalance has occurred in the Target II transfer system with central bank money. Target II is an interbank payment system for the real-time processing of cross-border transfers throughout the European Union.
What is happening now is a Greek importer is effectively creating a securitized liability with the Greek central bank, and the Greek central bank incurs a liability with the Bundesbank and receives money from the Bundesbank to pay for the import.
"As long as the Euro is intact, this is not a problem. Any loses incurred because of collateral default, for instance, are incurred in common by the European System of Central Banks. It could be considered akin to foreign exchange intervention in a fixed exchange rate system," Donovan noted.
As a result, creating an integrated Euro area banking system would help as it further internalize the imbalances that persist in the Euro area. A single bank regulator, a single source of capital for bank bail outs, and a single lender of last resort for the banking system would create a more integrated banking system across the Euro area than exists today.
"To be sure this would do nothing to change the relative competitiveness or growth issues that plague the Euro area monetary union. However, the risks that surround the essential capital flows would be lessened" the economist added.