Banking Unions: Distorted Incentives and Efficient Bank Resolution

A banking union limits international bank default contagion, eliminating inefficient liquidations. For particularly low short term returns, it also stimulates interbank flows. Both effects improve welfare. An undesirable effect arises for moderate moral hazard, as the banking union encourages risk taking by systemic institutions. If banks hold opaque assets, the net welfare effect of a banking union can be negative. Restricting the banking union mandate restores incentives, improving welfare. The optimal mandate depends on moral hazard intensity and expected returns. Net creditor countries should contribute most to the joint resolution fund, less so if a banking union distorts incentives.