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The balkanization of European banking

The sudden urgency among policymakers to proceed with European banking union stems from a dawning realization of the extent to which national regulators have promoted an opposite response to bank deleveraging: trapping bank capital and liquidity inside their borders to conserve local credit availability.

This balkanization will render ECB monetary policy irrelevant and make the credit crunch even worse in the periphery and recession more likely to spill over into the core.

Risk was very much on last month, with spreads on peripheral eurozone sovereign bonds narrowing and European bank issuers returning to the primary debt capital markets as yield-hungry, cash-rich investors chased returns. Optimism among investors that European policymakers were getting a firmer grip on the eurozone crisis even appeared to survive the inconclusive eurozone summit of October 18-19.

This put back the deadline for creating a single supervisory mechanism for European banks to some time later in 2013, rather than the start of the year as optimistically first outlined in June. But at least it left open the prospect of progress on this essential precondition for the European Stability Mechanism directly to recapitalize struggling banks without also adding to the liabilities of struggling sovereigns.

The danger now, amid all the earnest talk of the numerous legal and operational complexities of European banking union, is that it draws attention away from the reality that national regulators are quietly applying an alternative remedy to the risks of bank deleveraging and credit shortages.

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