Although significant progress has been made in strengthening the euro area's architecture since the financial crisis 15 years ago, the monetary union remains incomplete, which will leave eurozone countries more vulnerable to financial shocks. The Economic and Monetary Union (EMU) had been designed to force members to take responsibility for their financial stability by prohibiting euro area members from assuming the financial liabilities of others. In the face of the financial crisis of the late 2000s and early 2010s, however, the absence of an overarching financial architecture capable of pre-empting a systemic financial crisis due to the so-called sovereign-bank nexus was recognized as a major design flaw that made the euro area particularly vulnerable to systemic financial crises. In some countries (like Greece, Italy and Portugal), sovereign distress and default caused banking sector instability. In other countries (like Cyprus, Ireland and Spain), banking sector weakness led to sovereign financial distress. Without the ability to intervene and backstop sovereigns and national banking sectors, this nexus risked turning into a self-reinforcing financial doom loop. In response to the Greek financial crisis, the euro area created financial instruments and financial architecture to deal with financial instability by providing distressed countries with financial support in the form of loans issued to Greece's government. In the wake of the Spanish banking crisis, Europeans discussed the possibility of public, joint and direct recapitalization of banks through the European Stability Mechanism, which was originally meant to provide loans to governments only. The instrument is on the books, but EU countries have been wary of using it due to the requirement that governments provide financial support, among others. With a fiscal union not on Brussels' agenda due to disagreement between countries with high and low debt levels over risk-sharing, moving toward greater euro area banking sector integration represents the second-best solution, though it would involve much lower levels of risk-sharing and hence collective risk mitigation. 

• Prior to the 2009 financial crisis, the eurozone had only limited harmonization of banking regulation, and only in the form of directives rather than regulations, such as the Banking Directive (established in 2000) and the Capital Requirements Directive (established in 2006). National authorities largely remained in charge of supervision. The European Union also created a Committee of European Banking Supervisors (CEBS) in 2004.
• The European Union's Maastricht Treaty contains an enabling clause that allows the European Central Bank to take on prudential supervision of credit institutions and other financial institutions, subject to European Council approval and European Parliament assent. This article formed the legal basis for the euro area members to establish a banking union and delegate supervision to the ECB.
• In 2012, the Van Rompuy paper proposed creating a banking union, a fiscal union, an economic union and a political union to strengthen the EMU and the European Union. The banking union presented the path of least political resistance.

The European Union's banking union was originally intended to consist of three pillars — supervision, resolution and common deposit insurance — but euro area governments only succeeded in establishing the first two. Rather than a politically impossible fiscal union to sever the bank-sovereign nexus, EU governments agreed to move toward a banking union by establishing eurozone-level banking supervision and a resolution authority (including a resolution fund). This was designed to reduce the risk of destabilizing financial spillovers by preventing bank failures from triggering sovereign distress and by preventing sovereign distress from destabilizing the national and European banking sectors. The European Union's Single Supervisory Mechanism entered into force in 2014 and transferred the supervision of larger euro area banks from national supervisory authorities to the European Central Bank, or ECB. Smaller and mid-sized banks remained (and remain to this day) under the supervision of national authorities, though the ECB was given the power to intervene in case of systemic financial stability risk. The Single Resolution Mechanism consists of the Single Resolution Board (created in 2014), as well as the Single Resolution Fund (created in 2016), which is financed by contributions from banks and provides the board with the means to intervene in case of banking crises. But euro area governments failed to create a common backstop supporting the Single Resolution Fund, or SRF, due to Italy's unwillingness to ratify the required ESM treaty change. They also failed to establish a common European deposit insurance scheme, or EDIS, due to opposition from creditor countries to underwrite other countries' banking sector risk. 

• All countries that use the euro are automatically members of the Single Supervisory Mechanism, while those that do not use the euro can opt in to the regime.

Creditor countries, meaning countries with low levels of government debt (like Germany), have reservations about the establishment of a common European deposit insurance scheme, while Italy, a country with high debt levels, has blocked the creation of a common backstop to the SRF. As it stands, the SRF has only limited funds to deal with a systemic banking crisis. But creditor countries remain unwilling to pledge to guarantee euro banking sector deposits in the guise of an EDIS for fear of directly or indirectly underwriting debtor countries' banking sectors and sovereigns. From these countries' point of view, a common deposit insurance backed by public resources would provide a subsidy to debtor countries while still letting them load their banking sector with government debt. Instead, Germany has pushed for higher capital charges on bank holdings of sovereign debt to reflect the higher risks of banking sectors' holding significant amounts of lower-rated national government debt. Such concentration charges would reduce the risks to debtor countries' banking sectors and would, in turn, indirectly reduce the risk to creditor countries (or countries able to backstop their banking sector due to low levels of government debt). But from debtor countries' point of view, imposing a limit on their banking sector's ability to hold government debt would force their banks to raise more capital and/or reduce their government's ability to sell debt to banks. Germany's proposal is thus unacceptable for countries with high levels of government debt, like Italy, as they rely on their banking sector to provide financing, particularly during a crisis. However, without progress on the so-called regulatory treatment of sovereign exposures, creditor countries are not going to back a European deposit insurance regime for fear that it would see their banking sectors indirectly insure other countries' sovereign risk.

• The SRF is limited in size, accounting for only about 1% of covered deposits. The fund is not meant to be used to absorb financial losses incurred by a distressed bank or to recapitalize distressed bans. Under certain, restricted circumstances, the SRF can provide substantial support to a bank under resolution, but only if at least 8% of the bank's total liabilities have been bailed in; contribution also cannot exceed 5% of the bank's total liabilities.
• The rejected SRF common backstop was meant to replace the Direct Bank Recapitalization Instrument, or DBRI, which was introduced in 2014 and allows the ESM to directly recapitalize ECB-supervised banks in case of systemic stability risks and under certain conditions. The DBRI limits common risk-sharing by requiring member governments whose banks are in trouble to make a potentially significant contribution to a bailout, thus limiting risk-sharing and partly undermining the objective of severing the sovereign-bank nexus. But the DBRI is difficult to activate and has thus never been used. 

Further progress on banking integration remains unlikely until another major crisis forces creditor and debtor countries to reach a compromise. Making further strides toward a more complete banking union will require euro area governments to find a compromise on sovereign exposures, the extent of an EDIS, and risk-sharing more broadly. However, countries with low government debt (like Germany and the Netherlands) will remain unwilling to provide significant public resources to support other countries' banking sectors in the guise of a common deposit insurance scheme, unless highly indebted countries (like Italy and Spain) account for the higher risk sitting on their banking sectors' balance sheets due to their significant holdings of government debt securities. But debtor countries will also remain reluctant to limit their banking sectors' holdings of sovereign debt by agreeing to Germany's proposal of higher capital charges. This impasse is unlikely to be resolved anytime soon, as the current stability of eurozone banks — which made it through the recent period of global monetary tightening relatively unscathed — sharply limits the incentives to reach an agreement. Substantial progress on banking sector integration will thus likely hinge on another major crisis that forces eurozone countries to come together and find a consensus to crisis-proof the currency area. 

• The previous European Commission failed to establish or make progress toward a European deposit insurance scheme and creating a common backstop to the SRF, despite pledging to do so when it came to office in 2019. This shows just how far apart creditors and debtors are on the issue of completing a banking union. The new European Commission, which is about to take office, remains verbally committed to making progress on capital markets integration. 

The lack of a sufficiently large common backstop means that sovereign distress can quickly roil the eurozone's banking sector, representing an ongoing risk to the currency area's stability. A systemic banking sector crisis, triggered by a sovereign debt crisis for example, risks pushing the eurozone's highly indebted governments into financial distress if they are forced to bail out banks, though euro area supervision would still help limit negative spillover effects in this scenario. If such countries were to experience significant financial distress or default, it would significantly increase pressure on their banking sector, particularly if banks hold significant claims on the government (as is currently the case in Italy and Spain). In such a crisis, depositors would be highly incentivized to move their funds to banks in financially safer eurozone countries, which would further destabilize the distressed country's banks and make it harder for the government to raise financing. A common deposit insurance, however, would limit this risk of destabilizing deposit flight because depositors would be compensated for any losses incurred from a bank failure, thus constituting a potentially significant financial resource transfer from non-crisis countries to crisis countries. But Italy continues to firmly reject the grand bargain that would see the establishment of a common deposit insurance scheme in exchange for introducing sovereign exposure limits or higher capital charges, thereby leaving the eurozone more exposed to a wider banking crisis than it needs to be. Similarly, Germany continues to oppose the establishment of a common deposit insurance as long as various national banking sectors hold significant amounts of government debt on their balance sheet without accounting for their respective credit risk.

• Banking sector deposits in Italy and Spain exceed 100% of their respective GDPs, while government debt in Italy, France and Spain exceeds 100% of GDP. By comparison, Germany and the Netherlands' banking sector deposits both stand at roughly 100% of GDP, but their government debt is lower, at 63% and 43% of GDP, respectively. This makes a sovereign financial crisis that then leads to a systemic banking sector crisis far less likely.