If you want to know whether any set of proposals for a European banking union is sensible, you should ask the following simple question: will it render Spain’s position in the eurozone sustainable?
The Spanish government has confirmed that it is now ready to seek EU aid. But the idea for the European Financial Stability Facility to lend money to the Spanish bank recapitalisation fund, known by its Spanish initials Frob, does not meet this test. It reshuffles debt from one end of the Spanish economy to another. Spain’s total debt was 363 per cent of gross domestic product in mid-2011, according to a report by the McKinsey Global Institute, and with the prospect of a severe economic depression ahead, its crisis cannot be solved through a combination of austerity and liquidity support. The eurozone must recognise that some form of debt relief, or default, will be inevitable.
This could come through various channels. One way would be for a eurozone agency to inject direct equity into the Spanish banking system, and then break it up. Such a system does not yet exist. It requires a new inter-governmental treaty that would sit alongside the existing eurozone crises treaties – the fiscal pact, and the treaties of the EFSF and the European Stability Mechanism. So what elements should a treaty on a banking union contain for it to meet our test?
First, a deposit insurance corporation that insures the euro value of each bank deposit up to an agreed ceiling, say €50,000. The European Council should give an immediate political commitment that it would make good such losses even in the most extreme circumstances. The political commitment should be followed up with the creation of a formal deposit insurance company, perhaps implicitly backed by the European Central Bank.
Second, a recapitalisation and resolution authority that is workable and large enough. Ideally, such an authority would be completely centralised. The European Commission’s resolution proposal last week was entirely useless because it stuck to the principle that each country resolves its own banks. This is utter madness in a monetary union. Unless you separate the Spanish prime minister from his banks, you will not re-establish trust in the system. After what happened at Bankia, no one in their right minds believes any published account of a government-backed Spanish bank. We have to get real here. Most people involved in financial regulation in the EU are totally oblivious to the constraints of a monetary union.

Third, bank regulation and supervision. This is the area that will interact most with European legislation –