May 25, 2012 / 7:56 AM / in 5 years

Euro zone must head toward banking union: ECB's Praet

European Central Bank (ECB) President Mario Draghi (C) speaks to France's Central Bank Governor Christian Noyer (L) and Member of the Executive Board of the ECB Peter Praet before the start of an ECB meeting in Barcelona May 3, 2012.Alberto Estevez/Pool

MILAN (Reuters) - The euro zone needs to push ahead with its financial sector reform plans and create a centrally managed and funded body to handle troubled banks, a European Central Bank policymaker said on Friday.

"Europe needs to move towards a 'financial union', with a single euro area authority responsible for the supervision and resolution of large and complex cross-border banks," ECB Executive Board member Peter Praet said.

"Decisive and far-sighted reforms like these, unrealistic until a short while ago, are now gaining support. Reacting to the pressure of events may seem unattractive, but it may also be the only way forward," he said in the text of a speech prepared for a financial conference in Milan.

Praet told the conference that there was "no escaping a banking union" and that a resolution framework was an essential part of a single market.

The European Commission will present a proposal in early June to wind up banks when they hit trouble.

The current crisis meant that deleveraging by banks - which curtails credit provided to companies and consumers - could not be avoided, but liquidity provided by central banks could to some extent ease the process, said Praet, who oversees the ECB's economics department.

The ECB has given banks 1 trillion euros ($1.3 trillion) into cheap loans which have been widely credited with helping troubled debtor states meet substantial portions of their 2012 funding needs early in the year, by encouraging banks to buy government bonds, as well as keeping the banks liquid as they manage bad debts.

"The idea is of smoothing the unavoidable process of deleveraging to avoid the negative externalities of (bank) fire sales of assets," Praet said. The challenge was not to slow down necessary reforms, both in the financial and public sectors.

He also urged governments to restore investor confidence in their ability to manage their debts, saying countries such as Italy, Spain and Belgium had good arguments to support their case.

Italy and Belgium had both proved in the past that they could service their debt even when the weight of interest payments over domestic output reached a peak. Praet signaled that also in the case of Spain the debt servicing ratio looked manageable.

"Governments have to restore credibility in debt sustainability," he told the conference. "When you look at the figures in many countries it's objectively not so difficult."

Praet also said the euro zone needed to fight against the forces currently undoing its integration and must work to give "itself a sounder, more complete and resilient economic governance framework."

"There is a limit to what market operations alone can achieve. They can neither address the underlying causes of the deterioration nor completely offset its effects," he said in the text of the speech.

The central banker said the crisis had damaged the cross-border integration of financial markets in Europe, hampering the transmission mechanism of monetary policy.

Praet said it was important to break the link tying banks to sovereign risk, but added this was complicated.

Lenders in debt-laden euro zone countries have increased their exposure to sovereign risk by stepping up purchases of domestic government bonds and making up for the shrinking take-up by foreign investors.

(for speech click here)

Additional reporting by Marc Jones in Frankfurt; Editing by Ruth Pitchford

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