Europe Economy

Europe’s banking plans: Backstops and bail-ins

EU banking union: What you need to know

The euro zone's plans to reshape its banking system and deal with future banking crises can seem like nothing more than an excuse to generate acronyms and create new bureaucracies.

Even European Central Bank (ECB) President Mario Draghi has warned that "decision-making may become overly complex" as a result of the new plans.

Another concern is that if the movement towards "bail-in" rather than "bail-out" – as signaled by the Cyprus banking crisis – continues, this could mark a sea change for investors in euro zone bonds.There are three key parts to the banking union: letting the European Central Bank (ECB) supervise euro zone banks; resolving future bank collapses and insuring ordinary people's savings. While most seem agreed on the first, the second two have been more difficult to sort out.

The European Commission has suggested that euro zone banks all pay into a fund to bail out collapsed banks, which will eventually contain 50 billion euros after 10 years of payments. Olli Rehn, the EU commissioner in charge of economic affairs, described an agreement Tuesday night on this backstop, including another bank backstop during the decade where the rescue fund is being built up, as a "crucial breakthrough."

(Read more: Euro zone agrees 'backstop' for failing banks)

"This could be a competitive disadvantage because that money is going to have to come out of the real economy, and that's not what Europe really needs," Christian Schulz, senior economist at Berenberg Bank, told CNBC.After a warning that negotiations might have to continue during Christmas week, the threat of working on December 23rd seemed to focus finance ministers' minds.

Germany, the euro zone's biggest economy, has been wavering over the fund, as it is eager to avoid having its banks and population having to pay out more to bail out its struggling euro zone counterparts. It has raised its hackles over the European Stability Mechanism, the bailout fund for struggling euro zone countries, to which is it the biggest contributor.

(Read more: Why the euro zone bond rally may be ending)

Frankfurt skyline
Chris Hepburn | E+ | Getty Images

Draghi has called for a "bail-in" to be a key part of the banking union plans.

The "bail-in" of Cyprus's banks was perceived as a slap on the wrist to bondholders, after they were blamed for driving up the cost of debt for other struggling European countries. It meant that its bondholders, who hold one form of bank debt, had to sacrifice some of their investment before other debtors. If this becomes more widespread in other banking collapses, it could drive up the interest charged by bondholders – which some have warned would also damage the wider economy if it means that banks have to charge higher interest on their lending as a result.

(Read more: Cyprus crisis not over yet)

One of the common themes uniting those euro zone countries which have needed bail-outs in the course of the crisis is how closely the solvency of their banks is linked to the solvency of their government. This problem has been exacerbated in Spain and Italy since the ECB launched its cheap loans program, with its banks using the loans to buy up their local government bonds and drive yields on the bonds down.

(Read more: 'Doom loop' for Europe's debt markets)

Plenty of skepticism remains over European plans. It is difficult to determine how good your crisis mechanisms are until that crisis emerges.

"It does not sound like a process which would have prevented the Lehman disaster," Schulz warned.

- By CNBC's Catherine Boyle. Twitter: @cboylecnbc.