Nicolas Véron

EU Trade Policy amid the China-US Clash

The Greens/EFA Group of the European Parliament commissioned this paper which I coauthored with Anabel Gonzalez, and published it earlier this month on the same day as Anabel gave testimony about it in Brussels. In it, we take a holistic view of the changing trade policy landscape and especially the escalating frictions between China and the United States. We recommend that the EU should lead from strength, along several dimensions that include outreach in China and in the US, finalization of the China-EU Investment Agreement, the multilateral framework and WTO, the EU-Japan-US trilateral discussions, bilateral EU-US trade arrangements, and relationships with other jurisdictions around the world. 

Update (August 1, 2019): the same text was republished as a Working Paper by the Peterson Institute. 

Download the paper here in case the above link is broken. Click here for the PIIE version. 

An Effective Regime for Non-viable Banks: US Experience and Considerations for EU Reform

The European Parliament today published this study, in which Anna Gelpern and I take a holistic look at the EU regime for non-viable banks - including the EU resolution framework, national insolvency proceedings, and deposit insurance, to which we add state aid control and what we call mutual support arrangements. We take the US regime, centered on the FDIC, as the starting point of our analysis (as requested ECON Committee staff), and consider avenues for EU reform in light of this benchmark. 

Download the study here in case the above link is broken. 

European Parliament Election Results: The Long View

This blog post was published yesterday by Bruegel, and today by the Peterson Institute. As usual the two version are near-identical - below is the one published by PIIE. 

The newly elected European Parliament, which will start its sessions in early July, has reshuffled politics throughout the region by including more members from the far right and fewer from traditional political groups of the center-left and center-right. But viewed from an EU perspective, there is more stability than meets the eye.  In fact, the EU-wide returns are not as transformative as those of five years ago.

Comments about the European Parliament election results are predictably all over the place and typically reveal more about the commentators than anything else. To get a clearer sense of direction, it may be useful to compare the 2019 election outcome, not only with recent opinion polls or the 2014 election but also with all the other elections (once every five years) since the first one in 1979. My own perspective is affected by the fact that I did exactly that after the previous election in 2014, when I published a chart and brief post arguing that the then-observed increase in votes for what I dubbed “non-mainstream” parties was significant but did not bring their share in the European Parliament to a historically unprecedented level (see figure 1).

In this post, I use the same typology as in 2014 to analyze the results of the 2019 election. Figure 1 is my 2014 chart.

The emphasis on typology is important, because the devil is in the labeling. Labels such as “populist” or similar monikers are often a matter of opinion. Some parties are perceived as more disruptive than others, but such perceptions are easily distorted—not least since some of these “insurgents” have been firmly in power for some time, such as Fidesz in Hungary since 2010. Similarly, my choice to label UK conservatives as “non-mainstream,” except during the long decade of their membership of the European People’s Party (EPP) group, may be questioned from a British perspective, but it makes more sense from an EU perspective both before and after the Tories’ membership in the EPP. (The yellow line in figure 1 refers to the group now named European Conservatives and Reformists (ECR) and its predecessor the European Democrats in the late 1970s and 1980s.) That same choice arguably makes even more sense today.

I produced the 2014 chart in late June of that year, about a month after the election, when the membership of national parties in the European Parliament political groupings had coalesced. We are not yet there in the 2019 cycle, and indeed there are more uncertainties than usual as to the boundaries of these pan-European groupings. An additional and large uncertainty is related to Brexit, to which I return below.

But thankfully there are many projections based on current affiliations, declarations, and opinions. In figure 2, I use the projection by Simon Hix and his colleague Kevin Cunningham of the London School of Economics. Their projection has the advantage of minimizing the number of unaffiliated members of the European Parliament (MEPs), i.e., they allocate more of the elected MEPs to specific party groupings than most others, including when these MEPs ran under the banner of parties that were not represented in 2014. That gives more precision to the result. Other projections, however, were not drastically different when consulted on May 28, 2019, such as those by Europe Elects, The Guardian, Politico, or on Wikipedia. For the 2014 and earlier elections, I just kept the numbers from my 2014 post, even though some MEPs or parties have changed their group affiliation between 2014 and 2019.

The implications are quite clear. The strength of the far right in 2019 is notable and unprecedented, even though in 2014 it was partly masked by the fact that France’s National Front MEPs were labeled “independent” (they joined a group only in 2015). So is the fall in the traditional Volkspartei combination of center-left and center-right, namely EPP and the Socialists & Democrats (S&D). For the first time ever, these two no longer command a majority together. But these trends are offset by others: the further erosion of the far left and the rise of the Greens and liberal centrists (Alliance of Liberals and Democrats in Europe [ALDE], to which the 2019 projection adds presumed allies especially in France and Romania). As a consequence, the broad grouping that I labeled “EU mainstream” in 2014 has a near-identical share of total MEPs, close to 70 percent, and so does the “non-mainstream” grouping, at around 30 percent. Viewed through this prism, the disruptive election was 2014, not 2019. This election is one of stability along the mainstream /non-mainstream divide, even as each camp gets internally reshuffled.

In my 2014 post I concluded on what was then a contrarian note, namely the possibility of “another trend reversal,” by which I meant some recovery of the mainstream camp in 2019. As figure 2 suggests, this recovery has not happened. The mainstream share, as I defined it, declined slightly in 2019 and will decline further if, as could well happen, parties such as Fidesz and Romania’s PSD leave the EPP and S&D groups, respectively. But another event may intrude, if the United Kingdom confirms its stated intention to leave the European Union. In that case, the 73 just-elected British MEPs will lose their seats and will be partly replaced by 27 MEPs from 14 other member states, who were also elected in the 2019 election but are currently in limbo. (One of them is Sandro Gozi, former Italian undersecretary for European affairs and number 22 on the list of the centrist La République En Marche [LREM] party in France.) A full list of these 27 “extra” MEPs was not found while researching this post, but its party composition can be expected to be broadly similar to that of the 678 MEPs of the EU-27 member states – i.e., excluding the United Kingdom. Since the just-elected UK MEPs are comparatively less “mainstream” than the EU-28 average under the convention used here (52 percent mainstream to 48 percent non-mainstream, to be precise), that simulation would actually result in a very slight trend reversal, all things equal (see dotted lines in figure 2).

Needless to say, all things are not equal, and further rejigging of the party groups is to be expected, some of it presumably affecting what is presented here as the mainstream /non-mainstream boundary. But the broader picture is likely to hold. Viewed from a long-term EU perspective, the new European Parliament may be unprecedentedly diverse but is not exceptionally radical.

Taking Stock of the EU Single Resolution Board

My study on the Single Resolution Board (SRB) was just published by the European Parliament, in advance of a hearing of SRB Chair Ms Elke König next week. The SRB is an important pillar of Europe's fledgling banking union, and mine is one of the very first assessments of its performance as a recently established authority (following a report by the European Court of Auditors published in December 2017). 

Click here to download the study in case the above link is broken. 

A Better EU Supervisory Architecture to Fight Money Laundering

Bruegel today published this Policy Contribution (click here if the previous link is broken), in which Joshua Kirschenbaum and I review the policy framework for Anti-Money Laundering (AML) in the European Union, benchmark it against the United States, and make recommendations to improve the now-broken AML supervisory architecture. 

Update (December 18): an abridged version of the same analysis was just published by the Peterson Institute. 

Integrity of Official Statistics Under Threat

This op-ed, jointly written with Ted Truman, was published last month by the reference Greek daily Kathimerini, in print as well as online in Greek and English. It was reposted this week by the Peterson Institute and Bruegel. 

Andreas Georgiou, former head of the Hellenic Statistical Authority (ELSTAT), has become the public face of the global threat to the integrity of official statistics and statisticians. The facts of the case are well known. The International Statistical Institute, the American Statistical Association and multiple regional statistical bodies have decried the threat in their expressions of support for Georgiou. A recent petition collected over a thousand signatures, including from nine Nobel laureates in economics.

Georgiou has been convicted for “violation of duty” for not submitting ELSTAT’s final figures on the 2009 budget deficit for approval by a politically appointed board. Given what is known of the views held by that board’s members, seeking its approval would surely have led to misleading figures. Instead, he followed the European Statistics Code of Practice, which assigns “sole responsibility” to heads of national statistical institutes (NSIs), such as ELSTAT, for their data production and dissemination. The appeals court conviction, upheld by the Supreme Court, ignored the fact that the European Statistics Code of Practice had been explicitly endorsed under Greek law before Georgiou took up his post. The irony is that successive Greek governments, while claiming to stand aside from the prosecutions of Georgiou, have used the same figures and statistical methodologies to justify financial support and now debt relief from their European partners. Unfortunately, European leaders have largely refrained from bringing pressure on Greek politicians to stop damaging the reputation of Greece and the European Union.

Reliable official statistics are essential building blocks of sound economic policy. Budget projections inevitably contain a combination of revenue and expenditure estimates and a dose of politics. Budget outcomes, as recorded in official statistics, however, are different. They must be accurate and above suspicion of political manipulation. They are crucial to the transparency and democratic accountability of governments. They are critical to the functioning of market activity, saving and investment, and thus to growth, employment and prosperity. Concerns about political manipulation of statistics are especially relevant for the euro area, where joint economic policies rely critically on the accuracy of national statistics on economic growth, budget outcomes, and sovereign debt, which are aggregated (but not compiled) by Eurostat, a department of the European Commission.

Moreover, prudent lenders in international financial markets rely on the integrity of national statistics to make investment decisions; less confidence in that integrity translates into higher borrowing interest rates for the government as well as the private sector. The case of past inflation statistics in Argentina illustrates the damage that politically motivated statistical manipulation can do to a country’s international reputation and access to markets, as well as to its economic prospects more broadly.

Georgiou’s case exposes the inadequacy of the existing safeguards in Europe’s policy on official statistics. The EU system is failing the most basic test of its ability to deter political pressures on official statistical production, with potential chilling effects on official statisticians in other member-states and more widely in countries around the world. For example, the process for compiling the all-important decennial census in the United States is in danger of political manipulation by the addition of a question about citizenship in the 2020 census, which could discourage non-citizens from participating. Everywhere, a major source of potential political pressure on statistical agencies is via constraints on their budgetary funding, which is controlled by national parliaments.

The multiple criminal and civil prosecutions against Georgiou have already damaged Greece’s international reputation by raising doubts about its sustained capacity and willingness to produce reliable official statistics. Greece will feel consequences if it seeks to return to international markets without reversing this damage. More broadly, Greece will not achieve the long-lasting growth, stability and prosperity that it wants without establishing trust in its official statistics, which cannot be achieved as long as Georgiou’s persecution continues.

The damage extends beyond Greece. EU leaders and institutions have underestimated how much the case of Georgiou is harming the reputation of the euro-area policy framework, which relies heavily on economic statistics from its member-states. The persecution of Andreas Georgiou must end. And Greece and the EU must ensure that similar cases never happen in the future.

Germany's Savings Banks Are Uniquely Intertwined with Local Politics

This post, co-authored with Jonas Markgraf, was published on July 17 by the the Peterson Institute and on July 18 by Bruegel. 

The roughly 400 savings banks in Germany, known as Sparkassen (singular Sparkasse),  represent about 15 percent of the country’s domestic banking assets. They have unusually direct links with local political communities, which are widely known in Germany but not well understood in the rest of Europe. This post describes these structural links and presents a new dataset about them.

The significance of disparate practices within the euro area banking systems has risen with the advent of banking union, or the pooling of supervisory policy with a central role for the European Central Bank (ECB) in force since November 2014. Even though the banking union is incomplete, and almost all Sparkassen are “less significant institutions” (LSIs) subject to only indirect supervision by the ECB, the banking union implies greater integration and interdependence among all banks in the euro area than in the past, when supervision and crisis resolution were strictly national competencies. Thus, differing banking structures are now relevant to the entire euro area.

The idiosyncratic structures of the Sparkassen derive from German financial history. Deutsche Bundesbank data indicate that Sparkassen represent €1.2 trillion out of Germany’s total domestic banking assets of €7.8 trillion as of April 2018, not counting other public-sector banks (such as the regional banks or Landesbanken) with which the Sparkassen also have structural links.

This analysis is based on a unique dataset constructed from individual Sparkassen annual reports. All the underlying figures are publicly available but are not easily aggregated. The dataset is based on individual data on the composition of Sparkassen (supervisory) boards (Verwaltungsrat) in 8 out of 16 German federal states, namely Bavaria, Brandenburg, Hesse, North Rhine-Westphalia, Rhineland-Palatinate, Saarland, Schleswig-Holstein, and Thuringia. (The sample may be extended to all states in future research.) The eight states in the sample represent 60 percent of Germany’s population (2016), 61 percent of its GDP (2017), and 278 Sparkassen out of a national total of 413, or 67 percent of all Sparkassen and 64 percent of all Sparkassen assets (DSGV 2015). There is no reason to assume that the patterns in the eight states outside the sample should be markedly different from the ones observed within it.

This post focuses on the Sparkassen relationships with elected politicians. Three findings stand out and do not appear to have been specifically documented before.

1. Elected Politicians Chair Most Sparkassen.

Sparkassen are noncommercial public-sector entities, whose controlling “owners” (Träger) are municipalities and/or counties, even though these local governments hold no liability for Sparkassen losses as has been established by EU competition policy jurisprudence. (All Sparkassen, however, are members of elaborate formal risk-sharing frameworks at the state and federal levels, including a shared deposit insurance scheme and an institutional protection scheme.) Accordingly, the politicians sitting on Sparkassen boards tend to be those elected at the county or municipality level and not federal- or state-level politicians, with few exceptions.

The definition of “politician” adopted for this analysis is highly restrictive, namely a currently serving elected official at the county (rural Landkreis or Kreis, urban Stadtkreis or kreisfreie Stadt) or municipality level (Gemeinde). The elected chief officer of a county is a Landrat (rural) or Oberbürgermeister (urban), and the chief officer of a municipality is a Bürgermeister. This nomenclature omits elected members of local government councils (at the municipality or county level) who are not council heads. It also omits former elected officials and other individuals who may strongly identify with political parties and interests. Thus, the methodology tends to underestimate the extent of the links between local political communities and Sparkassen boards.

Under these definitions, politicians represent a minority of Sparkassen board members but the overwhelming majority of board chairs, as summarized in table 1. In five of the eight states in the sample, all Sparkassen chairs are politicians.

Table 1: Presence of Politicians among Sparkassen Boards and Chairs

Source: annual reports, authors’ calculations. All data are as of January 2015.

These observations are fairly constant over time. Over the decade 2006 to 2015, the number of Sparkassen in the eight states declined slightly, from 293 to 278; the proportion of politicians among board members increased slightly, from 16 to 18 percent; and their proportion among board chairs was stable, fluctuating between 82 and 84 percent.

2. Most County Heads Are Involved in Sparkassen.

Conversely, an overwhelming majority of county heads (Landräte and Oberbürgermeister) chair a Sparkasse, as summarized in table2. There has been a lot of consolidation (mergers) of municipalities in recent decades, but less so of counties, which partly explains the high observed ratios.

Table 2: Presence of Sparkassen Board Chairs among County Heads

Source: annual reports, authors’ calculations. All data as of January 2015.

3. Many Politicians Derive a Tenth or More of Their Personal Income from a Sparkasse Position.

Only North Rhine-Westphalia appears to disclose board fee amounts paid to every board member. For each Sparkasse in that state, disclosures of the chair’s annual fees for 2015 can be added to an estimate of that same individual’s 2015 salary as a local government official (“government salary”), available from the official salary bracket, to provide an estimate of aggregate income (thus omitting any additional sources of income though). Only those Sparkassen whose boards are chaired by politicians are included in the sample. Table3 shows the results, with Sparkassen ranked by decreasing order of total assets. Unsurprisingly, the amount of chair’s fees is correlated to the volume of a Sparkasse’s total assets, explaining much of the observed variation. On average, using these definitions, politicians in North Rhine-Westphalia who chair a Sparkasse’s board receive 12 percent of their individual income from Sparkassen board fees.

It is hard to assess the extent to which this finding may be idiosyncratic to North Rhine-Westphalia. Individual board fee disclosures in other states would be needed, of course, to extend this analysis to the whole of Germany.

Table 3: Compensation of Sparkassen Chairs (North Rhine-Westphalia)

Source: DSGV (Sparkassen assets and employee numbers), Bundesanzeiger (income data). All data as of January 2015.

Euro Area Comparative Perspective

These three stylized findings appear highly specific to Germany’s Sparkassen. Leaving aside promotional and public development banks, which do not compete directly with commercial banks (e.g., Spain’s ICO, Finland’s Municipal Finance, France’s Caisse des Dépôts and SFIL, or Germany’s own promotional banks at the national [KfW] and state levels), bank board membership of politicians (as defined here) appears to be virtually nonexistent in other EU member states. In some of the member states, such board memberships were significant in the past, though rarely as significant as currently in Germany, but have nearly or entirely disappeared as the banking sector was reformed and/or restructured. In Germany itself, politicians may sit on boards of banks other than Sparkassen, including some of the cooperative banks and especially Landesbanken, but less frequently than observed in Sparkassen.

Our respective research on banking structures and specific recent enquiries supports this claim. For example, in Italy and Spain, some politicians may sit on the boards of some of the local political foundations that are shareholders in some of the banks, in certain cases with a controlling stake, but not on the banks’ boards themselves, with few exceptions that are all insignificant from a national banking system perspective. In France, regional savings banks, now integrated in the BPCE Group, may have one board member who represents the local government and is a politician, but only one and never the chair. In Austria, the savings banks (also called Sparkassen) share some attributes with those in Germany but have been consolidated in the Erste Group, whose governance is essentially commercial and whose board does not include politicians. In the Netherlands, there are no politicians even on the boards of the two national promotional banks, BNG and Nederlandse Waterschapsbank, let alone other banks. This is not to say that there are no links between political and banking communities in these countries but that such links do not take the form of politicians holding a board chairmanship or even, in the overwhelming majority of cases, any board membership.

The implications of these findings are beyond the scope of this post. A future research agenda could be developed to complete the sample, extend the comparison to systems and countries beyond the euro area, and explore the resulting policy challenges and tradeoffs.

 

Jonas Markgraf is a PhD student and research associate in State, Risk, and Society at the Hertie School of Governance (Berlin). Starting September 2018 he will be a postdoctoral research fellow at the University of Oxford. The research reported in this post was partly funded by the German Federal Ministry of Education and Research (Research Grant No. 01UF1508). Nicolas Véron is senior fellow at Bruegel and the Peterson Institute for International Economics.

The European Union Must Defend Andreas Georgiou

This post was published today by the Peterson Institute. 

Update (June 26): the same post was also published by Bruegel. 

Relentless prosecutions in Greece against Andreas Georgiou, the highly respected former head of the country’s national statistical institute ELSTAT, are more than a matter of shameful harassment by Greece. His case raises disturbing questions about the integrity of European statistical processes. Forceful action by EU authorities on Georgiou’s case is long overdue. The European Union also needs to consider reforming its statistical framework to ensure a similar scandal cannot recur.

Georgiou’s legal ordeal began in 2011 and has included accusations of inflating Greece’s 2009 budget deficit, a key figure in the context of the country’s loss of financial market access and request for financial assistance in 2010, and of “violating his duty” by not respecting ELSTAT procedures. The sequence of legal developments, interwoven with Georgiou’s scapegoating by several Greek political leaders, is too long to be summarized here. (It is documented on the website of the Friends of Greece, a dedicated advocacy group.)

A new low was recently reached when Greece’s Supreme Court irrevocably rejected Georgiou’s request for annulment of his Appeals Court conviction for having refused to submit Greece’s 2009 government deficit and debt numbers for prior approval to ELSTAT’s politically appointed board. He was also given a two-year suspended prison sentence. But Georgiou was merely following the European Statistics Code of Practice, which assigns “sole responsibility” to heads of national statistical institutes (NSIs), such as ELSTAT, and had been endorsed under Greek law prior to these events. Furthermore, the same figures and methodologies used by Georgiou’s ELSTAT to produce them have been subsequently used by the Greek government, including as the basis for European and international financial assistance and debt relief.

While Greece and its Supreme Court have justifiably been criticized by numerous international commentators on this sinister drama, and a recent petition has collected over a thousand signatures, including from nine Nobel laureates in economics, the flaws it reveals in the EU statistical architecture go well beyond one country. The concern is especially relevant for the euro area, where joint economic policies rely critically on the accuracy of national statistics aggregated (but not collected) by Eurostat. Information is the lifeblood of policymaking. If statistics on such items as economic growth, budget deficits, and sovereign debts cannot be relied upon, the euro area cannot have a good fiscal framework or sound monetary policy.

Eurostat is a Directorate-General of the European Commission and the central hub of the European Statistical System (ESS), a formal partnership of 347 national and subnational authorities in 32 participating countries (the European Union plus Iceland, Liechtenstein, Norway, and Switzerland), of which 201 entities are in the euro area. These participants include each country’s NSI and a highly variable number of other public bodies, employing an estimated 46,300 staff Europe-wide as of 2015. Eurostat, which has around 800 employees of its own in Luxembourg, can exercise a degree of quality control over the network’s other members, including limited scope for onsite investigations and fines in cases of malpractice, under new EU legislation adopted in the wake of the Greek crisis of 2009–10.

Georgiou’s case, however, exposes the inadequacy of the existing safeguards in the real world of Europe’s statistical politics. This is not about any ambiguous grey area but entirely and straightforwardly about the integrity of statistics and the independence of statistical authorities. The EU system is failing the most basic test of its ability to withstand political pressure. Moreover, it would be naïve to think that such things can happen only in Greece. As Georgiou himself has noted, “Official statisticians everywhere in the world are facing the same pressures because they basically construct the picture of reality. And people who have power, or want to have power, want to control that version of reality.”

It is thus troubling how little the European Union appears to have done about it. The European Commission’s only known initiative was to send a letter to Greece’s (then and now) finance minister Euclid Tsakalotos in August 2016, about which Commissioner Marianne Thyssen made public comments. That action came late in the sequence of events, and only after significant international media coverage and public outcry about Georgiou’s sorry situation. Neither the Commission’s letter nor Tsakalotos’s response have been made public, and there is no indication that the Commission has followed up on this exchange in any meaningful way. A comment by Commission Vice President Valdis Dombrovskis in August 2017 that the independence of NSIs “is protected in EU law [and] cannot be challenged” is squarely contradicted by what is happening to Georgiou. To its credit, the European Parliament has paid more sustained attention, including by calling Georgiou to testify and by publishing two well-documented summaries of the case. A written question was jointly sent by 12 members of the European Parliament to the European Commission in October 2017. Commissioner Pierre Moscovici’s response four months later sadly did not signal any intent to act.

Similarly, Eurostat has not publicly reacted to the alarming judicial developments of the past three years or since Georgiou left ELSTAT. Eurostat’s most recent public pronouncements on the matter appear to be the statements by its then director-general in January 2013 and jointly by ESS principals (including Eurostat’s head) in February 2013 and May 2015. This reticence is in striking contrast to numerous recent public expressions of concern and support for Georgiou from the International Statistical Institute, the American Statistical Association, multiple regional statistical bodies, as well as two consultative bodies of the ESS, the European Statistical Governance Advisory Board and the European Statistical Advisory Committee.

On June 22, 2018, the Eurogroup adopted a statement on the completion of the financial assistance program for Greece and debt relief. Somewhat encouragingly, this statement makes specific reference to Georgiou’s situation, but the language remains too vague for comfort. The European Union, including the European Commission and its statistical arm, need to more assertively defend Georgiou and, beyond him, the integrity of national statistics compiled by independent statistical agencies. Respect for the Greek justice system, despite its glaring flaws, must not constrain Brussels and Luxembourg to silence. They can and should do more.

First, responsible EU officials should publicly declare that what has happened, including the latest Supreme Court judgment, is offensive to common sense and sensible public policy. Eurostat, in particular, must break out of its deafening silence of the past few years.

Second, future European financial assistance and debt relief to Greece, along the lines announced on June 22, should be conditional on the Greek government publicly and unambiguously confirming what any minimally informed observer already knows (and Eurostat has attested), namely that all the figures Georgiou’s ELSTAT produced were correct both in substance and process. This would help end absurd conspiracy theories about these figures, which have surprisingly many followers in Greece. Indeed, the Greek president could and should render Georgiou’s conviction null and void, as he has the authority for. The European Parliament could also do more, for example, by calling Georgiou’s Greek tormentors to testify and possibly by blocking EU financing to Greece as long as the case is not resolved satisfactorily.

Third, the European Commission should recognize Georgiou’s service to the EU public interest by covering his legal fees. Last year Greece’s creditors extracted a commitment from Athens to contribute to covering these costs, but the resulting Greek legislation made the covering of Georgiou’s legal fees conditional on him winning the cases, creating a perverse incentive for courts to convict him in order to minimize the burden on the Greek taxpayer. (A bitter irony is that the same initiative of the creditors enabled the Greek government to reimburse Georgiou’s accusers instead.)

Fourth, the Commission should belatedly act on Dombrovskis’s above-quoted strong words that ELSTAT’s independence is protected by EU law. It should open an infringement case against Greece for failing to create and support the conditions that ensure the production of European statistics with professional independence, impartiality, and objectivity.

Fifth, the European Union should ensure another similar fiasco does not happen in the future, in Greece or any other member state. As Georgiou has himself suggested, the European Commission should propose EU legislation that would shield national statisticians in all EU member states from prosecution for their European statistical work, when that work has been performed in compliance with the EU statistical framework and been duly validated by EU institutions.

Sixth, the European Union should open a far-ranging debate on whether and what additional structural changes to the ESS may be needed in order to ensure the immunity of official statistics to manipulation and pressure from national governments and political interests. Even with the additional protections suggested above, a more integrated structure may be required for at least some critical statistical functions. An imperfect comparison is in the corporate world. In many international businesses, local financial controllers used to report to local management. But with increased corporate complexity, cross-border integration, and enabling technology, financial controllers now typically report directly to headquarters. It may be time for the ESS to envisage a similar shift.

There is no need to emphasize how harmful Georgiou’s case has already been to Greece’s international reputation, not least as the country seeks to regain access to international financial markets. But it is often overlooked that the European Union is being damaged as well. It is high time EU leaders discharged their responsibilities and ensured that EU statistics are taken seriously.

Bank Crisis Management and Resolution: What Is Missing?

I contributed to a collective project of ESMT and the German Sachverständigenrat which resulted today in the publication of an e-book on euro area reform. Chapter 6 of the e-book summarizes and updates a presentation I gave in August 2017 on the new euro area regime for bank crisis management and resolution, and adds notes of the ensuing discussion among the project group. I argue that the new system has broadly passed its first real-life tests in 2017, even though these confirmed the existence of various shortcomings that will need addressing as experience accumulates. 

Market Discipline in Chinese Finance

The Peterson Institute last week published this Briefing (click here if the previous link is broken), compiling the essays presented at a joint PIIE-CF40 conference last month in Beijing. My contribution (chapter 8), co-authored with Martin Chorzempa, considers the challenges and possible sequencing of introducing more market discipline into the operation of China's financial system. 

EU Financial Services Policy Since 2007: Article in Global Policy

My article "EU Financial Services Policy since 2007: Crisis, Responses, and Prospects" was published this month in the crisis 10-year anniversary issue of the Global Policy journal. 

Update (June 22): the same text was republished by Bruegel and the Peterson Institute in their respective Working Paper series. (Click here and  here respectively to download, in case the previous links are broken.) 

Ten Years after the 2008 Financial Crisis: Op-ed in People's Daily

I wrote this op-ed for People's Daily, which posted it online and published a slightly abridged Chinese version in print on May 15.

Did the 2008 Financial Crisis Change the World?

The financial crisis that culminated a decade ago with the bankruptcy of Lehman Brothers was a major shock to the world, by several measures the greatest since the end of World War II. Its ramifications have been complex, and it is still too early for a definitive assessment. Still, the ten-year anniversary provides an opportunity to take stock. The surprise is how limited the lasting impact appears to be, in the United States and arguably also in Asia. The only large economic region where the crisis has been unquestionably transformational is in Europe.

First, a bit of semantics. The expression “global financial crisis” has been widely used, but there really was no such thing. A North Atlantic financial crisis, encompassing the United States and Europe, started in 2007 and climaxed into outright panic from mid-September to mid-October 2008. In the rest of the world, there was no financial instability, but a severe if brief negative economic shock in late 2008 and early 2009. There and in the United States, the crisis was over by 2010. In the euro area, by contrast, it was amplified by fault lines in the regional monetary union’s incomplete policy architecture, and lasted considerably longer as a consequence, arguably until mid-2017. Only then was the last remaining significant pocket of euro-area financial system fragility eventually resolved, namely the Italian financial sector restructuring epitomized by the closure of two large banks and the public rescue of a third one.

Now for the durable consequences. In the United States, some analysts argue that the crisis paved the way for the illiberal, protectionist turn of the Republican Party and the Trump presidency, but this is highly debatable. An increasing body of social science research suggests that the drivers of the 2016 Trump victory had more to do with identity than economics, and responded to developments that predated the crisis. In this analysis, many white males in the Unites States feel their traditional collective social dominance increasingly under attack, from outside by the rise of China and the corresponding erosion of America’s global preeminence, and from inside by the increasing racial and gender diversity of U.S. society. Both these trends started long before 2008. The post-2008 “Great Recession” changed the lives of millions of Americans, but did not fundamentally alter the structures of America’s economy and society, in striking contrast to the Great Depression of the 1930s which ushered in a spectacular expansion of the economic role of the Federal Government and a radical transformation of the U.S. financial system. In comparison with the New Deal legislation, the Dodd-Frank Act of 2010 was an adjustment at the margin, and may still be at least partly reversed.

The structural consequences of the 2008 shock may last somewhat longer in China. The Chinese authorities’ response to the shock was a massive stimulus, mainly channeled through the banking system, which greatly expanded debt in the Chinese economy. Meanwhile, the debt challenge remains for China to reduce this leverage without compromising stability.

In Europe, however, crisis-induced changes have been profound and permanent. This was the first large-scale economic crisis since the introduction of the euro in the late 1990s, and it almost led to the monetary area’s breaking up, in 2011-12 when Italy and Spain came close to losing sovereign debt market access, and again during the Greek aftershock episode of 2015. While euro area leaders dithered for far too long, they eventually thrashed out a firm policy response in 2012 with the creation of a large common financial assistance fund, the European Stability Mechanism, and the pooling of banking-sector oversight from the national to the euro-area level, a complex project known as banking union which has now been operational for several years. This greater integration, in turn, was a key driver of the British government’s ill-fated decision to submit the United Kingdom’s EU membership to referendum in June 2016, resulting in the ongoing drama of Brexit. As a result, the European Union will never be the same again, no matter how these developments may further unfold.

From a global perspective, the crisis appears to have slowed the pace of cross-border trade and economic integration, but the more recent data suggest that this impact may have been temporary rather than permanent. If so, and on the whole, the world will have weathered the 2008 crisis rather well. But once again, it is still a bit too early to be certain. 

Completing Europe’s Banking Union Means Breaking the Bank-Sovereign Vicious Circle

This blog post coauthored with Isabel Schnabel was published this week by PIIE, Bruegel and Vox. 

Several euro area leaders, including the German chancellor, her finance minister, and the French president, have recently referred to the need to “complete the banking union.” These public calls echo those made in more formal settings, in intergovernmental meetings and European Commission communications over the last half decade. They inevitably raise the question of what criteria should be used to assess the banking union’s completeness. A narrow interpretation, based on euro area leaders’ past commitments, equates it with breaking the bank-sovereign vicious circle; a more ambitious long-term vision for complete banking union implies the removal of all cross-border distortions within the euro area banking market. Even the minimalist version, however, entails more reforms than those publicly under current consideration.

“Banking union” has become a widely used expression to refer to the project of shifting banking-sector policy instruments from the national to the European level, but there is no official or legal definition of what it is or should be. Its first recorded use in public was made outside of officialdom (albeit on a suggestion from a European Commission official, Maarten Verwey), and it was gradually popularized in expert circles and the media. Euro area leaders endorsed banking union as their policy at a landmark summit in late June 2012, but waited almost a year until adopting the expression itself.

The Bank-Sovereign Vicious Circle Forms through Direct and Indirect Financial Linkages

The same leaders, however, associated banking union from the start with a clearly stated objective, namely that “[i]t is imperative to break the vicious circle between banks and sovereigns.” That sentence opened the June 2012 summit statement, and was identically repeated on several subsequent occasions. It refers to the mechanism, first observed by International Monetary Fund (IMF) scholars in 2009 and then increasingly acknowledged in European policy discussions, by which sovereign risk and bank risk are highly correlated with each other in Europe’s monetary union. Thus, a major banking-sector problem will cause fiscal distress (as happened in Ireland and Cyprus), and conversely, reckless fiscal management will result in a credit squeeze (as in Greece); the ensuing financial fragmentation across country borders impairs the operation of area-wide monetary policy and ultimately risks a break-up of the monetary union, giving rise to redenomination risk. This vicious circle, also referred to as the euro area’s “doom loop,” is best understood as a combination of direct and indirect financial linkages, summarized in the following chart. (Olivier Blanchard, then the IMF’s chief economist, appears to have been the first to produce this depiction of the bank-sovereign vicious circle in the summer of 2011, in internal IMF material that has unfortunately not been published.)

Selected contagion channels between banks and sovereigns in the euro area

A “complete” banking union, then, must include a policy framework in which the bank-sovereign vicious circle is broken. This is evidently not yet the case, as many of the above depicted linkages have remained essentially intact since the start of banking union almost six years ago. Deposit insurance is still national, as have been ad hoc schemes to support failing banks and their creditors. (In just one country, Italy, and in the past year only, these have included national liability guarantees, the precautionary recapitalization of one major bank, and the reimbursement of losses incurred by retail savers and investors in senior debt). Meanwhile, most euro area banks still exhibit significant home bias in their sovereign exposures, namely the fact that their direct credit exposures to euro-area sovereigns remains concentrated in their home country. Furthermore, most euro area banks retain a largely domestic footprint, implying powerful indirect linkages through the domestic economy. In addition, a surprisingly large number of them are controlled or otherwise influenced by national governments and/or politics, which reinforces the bank-sovereign nexus. For example, a very significant share of the German banking system is directly controlled by local or state governments.

The Ideal Single-Market Banking Union: Worthwhile, But Remote Prospect

A maximalist version of “completing the banking union” would remove all national determinants of banks’ activity and business models, thus fulfilling the promise of a perfect internal market in which all cross-border competitive distortions have been eliminated. (The privatization of publicly-owned banks could be viewed as an integral part of that agenda.) The United States comes close to a seamlessly integrated banking market—a surprisingly recent development, which followed the deregulation and reforms of the 1980s and 1990s. Relevant distortions in Europe include wide national variations in banking regulation, taxation, accounting, auditing, insolvency law (both for banks and their clients), and the policy frameworks for pensions and housing finance, to name only a few. This maximalist agenda, which may be labeled a “single-market banking union,” has many things in common with the European Commission’s ongoing effort towards a capital markets union. Like the latter, it is a worthwhile long-term project that cannot realistically be completed any time soon.

The Realistic Approach to Completing Banking Union: Breaking the Vicious Circle

But a single-market banking union may be placing the bar too high for proclaiming the project “completed.” The bank-sovereign vicious circle can arguably be broken with a much more limited package of policies that would address the critical linkages pictured above. This comparatively more modest approach may be called a “no-doom-loop banking union:” falling far short of the fully-fledged single-market banking union, but good enough to declare mission accomplished with a straight face. A recent Franco-German euro report, to which we both contributed, outlines one possible way to do that. It suggests:

• a European deposit insurance scheme that guarantees all covered deposits in the euro area identically and unconditionally (banks’ contributing fees would remain differentiated on a national basis, to account for the differences that will persist as long as a single-market banking union is not achieved);
• sovereign concentration charges, i.e. a regulatory incentive for euro area banks to diversify their sovereign exposures within the area but away from their home country; and
• phasing out restrictions on cross-border pooling of capital and liquidity by multinational banks within the euro area, thus encouraging cross-border integration that will mitigate the indirect linkages.

Implementing such an agenda would inevitably entail a long transition period, but the corresponding policy choices are sufficiently straightforward and commonly understood for policymakers to make binding decisions shortly.

Banking policy steps currently under active discussion in the euro area including tackling non-performing loans that are a legacy of the past decade of crisis and those that will arise in the future; setting in motion a quasi-fiscal backstop to the Single Resolution Fund, a commitment all member states made in 2013; and finalizing the banking legislation proposed by the European Commission in November 2016 and whose subsequent discussion has stalled. All of these steps would be useful, even necessary, but none of them, even taken together, would plausibly amount to “completing the banking union.” For that, the very lowest threshold would be to effectively break the bank-sovereign vicious circle: politically more challenging for sure, but still doable this year if political leaders take their own banking-union-completion slogan seriously.

Making a Reality of Europe's Capital Markets Union

Bruegel published this Policy Contribution last Friday, in which André Sapir, Guntram Wolff and I suggest priorities to advance the European Union's project of a Capital Markets Union (CMU). CMU was announced with great fanfare in 2014 but has remained a largely rhetorical proposition for lack of clarity about the objectives and approach. We suggest front-loading a reform of ESMA (the European Securities and Markets Authority, established in 2011) to make it a catalyst of further progress towards CMU. André and Guntram presented the paper to EU finance ministers and central bank governors, and answered their questions and feedback, at the Informal ECOFIN meeting in Sofia on Friday. 

Click here to download the document in case the above link is broken. 

Breaking the Stalemate on European Deposit Insurance

This blog post, written together with Isabel Schnabel, was published by PIIE and Bruegel.

In the wake of the European financial and sovereign debt crisis, the euro area embarked in 2012 on establishing a banking union. Its aim was to elevate parts of banking sector policy from the national to the European level, particularly bank supervision and resolution. Successive EU-level reports, including the Four Presidents’ Report of 2012 and the Five Presidents’ Report of 2015, have highlighted a European Deposit Insurance Scheme (EDIS) as a necessary component of banking union. In 2015, the European Commission published a legislative proposal (hereinafter EC 2015) to set up a fully integrated, country-blind deposit insurance system by 2024.

A number of different proposals have arisen in this area. A recommendation by Daniel Gros (Gros 2015), director of the Centre for European Policy Studies, would retain a permanent autonomous role for the existing national deposit insurance schemes in a re-insurance system. Meanwhile, none of these options has met sufficient consensus among euro-area countries, producing a deadlock in the policy discussion, with no apparent progress in the legislative discussion of the EC 2015 proposal.[1]

In a Franco-German report in January, we proposed, jointly with our coauthors, to end the deadlock with an EDIS design that is institutionally integrated but financed in a way that is differentiated across countries. Our recommendations are outlined here and compared with EC 2015 and Gros 2015.[2]

EDIS as part of a broader policy package

Our EDIS proposal is tied to the introduction of sovereign concentration charges and tighter treatment of nonperforming loans (NPLs). It calls for “the coordinated introduction of sovereign concentration charges for banks and a common deposit insurance.” This connection is necessary to prevent the system from being “abused by governments that can force or nudge domestic banks to grant them preferential credit conditions by using their access to deposit funding.” By contrast, EC 2015 does not include any proposals on the regulatory treatment of sovereign exposures. In his own proposal, Daniel Gros observes that he “has not addressed the issue of the large holdings of banks of the debt of their own government” while hinting at “strict diversification limits,” which echo our recommendation of sovereign concentration charges. As for NPLs, our proposal calls for the European Central Bank (ECB) to foster better accounting for these loans on banks’ balance sheets and reduce their aggregate volume, including for smaller banks principally supervised by national authorities. The report calls for “full implementation of a uniform regime for NPL provisioning covering both legacy and new NPLs.”

A fully integrated institutional setting

A major difference between our proposal and Gros 2015 is that in our proposal, national deposit insurance schemes disappear after a transition period, replaced by a system with “a single authority at the European level,” which we suggest should be the Single Resolution Board (SRB) with due adjustments, and the existing “separate national deposit insurance institutions would be phased out.” In the event that the EDIS scheme would need to make direct payouts to individuals, it would rely on national authorities, e.g. the national resolution authority, but this arrangement would be purely for implementation purposes and the European authority would make all the significant decisions.

As a complement to our EDIS proposal, new EU legislation should eliminate the widespread practice of geographical ring-fencing of capital and liquidity by national authorities, which hinders the emergence of cross-border banking groups in the euro area. Since the protection of national deposit insurance schemes is the main reason cited to justify such practices, their phasing-out would make this reform possible and increase the potential for cross-border banking acquisitions, contributing to breaking the bank-sovereign vicious circle.

Our proposal envisions country-blind protection of insured deposits. After the end of the transition period, Cypriot or Greek insured deposits would be protected identically to German or Finnish ones, without any qualification or conditionality. This is essential to establish trust. We fear that the deposit re-insurance concept in Gros 2015, which perpetuates autonomous policy decision-making on deposit insurance by national authorities, could lead to uncertainty as to the automaticity of payouts, especially in cases where a country’s politics or policies are controversial in the rest of the euro area—a possibility that was illustrated in March 2013 in Cyprus. Thus, the operation of the system from the insured depositor’s perspective must be fully insulated from national political vagaries, as it is in our proposal (and in EC 2015).

A funding framework that recognizes national differences

The system would not be country-blind in terms of its funding mechanism, a key difference with EC 2015 but a similarity to Gros 2015. Our analysis is that despite the progress towards the completion of banking union, differences in national environments that affect banks’ business models will persist in terms of taxation, corporate and individual insolvency frameworks, housing finance, pension finance, and macroprudential policies. (All such policies are comparatively harmonized in the United States, in which there is correspondingly no need for state-level differentiation within the federal deposit insurance system.) This justifies differentiated assessments of bank risks and, correspondingly, deposit insurance fees across euro-area countries. As in most existing deposit insurance schemes and in EC 2015, there would also be fee differentiation at the level of individual banks to account for diverse risk profiles.

We have received objections that this would make EDIS different from its sibling, the Single Resolution Fund (SRF), which is already in place and will be fully mutualized by 2024. But since the European Union has chosen to distinguish resolution funding from deposit insurance (a distinction that does not exist in some other jurisdictions, e.g. the United States), and political sensitivities are evidently different about the two areas, there is no need for identical policy responses to the challenges tackled by EDIS and the SRF respectively. We do suggest, however, that both be managed by the same EU authority, namely the SRB.

Our proposal calls for two separate modalities for such country-level differentiation:

• First, a fee component depending on country-specific risks, such as the quality of the country’s legal framework for creditor protection, “based on structural indicators of creditor rights, such as the effectiveness of insolvency and foreclosure processes.” With harmonization of legal frameworks, fees would also converge. These indicators would have to be designed and measured at the European level, possibly by the SRB itself, or by an adhoc independent advisory body reporting to the SRB. The aim is to establish good structural credit policies in foreclosure and other areas, underlined by developments in Greece and Cyprus.
• Second, a structure requiring the cost of payouts associated with a bank failure to fall on banks in the same country in case of limited idiosyncratic shocks but to be mutualized in case of a larger crisis. The EDIS system would contain national compartments, akin to the ones that exist in the SRF during the current transition but which (unlike at the SRF) would be kept in the longer run. Two possible designs are a mutualized compartment alongside the national ones, similar to the transition-state SRF (“option1”), or a joint payout by all compartments in case one of them is depleted (“option 2”). In option 1, the ex-ante deposit insurance fee (i.e. in the absence of any bank failure triggering the insurance) would be split between the national and mutualized compartments, with a fixed allocation key set in the EDIS legislation that would apply identically to all member states. In both options, if a national compartment is depleted by payouts, there will be an ex-post fee paid only by banks domiciled in the corresponding country, until it is replenished. If the European compartment is itself depleted (option 1), or the joint capacity of all compartments to step in is extinguished (option 2), the ESM would step in as a backstop (as with the SRF)—which would not be a loss to the ESM, as it would be reimbursed by banks thanks to appropriate ex-post fees. The economics of this system are similar to those in Gros 2015, even though the institutional arrangements are fundamentally different. This difference is why we refer in the report to “the spirit of a re-insurance system,” with a first loss at the country level. The legal arrangement would be one of direct insurance, not re-insurance. Thus, unlike in Gros 2015, the national compartments we propose would be very different from the existing national deposit insurance schemes, which would no longer exist in the steady state as explained above.

Country-level differentiation would create sound incentives. Banks could choose to operate in a given member state either through a locally capitalized subsidiary or through a branch of an entity established in another (home) country. If it is a subsidiary, the deposit insurance (or in our proposal, the national compartment) would be that of the host country; if a branch, that of the home country. If a country has frequent bank failures that trigger deposit insurance payouts, or if its structural credit policies are unsound, the higher resulting deposit insurance fees may encourage banks to serve clients in that country through branches rather than subsidiaries. Such a country’s national compartment would correspondingly decrease in size, due to the reduction in the country’s total covered deposits, while other countries’ compartments would grow. This is how it should be.

Importantly, our proposal of country-level differentiation would have nothing to do with a country’s sovereign credit, and would therefore not contribute to the bank-sovereign vicious circle. The proposal would also create incentives for countries to reduce competitive distortions, such as those resulting from national housing finance and pension finance frameworks, insolvency law, or bank taxation.

Our EDIS proposal can accommodate the present diversity of banking structures in the euro area. In 14 of the area’s 19 countries representing together more than half of total covered deposits,[3] there is currently one single national deposit insurance scheme. But in five other countries, there are two or more schemes serving different segments of the national banking sector.[4] We suggest that these “could be treated as separate compartments, on a case-by-case basis under general criteria to be set to deter abuses.” These criteria could also create incentives to merge such schemes on a cross-border basis, e.g. to protect deposits in all the cooperative banks of several euro-area countries. Voluntary top-up regimes could also continue to exist, either on a national or a cross-border basis, with the understanding that our EDIS proposal (including any separate compartments for specific banking structures) only covers insured deposits up to the common limit currently set at €100,000.

Conversely, we advise against carving out small banks from the scope of EDIS (as is currently the case with the SRF), even those that participate in institutional protection schemes. Such small banks, or Less Significant Institutions (LSIs) as they are called in the jargon of the banking union, contribute at least as much as SIs to the bank-sovereign vicious circle, because their activities are typically less diversified across borders. We recommend that “an asset quality review of all LSIs, directly involving both the ECB and the European authority entrusted with EDIS [i.e. the SRB], would be performed as part of the implementation of the EDIS legislation, as was the case for SIs in 2014.” This step is important to ensure that the risk-sharing involved in EDIS is not abused to rescue banks that would be unsound from the start.

A winning option for all euro-area member states

The combination of country-blindness for the insured depositors but not for the contributing banks has not previously been proposed, as far as we know. But it would effectively serve to reconcile the twin objectives of risk-sharing and market discipline, the leitmotif of the entire report.

Our proposal is realistic and ready to be adopted in 2018. It would make retail bank runs much less likely in sovereign stress scenarios, and would thus reduce the redenomination risk exposed during the euro-area crisis. All euro-area countries would benefit, especially those with high debt or perceptions of credit risk, vastly offsetting any perceived downsides of introducing the sovereign concentration charges that are an indispensable complement to EDIS.

There is of course a need for further technical elaboration, not least on the transitional arrangements. The transition should not be too short. Somewhere between five and ten years is probably apt. For practical reasons, the legislative process probably has to wait until after the European Parliament election of 2019, but the Council could give a firm mandate, including a set duration for the transition, after a negotiation that need not last more than a few months. As our report puts it, “the key decisions in this area can and should all be taken in 2018.”

 

[1] A more recent Communication of the European Commission on banking union (October 2017) attempted to break this deadlock, but proposes only transitional arrangements.

[2] While this blog post was jointly written by the two of us in personal capacity, it was reviewed by the entire group of the report’s coauthors and there were no disagreements within that group about its content.

[3] Based on European Banking Authority (EBA) data as of end-2016. The 14 countries are Belgium, Estonia, Finland, France, Greece, Ireland, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Slovakia, Slovenia, and Spain.

[4] Specifically, and based on the same EBA data as of end-2016 as in the previous footnote, there are five separate deposit insurance schemes in Austria (respectively for savings banks, Raiffeisen banks, Volksbanks, regional mortgage banks, and commercial banks; there is an ongoing process to merge the mandatory components of these into one single national system); two in Cyprus (for cooperative banks and other banks); four in Germany (for cooperative banks, savings banks, public-sector banks, and commercial banks); two in Italy (for credit cooperative banks and other banks); and two in Portugal (for mutual agricultural banks and other banks). As per the EBA dataset, every single one of these dedicated insurance schemes has more covered deposits than the national deposit insurance scheme of Estonia.

Lessons for EU Integration from US History: The Long Road to a US Banking Union

The Peterson Institute just published this volume including a chapter I co-authored with Anna Gelpern, on the history of US banking sector development policy viewed through the prism of "banking union". It turns out to be an uncommon approach in the existing literature about US financial history, and the lessons for the EU are indirect rather than immediate - because the two stories (US and EU) are so different. 

Click here to read the full document in case the above link is broken. 

Reconciling Risk Sharing with Market Discipline: New Report by 14 French & German Economists

This comprehensive report on euro area reform was published today and co-authored by 14 French and German economists, including my Bruegel colleague Jean Pisani-Ferry, my PIIE colleague Jeromin Zettelmeyer and myself. It builds on earlier work, including my own particularly on banking union and Sovereign Concentration Charges. We view it as supporting the forthcoming EU-wide conversation on economic and financial reform, especially after the Italian election in March and the finalization of German coalition-forming negotiations. 

A summary of the argument is also available on Vox, as well as a French version on Telos and a German one on Ökonomenstimme. 

Click here to download the report in case the above link is broken. 

Bad News and Good News for the Single Resolution Board

This blog post was published yesterday by Bruegel and today by the Peterson Institute. 

The establishment in 2015 of the Single Resolution Board (SRB), a new agency of the European Union, is one of the most significant European banking reforms of recent years. The SRB was set up to quickly resolve banks that are failing or likely to fail, as part of a wider effort to break the vicious cycle between banks and sovereigns that nearly destroyed the euro area in 2011–12. A first assessment of this reform came up just before Christmas, when the European Court of Auditors (ECA) released a special report on the SRB. The report was discouraging on one level, citing many shortcomings of the new body. But there are also signs that the situation is improving and that the SRB is on its way towards fulfilling its assigned mission. For both reasons, this report, which is rich in previously undisclosed information and insight, deserves extensive analysis and debate.

The SRB was created following a decision by Europe’s leaders in December 2012 to create a Single Resolution Mechanism (SRM), whose legislative basis (the SRM Regulation) was enacted in July 2014. The SRB duly started operations in 2015 and assumed full authority on January 1, 2016 for the resolution of the 130-odd largest euro area banks, including by forcing losses on their claimants if need be (a tool known as “bail-in”).

As such, the SRB sits at the intersection of two major related but separate recent European reforms, namely the banking union and the adoption of a bank resolution framework. The first is about pooling most instruments and institutions of banking sector policy from the national to the European level in order to break the bank-sovereign vicious circle. The SRB is one of two new organizations created for the banking union, the other being the banking supervisory arm of the European Central Bank (ECB), known as ECB Banking Supervision or the Single Supervisory Mechanism (SSM).

The bank resolution framework allows banks that are failing or likely to fail to be “resolved” through an administrative process, in contrast to a court-ordered liquidation, whose protracted nature may generate damaging instability. The European Union’s adoption of this framework was largely inspired by US experience, where similar processes administered by the US Federal Deposit Insurance Corporation (FDIC), including creditor bail-in, were seen to work rather well during the financial turmoil of 2007–09. The framework is embodied in EU legislation known as the Bank Recovery and Resolution Directive (BRRD), which was initially discussed before the banking union (its early phase started in 2009–10) and enacted in May 2014. The BRRD resolution framework applies to all EU member states, while the banking union so far covers only euro area countries. Under BRRD, each member state must have established a National Resolution Authority (NRA), which in many but not all cases is hosted by the national central bank. Under the SRM Regulation, the SRB acts as the central resolution authority in the euro area, even though NRAs also exist in each euro area country and play a role in every resolution process.

The ECA report appears to be the first public in-depth assessment of the SRB, in contrast to the SSM about which detailed reports have already been published by, among others and in chronological order, Bruegel, the ECA itself, Transparency International (as part of a broader assessment of the ECB), and the European Commission. From the report, it seems that most if not all of the ECA’s auditing work on the SRB was completed by mid-2017. As is customary, the report includes a response from the SRB to the ECA’s observations and recommendations, presumably written in the fall of 2017, but not any response of the ECA to the SRB’s response.

The report contains both bad news and good news for the SRB. First, the bad news: It makes for painful reading. Essentially, the ECA demonstrates that the SRB was not ready to fulfil its mandate in its first year and a half of full authority, up to the end of the auditing phase around mid-2017. Resolution planning was not effectively achieved (§83 of the ECA report). Many crucial components of the planning process were not performed (e.g., §55, §56, §60, §63, §64, §65, §67, §68). The division of labor between the SRB and NRAs was left unsettled (§122). The flow of information from the ECB to the SRB was inadequate (§132). The SRB did not have a framework for making its own assessment on whether a bank is failing or likely to fail, a key task it has under BRRD and the SRM Regulation (§141). This shortcoming raises specific questions on whether the SRB played its role, for example, in the decision of precautionary recapitalization of Banca Monte dei Paschi di Siena in June-July 2017. There were no simulation exercises (“dry runs”) of resolution action, except an insufficient one (as it did not involve the NRAs) back in 2016 (§129).

It is clear from the ECA report that many of these critical shortcomings occurred during the startup phase of the SRB and were thus temporary. Even so, the ECA’s analysis suggests that better planning and prioritization could have helped avoid several deficiencies. This point is made explicit, for example, in the analysis of hiring bottlenecks (§103) and unrealistic targets set for the completion of transitional resolution plans (§34) and related recruitments (§114 and §125). A comparison of the ECA’s respective reports on the SSM and the SRB also implies the SRB could have done better. Both reports were issued about two years after the respective organizations assumed  authority (the SSM report came out in November 2016). The report on the SSM, titled “Good start but further improvements needed,” made it clear that ECB Banking Supervision was functional even though far from perfect. The SRB report, titled “Work on a challenging Banking Union task started, but still a long way to go,” is distinctly more parsimonious in its praise and refrains from declaring its object fit for purpose. Of course, the two institutions are considerably different and their respective assessments cannot be compared directly, not least given their very different mandates. One additional difference is that  the SSM benefited from the operational infrastructure of the ECB (that said, the European Commission was involved in the SRB’s initial buildup).

The revelation that the SRB was unprepared in 2016 and 2017, while perhaps not entirely surprising, sheds fresh light on the early development of the banking union. Viewed in retrospect, the ECB’s arguably excessive reluctance to declare any bank as failing or likely to fail in 2016 and early 2017 may have had something to do with its awareness of the SRB’s situation, and not only with the SSM’s own proclivity towards forbearance (which surely played a role in any case). For example, ECB Banking Supervision has been criticized, including by me, for having endorsed the ill-fated recapitalization of Banca Popolare di Vicenza and Veneto Banca by Italy’s Atlante fund in early 2016. (In June 2017, both banks were eventually recognized as failing and liquidated, at high public cost as the Italian government decided to reimburse all senior creditors.) Had the SRB been readier, would the ECB have ruled earlier that the two Veneto banks were failing, thus presumably avoiding further losses for a number of stakeholders, including the Italian public purse? Such questions arise from reading the ECA report, even though the answer to this one may well be negative.

Now for the good news. There are indications that the SRB is rapidly improving  from the sorry state described by the ECA. The SRB’s response does not attempt to dispute the report’s findings and does not denote a siege mentality, which is a good sign. Furthermore, the SRB argues that a number of problems the ECA identified have been tackled since the auditing phase ended and are on course to be resolved. For example, the understaffing that plagued the SRB’s early life is gradually being addressed, with total staff up from 35 in March 2015, 101 in end-2015, and 171 in end-2016 (ECA §105) to 306 expected in early 2018 and the target level of 350 later in 2018 (SRB’s response). According to the SRB, the division of responsibilities with NRAs has recently been clarified, and a new memorandum of understanding with the ECB is expected to improve the interinstitutional information flow. Redundant information requests, e.g., on derivative exposures (§93 of the report), have been streamlined.

The ECA report itself is good news. Its candor exemplifies effective accountability mechanisms in the EU institutional framework—even though it was apparently not part of the process of renewal of the SRB chair’s mandate, which, as it happened, was extended for five years the day before the report was published. It suggests that the institutions of Europe’s banking union can learn and improve. Given how ambitious the banking union project is, and that it is still very unfinished, such adaptability is not only welcome but also indispensable.

What does all this mean for the SRB itself? Despite all the flaws highlighted by the ECA, it passed its first real operational test in early June 2017 with the orderly resolution of Spain’s Banco Popular. Even leaving aside all the ongoing lawsuits that make it premature to reach final judgment, however, there was a strong element of luck in that case. The SRB has been commendably honest in acknowledging that a prior sales process made it possible for a buyer (the Santander group) to declare itself in record time, thus greatly facilitating the resolution process. Furthermore, there was no need to bail in any senior creditors given the bank The jury is still out on whether the SRB is now well-equipped to face its next real-world challenges. Time will tell. Its unsparing but constructive audit by the ECA can only help.

Europe Must Tackle Its Banks’ Sovereign Exposures

This blog post was published today by Bruegel and by the Peterson Institute. 

The euro area faces  a year of opportunity for completing the job of fixing the flaws exposed by the past decade of banking and sovereign debt crisis. The crisis is almost certainly over, memories are still fresh, and complacency has not yet fully set in. The political timetable for 2018 is propitious: France is energized with a new government, Germany will probably have one soon, and elections are expected in Italy in March. After that, no major political upheaval is expected until the European parliamentary election in the spring of 2019. The economic recovery is robust and broad-based. As European Commission president Jean-Claude Juncker put it, there is a favorable wind in Europe’s sails.

The driving engine of the euro area crisis, as acknowledged in communications from mid-2012 onwards, was the vicious circle between banks and sovereigns. Eliminating this fragility must be the central objective of the post-crisis agenda. This goal can be achieved through a fiscal union, a banking union, or both. With Europe’s incomplete political integration, policymakers have preferred pursuing a banking union over the past five years as a more practical path than a fiscal union.

Euro area reforms should aim at completing the still-fledgling banking union, specifically by cutting the link between banks and the sovereign debts of their home countries. These links remain  excessive despite the (broadly successful) establishment of a Single Supervisory Mechanism and Single Resolution Mechanism in the past half-decade. The reforms should have the ultimate goal of ensuring that any future sovereign debt restructuring does not automatically trigger a banking panic, and that in turn, future large-scale banking crises do not trigger sovereign debt distress.

Concentrated sovereign exposures are at the center of bank-sovereign financial linkages. Most (though not all) euro area banks have disproportionate sovereign exposure to their home country, for reasons that remain debated but have not been substantially eroded in the last few years of recovery. This “home bias problem” is unique to the euro area, where banks can and should diversify their sovereign exposures away from their home country without incurring currency risk. Not only is the home bias problem a key element of the vicious circle, it also deters progress on removing another major element, namely the fact that deposit insurance remains national. This is because some member states fear (not unreasonably) that an integrated European Deposit Insurance Scheme (EDIS), as proposed two years ago by the European Commission, could be abused by some sovereigns to secure preferential funding from “their” banks, in the absence of safeguards against such “financial repression.” Thus, achieving EDIS involves a broader policy package that includes addressing the home bias problem.

As detailed in a study published last month by the European Parliament, this challenge can be met with a new regulatory regime that would discourage concentrated sovereign exposures. This proposed mandatory (or in the jargon of the Basel framework for banking supervision, “Pillar-one”) instrument would consist of sovereign concentration charges, working as follows. In the current calculation of a bank’s risk-based capital ratio, the denominator is the bank’s total risk-weighted assets, an aggregate from which sovereign exposures (which are generally assigned a zero credit-risk weight) are almost entirely exempted. Under the proposed design, a second component would be added to that denominator, consisting of sovereign exposures weighted by coefficients (the concentration charges) that are set at zero for smaller exposures but increase with the exposure ratio (defined as the bank’s sovereign exposure to any given euro area country, over its tier 1 regulatory capital) above an “exemption threshold” set at 33 percent in the proposed calibration.

This rather simple design ensures that euro area sovereign exposures are not charged for sovereign credit risk but only for concentration risk, echoing the specific nature of the euro area’s home bias problem. (Sovereign credit risk is a distinct and intrinsically treacherous issue, which is not particularly specific to the euro area and may in the future be addressed by the Basel Committee at the global level.) Correspondingly, only euro area sovereign exposures of euro area banks would enter the calculation of sovereign concentration charges. Assuming banks respond to incentives, and eventually diversify their sovereign exposures within the euro area so that all come under the exemption threshold, this would not result in any competitive distortions that would put euro area banks at a disadvantage to their peers, either in other EU countries or in the rest of the world. EDIS would be introduced in parallel with sovereign concentration charges, ensuring a proper balance of risk sharing and market discipline.

This proposal builds on earlier suggestions made by regulators, and presumably echoes recent nonpublic discussions in venues such as the EU Economic and Financial Committee’s 2016 high-level working group on the regulatory treatment of sovereign exposures, or the Basel Committee. It also goes further, by including specific proposals for calibration and transitional arrangements. The suggested calibration is adjusted so that exposures above 150 to 200 percent of a bank’s capital are effectively discouraged (so that the capital is not wiped out in a sovereign restructuring that can typically involve a haircut of up to 30 to 40 percent), while exposures under 50 percent are barely penalized (which leaves ample space for activities such as market-making on sovereign debt markets, and avoids forcing banks into diversification into too many countries). The following table summarizes the calibration and its impact on capital ratios (itself dependent on the bank’s tier 1 capital ratio, thus the two columns on the right).

Effect of proposed calibration on capital ratios
			Capital impact (basis pointsa)
Exposure ratio (percent)	Marginal SCC (percent)	Average SCC (percent)	Tier 1 ratio = 10 percent	Tier 1 ratio = 15 percent
50	15	5	-3	-6
100	30	18	-17	-38
150	50	28	-41	-90
200	50	34	-63	-138
250	100	47	-105	-225
300	100	56	-144	-301
350	200	76	-211	-430
SCC = sovereign concentration charge
a. one hundredth of a percentage point
Source: Author's calculations.

This impact would not be immediate, though. The study recommends a lengthy transition period, in which the sovereign concentration charges are phased in gradually, and moreover, any sovereign debt outstanding before the new legislation’s entry into force would be exempted from their calculation (or “grandfathered”). The combination of a mild calibration and cautious transition arrangements would ensure that this significant structural change can be introduced without causing any disruption in sovereign debt markets, and at a negligible cost to the banks themselves. Since EDIS also involves a long transition from the current national deposit insurance regimes, the two reforms could be decided together next year, and then unfold in parallel to reach a steady state in the late 2020s.

Sovereign concentration charges, combined with EDIS, would not be a panacea for the euro area’s ills, but could decisively break the current deadlock in the discussion over banking union. For more fragile countries, the Europeanization of deposit insurance, and the corresponding sharply reduced probability of a euro area break-up (or “redenomination risk”), would more than offset any negative impact of domestic banks losing their role in smoothing the impact of sovereign debt market stress (a “shock-absorbing” role which, in any case, stands fundamentally at odds with the very principle of banking union). For countries currently perceived as low risk, the sovereign concentration charges would reassuringly bolster market discipline and ensure that EDIS is not subverted by national financial repression. Furthermore, removing the current uncertainty over the future regulatory treatment of sovereign exposures would lift an obstacle to desirable cross-border banking consolidation. Every country would gain, as would the euro area as a whole.

When the Banks Leave - Article in Prospect Magazine

This article was published in the December 2017 issue of Prospect Magazine in the UK, and reposted by PIIE. 

“Just left Frankfurt. Great meetings, great weather, really enjoyed it. Good, because I’ll be spending a lot more time there. #Brexit.” Thus tweeted Lloyd Blankfein, Chief Executive of Goldman Sachs, on 19th October. It was the first time a major US financial services firm had signalled a shift of its European operations away from London in this way: not as a decision conditional on future developments, but as an established fact of business life. It was the first, but presumably not the last. 

It is too late to hope that the City of London, by many measures the world’s leading financial centre and an economic engine for both the UK and Europe, could emerge unscathed from Brexit. The City, which generates tens of billions of pounds each year in tax revenues, will suffer relative both to its competitors and to how it would have performed without Brexit and probably in absolute terms as well. Harm is now unavoidable. The UK is suffering from heightened risk and the vagaries of its politics since the Brexit vote, including the unexpected outcome of this year’s election, have reinforced that perception. There is no status quo scenario: even if the UK was somehow to remain in the European Union after all, that would be disruptive too. 

By contrast, since June 2016, the perception of political risk has decreased sharply in the EU27, and the continent is also enjoying a robust economic recovery. The UK domino has fallen alone: no other member state wants to leave the EU. Emmanuel Macron’s victory in France has put an end to short-term worries about the integrity of the euro area. Other elections have yielded broadly reassuring results. Even the fiasco of Matteo Renzi’s lost referendum in Italy last December has not been disastrous. None of the numerous political challenges of the moment, including in Catalonia, Greece, Italy, Hungary, Poland and elsewhere, are widely perceived as threatening for EU integration or the euro. The EU27 remains exposed to external hazards—geopolitics, the oil price, a surge of refugees—but its major risks are no longer homegrown. 

More than that, the EU’s ability to weather the pressures of the euro crisis, the 2015 migration crisis, and the Brexit vote has left it stronger. As political philosopher Ivan Krastev notes in his 2017 book After Europe, “It’s quite possible that European publics will become more confident about the EU not because it’s become better but simply because it has survived.” Resilience confers legitimacy. In the euro area, the unfinished banking union adds to the sense of cohesiveness. Supervision by the European Central Bank was a reason cited by Nordea, the largest bank in the Nordic countries, when it announced in September that it would move its headquarters from Stockholm (outside the euro area) to Helsinki. 

The balance of political risk has shifted. Moving business from the UK to the EU27 no longer implies an increase in uncertainty. When Liam Fox, the International Trade Secretary, responded to Blankfein’s tweet by asserting that “money will go where money can be made, money can be moved, and money can be removed—that is a function of law and that is why London will remain pre-eminent,” it sounded debatable rather than self-evident. Given the likelihood that the UK will leave the single market, the default plan for most international financial firms will be to serve EU27 clients from an EU27 location. The implications vary among firms, but an estimated 15 to 25 per cent of the City’s business is tied to EU27 clients in a way that makes it likely to cross the Channel (or the Irish Sea).

Any countervailing effects, of Brexit helping the City to win business, will be considerably smaller. The bonfire of EU financial regulations will be smouldering at best—it is not clear which rules the UK will want to repeal in this area. Liberalising bankers’ bonuses could make sense, but would not go down well with the British public. It is equally doubtful that London could substitute new financial business for lost European trades. In past decades, the City has successfully wooed clients from Asia, Russia, the Middle East, the Americas and elsewhere. How could Brexit win more of that already high market share? Not through lower prices, which are not a driver of clients’ choices. Not through enhanced British soft power or international connectivity either, which have already been impaired since the referendum, and could deteriorate much further. 

Some UK firms may stay out of patriotism, but many homegrown firms, and nearly all foreign-held ones, will not be sentimental. If moving jobs and client relationships to the EU27 is what business logic suggests, it will happen. The US firms at the core of the City’s activity are also the most ruthlessly business-driven. Their employees’ fondness for London will count for little if clients are best served from Frankfurt, Dublin or Amsterdam. Blankfein made no mystery of the order of Goldman Sachs’s priorities. 

The City’s Brexit-inflicted damage over the next decade or so will amount to a significant slice, certainly more than a tenth. But how much worse could it get? That will depend on three interrelated factors: the UK’s openness to foreigners, the actual sequence and outcome of Brexit, and the competition from outside.

First is whether the UK will embrace the world or retreat from it—Global Britain or Little England? The City is critically dependent on foreign talent. It will be asphyxiated if the UK closes itself off. But there is also little doubt that a desire to reduce inward migration played a major role in the Brexit vote. As for trade and the economy, Mark Carney, the Governor of the Bank of England, stated the obvious when he noted in a September speech at the International Monetary Fund that Brexit “will be, at least for a period of time, an example of de-globalisation not globalisation.”

Can the UK pivot from there to greater openness? Or is it condemned, as John le Carré put it, to become “England all alone, a citizen of nowhere”? Even in the very short term, can the freedom of movement inherent in the EU internal market be maintained during the post-Brexit transition period—if there is one—or would such a proposition trigger a major political crisis? At Mansion House on 20th June, Philip Hammond, the Chancellor, bravely talked of Britain pushing “for a new phase of globalisation,” a Globalisation 2.0 that would be based on trade in services and not only goods. How Brexit could possibly catalyse this transformation is uncertain. 

Second, the City’s future will depend on whether the UK crashes out of the EU without any agreement, leaves the single market in an orderly way, or doesn’t leave it at all. This in turn will be largely determined by Britain’s attitude to the outside world. A “no-deal” exit would be akin to a selective default, and immensely detrimental to the UK’s reputation as a safe place for doing business. Should that happen, the City will remain the hub for domestic finance in the UK, but most of its international activity will leave and not return.

If the exit from the single market happens smoothly and yields a relationship with the EU based on a new treaty—the stated aim of UK-EU negotiations—the framework for financial services is likely to be comparable to the current EU-US arrangements: a web of supervisory relationships, including mutual recognition of rules, but on a case-by-case basis. This implies the permanent loss of most of the City’s EU-27-related business. Achieving a tighter treaty-based relationship would entail improbably squaring a circle that trade negotiators have struggled with for decades. Financial regulation is largely driven by concerns about stability and systemic risk, which cannot be entrusted to a foreign jurisdiction, no matter how close and well-intentioned. 

The most favourable Brexit scenarios for the City are those in which the UK never leaves the single market. These come in three varieties. The UK could remain in the EU, following a dramatic political shift. Time is now short for this, and it would probably be highly divisive. Even if there were a second referendum with a majority vote for “Remain,” Brexit would become the thwarted aspiration of a significant share of politicians and the public, which would bring yet more uncertainty. Alternatively, the UK could leave the EU and remain indefinitely outside it while still in the single market. A new government could decide, during a post-2019 transition period, with temporary single market membership, to make that status permanent, as it is with Iceland or Norway. Here too, uncertainty about a future change of status would persist, as it is unlikely that the UK would be satisfied with becoming a permanent subject of rules made in its absence in Brussels. Finally, the UK could leave the EU (though not the single market), and then re-enter it. In that case, the City may hope to recover some of the EU27-related business it would have lost in the intervening years. How much will depend on the political and economic conditions of the moment, which are evidently difficult to assess given that scenario’s current remoteness. 

Third and finally, the City’s success could depend on its rivals. New York’s international activity may prosper from Trumpian deregulation, or shrink if there is another systemic crisis. Asia’s financial centres may cut their current dependency on the west, or fail to realise their full potential because of the region’s unresolved geopolitical and governance challenges. Closer to home, the EU27 may become a fierce competitor thanks to its ongoing supervisory integration and the critical mass of its internal market, or fall to its old demons of fragmentation and mercantilism. 

To speak the language of financiers, Brexit has no net upside for the City, only net downsides. For the UK economy more broadly, things are more nuanced. Some re-balancing can be expected. As Charles Goodhart of the London School of Economics has noted, advanced manufacturing is unlikely to benefit, given its dependency on complex supply chains. Brexit, by erecting barriers, will negatively impact the UK’s position in those chains. But other services sectors could benefit from the spare capacity freed up by the City’s losses, in terms of available workforce and real estate, and from a devalued currency. If so, then London could grow ever-more dominant in the UK economy, even as it becomes less central to the European and global financial system. Given the political drivers of Brexit, and the geographical patterns of voting in the referendum, that would be somewhat ironic.