Nicolas Véron

Is Europe Ready for Banking Union?

This column was published by Bruegel and the Peterson Institute, and separately by Vox, the Australian Financial review, the Globe and Mail (Canada), Caixin (China), FT Deutschland (Germany), El Economista (Spain), Les Echos (France), Il Sole 24 Ore (Italy), Publico (Portugal), and RBC Daily (Russia). 

Systemic fragility in the European banking sector predates the Greek fiscal crisis. It was revealed by the subprime/Lehman shock of 2007-08, and has never been properly addressed since then in spite of successive “stress tests.” In recent weeks, several senior policymakers have become more explicit on the need for a “banking union” – in other words, a federal framework for banking policy. Among them is Christine Lagarde, managing director of the International Monetary Fund (IMF), who on April 17 said, “To break the feedback loop between sovereigns and banks, we need more risk-sharing across borders in the banking system. In the near term, a pan-euro area facility that has the capacity to take direct stakes in banks would help. Looking further ahead, monetary union needs to be supported by stronger financial integration, which our analysis suggests should be in the form of unified supervision, a single bank resolution authority with a common backstop, and a single deposit insurance fund.” The European Central Bank President, Mario Draghi, echoed these words at the European Parliament on April 25, declaring that he saw “financial stability clearly as a common responsibility in a monetary union” and that ”ensuring a well-functioning Economic and Monetary Union implies strengthening banking supervision and resolution at European level.”

Many academic observers now agree that a banking union, together with some form of fiscal union, is a necessary condition for a sustainable Eurozone monetary union and for a resolution of the current crisis. But in spite of the creation of a European Banking Authority last year, the action taken so far has been modest. Spain is a case in point: Madrid could have appealed to the European Financial Stability Facility (EFSF) for a loan specially targeted at recapitalizing its banks, but it has preferred to go it alone with the nationalization of ailing champion Bankia, and a new round of property-related write-downs that have provoked much market skepticism.

Several reasons explain why banking policy integration is difficult. The UK, Europe’s dominant financial hub, is not a Eurozone member and resists any encroachment on its supervisory sovereignty. Some member states remain committed to bolstering national banking champions or to protecting links between local banking and political communities – links that effectively make the banks instruments of the state’s industrial policies. The ability of debt-burdened governments to pressure domestic banks into buying their sovereign debt, also known as financial repression, is another impediment to change. Of course, a banking union would potentially involve controversial financial risk-sharing or cross-border transfers.

These constraints prevent Europe from moving in one step to a consistent architecture for its banking union. European leaders eager to discuss how to prevent the next crisis are often in denial about the current one. Their rhetoric tends to evoke an imaginary world in which finance is stable, economic incentives are aligned with social responsibilities and moral sentiments, and public authorities understand the financial system perfectly. From a policy perspective, such flights of fancy are an increasingly unaffordable luxury, especially in light of the urgent need for crisis management and survival.

Three priorities are obvious. First, the banks must share risks as widely as possible. It is unreasonable for European governments to reimburse all creditors of failed banks, including senior unsecured creditors in all cases to date (except for two banks in Denmark and a few very tiny ones elsewhere) and subordinated creditors in almost all cases in Continental Europe. In the US, by contrast, almost all restructuring processes have forced creditors to take heavy losses, except for a handful of prominent cases (Bear Stearns, Fannie Mae, Freddie Mac, AIG, and the carmakers). A European approach should avoid the perverse incentives that have held taxpayers hostage to failed banks’ creditors. There are many complex legal and financial issues at stake, but ultimately the choice is political.

Second, Europe needs an operating capability to restructure banks without having to rely on national authorities that have failed their supervisory duties. This objective requires building up an effective temporary task force of restructuring professionals who can intervene quickly on behalf of the entire Eurozone and manage corresponding legacy assets. Such tools do not currently exist. The Swedish Bank Support Authority of 1992, or in a different context Germany’s post-unification Treuhandanstalt, are relevant precedents.

Third, and most urgent, retail bank runs must be prevented. The best way would be for the EFSF or its successor fund to explicitly guarantee all national deposit insurance systems in the Eurozone. Such “deposit reinsurance” would bolster the integrity of the Eurozone and immediately enhance trust in its banks. Of course, strong European-level supervisory structures should eventually be built to prevent moral hazard. It will take more time to combine these different pieces into a consistent European banking policy framework. The current moment calls not for perfect fine-tuning, but for swift and bold commitments.

Move the FSB Secretariat to Asia

This post was published by Bruegel and the Peterson Institute, and is forthcoming in a joint newsletter of Bruegel and the Korea Institute of Finance. 

On the face of it, the financial crisis of 2007-08 has helped rebalance the governance of global financial authorities, partially correcting the prior underrepresentation of emerging economies and of Asia in particular. From November 2008 to April 2009, the G7/G8 was superseded by the G20, the Financial Stability Board (FSB) was empowered and enlarged to include major non-Western economies, and discussions began on reconfiguring the governance of the International Monetary Fund and World Bank. The Basel Committee on Bank Supervision was also adjusted to broaden its membership.

Much remains to be done to enable Asians to feel a genuine sense of ownership, however. Membership may have been broadened, but these institutions, which were generally created by Westerners for Westerners, remain predominantly run by Westerners[1]. In a recent count of the 25 top full-time and part-time positions at the 11 main global financial authorities[2], 20 were held by Westerners, and only three by Asians, including two deputy positions (Véron, 2012). Meanwhile, Asia now represents 25 to 35 percent of the world’s economy and financial system (depending on the indicator chosen), a share almost certain to increase in the near future. Asians correctly perceive a mismatch between their role in the global economy and their voice in global institutions (Cho, 2011).

An important but underestimated contributor to this mismatch is the fact that all global financial authorities are located in the West, and almost all in Europe. (The two exceptions are the International Monetary Fund and World Bank, both in Washington.) This is obviously a legacy of history. The first such institution, the Bank for International Developments (BIS), was established in Basel primarily to solve a European problem, the payment of World-War-I reparations by Germany, which involved mostly European stakeholders. Once created, institutions generally do not move, and some of them spin off new ones in the same place. The BIS remains the host locale of five other global financial authorities, including the FSB. But the issue of location is not merely symbolic. Anyone who has ever had to plan a round trip from Beijing (or for that matter, Brasilia) to Basel knows that being physically close to global institutions, as are all Europeans, offers a practical advantage in international financial regulatory discussions.

For each institution, there is a perfectly good case to keep it where it is. Beyond the cost of moving, joint work among the authorities justify keeping them close to each other. In addition, Europe’s time zones make it easier to maintain liaison with both Asia and the US. But according to this logic, no global financial authority will ever be located in Asia, and it will be increasingly difficult for Asians to resist the impression that they don’t have an equal stake in the global system.

The G20 leaders should break this cycle. Fortunately, an almost ideal opportunity is at hand. Negotiations are ongoing under the Mexican presidency of the G20 to reform and strengthen the governance of the FSB, loosening its ties with the BIS both in terms of financing and of operational arrangements. The discussions are expected to produce an agreement at the mid-June summit of the G20 in Los Cabos. Much of the discussion concentrates on the future representation in the FSB’s structures of different policy sub-communities (central bankers, finance ministry officials, supervisors). But relocation of its permanent secretariat should also be on the agenda. Unlike the IMF, OECD or BIS, the FSB secretariat has only a small staff of about 20 professionals, most of whom are internationally mobile. And because its global role is increasingly important, a transfer to Asia would be more than a token gesture.

Where in Asia? Some obvious criteria need to be fulfilled: air travel accessibility; political stability; the rule of law; and amenities that make it possible to attract highly qualified international staff. Among Asian cities, Hong Kong, Seoul, Singapore, and Tokyo meet these criteria to a sufficient degree. Switzerland can be expected to resist losing the FSB, but it would gain from strengthening the global financial policymaking order. So would all Western players.

Relocating the FSB to Asia, of course, should not substitute for other initiatives to fulfill the G20 promise to deliver an effective global financial policy framework reaching the goals of stability, growth, and inclusiveness. Nor should it substitute for financial reform in Asia, where the allocation of capital remains inefficient. But tackling the mismatch, in which Asians are inadequately empowered even as their economic and financial position is increasingly central, has to start somewhere. Moving the FSB secretariat eastwards would be a reasonable place to begin.

 

References

Cho Yoon Je (2011), “What do Asian Countries Want the Seat at the High Table for? G20 as a New Global Economic Governance Forum and the Role of Asia,” ADB Working Paper Series on Regional Economic Integration No. 73, Asian Development Bank

Véron, Nicolas (2012), “Asia’s Changing Position in Global Financial Regulation”, Asian Development Bank / Korea Capital Markets Institute / Peterson Institute for International Economics, forthcoming

---

[1] Defining the “West” according to common practice, as the US and Canada, Europe up to the current Eastern boundary of the EU, Israel, Australia and New Zealand.

[2] These are the FSB itself and its ten members which have a global scope, namely the Bank for International Settlements, Basel Committee on Banking Supervision, Committee on the Global Financial System, Committee on Payment and Settlement Systems, International Association of Insurance Supervisors, International Accounting Standards Board, International Monetary Fund, International Organization of Securities Commissions, Organization for Economic Co-operation and Development, and World Bank. 

 

President Hollande's First Steps

In this interview by the Peterson Institute's Steve Weisman, I comment on the second round of the French presidential election and François Hollande's possible policy choices, and what it means for Europe. 

The European Debate on Bank Capital Requirements

This post was published today by Bruegel and PIIE. 

The European Union (EU)’s finance ministers are furiously debating a piece of legislation known as CRD4/CRR (the acronyms stand for the fourth Capital Requirements Directive and the Capital Requirements Regulation). The measure is intended to implement the Basel III accord on bank capital, leverage, liquidity and risk management, which was adopted at the global level by the Basel Committee on Banking Supervision in late 2010.

There are two main unresolved issues. First, the legislation’s departures from the Basel III Accord; and second, whether individual member states should be allowed to impose core prudential requirements (known in the Basel jargon as Pillar I) beyond the commonly agreed minimum, especially as regards capital ratios.

The first item matters not only for the EU but also from a global perspective. The current EU debate is mostly about the definition of capital, and especially the exception for so-called “silent participations” in some German banks and the capital treatment of insurance subsidiaries, which affect some large French banks among others; on both items, the CRD4/CRR draft is seen by many observers as not compliant with Basel III.

The issue is part of a broader question. The EU was a strong promoter of internationally consistent financial standards before the crisis. Its stance helped EU institutions fulfill their own agenda of single market harmonization. The EU adoption of the original Capital Requirements Directive (implementing the previous global capital accord, known as Basel II) and its adoption in 2002-05 of International Financial Reporting Standards (IFRS) arose from an alignment of interests between EU institutions and global standard-setters. EU institutions viewed such harmonization as an overriding good superseding any misgivings they may have had about a particular standard’s content. There were exceptions of course. For example, the European Commission “carved out” some parts of an international accounting standard on financial instruments (IAS 39) when it was endorsed into EU legislation in late 2004. But the general picture was very consistent. This made the EU unique in the global context, as a consistent champion of global standards even when it did not determine their content (Elliot Posner and I analyzed this dynamic in a 2010 paper).

The crisis has changed the dynamics between the EU and global standard-setters. EU institutions now seem to care more about the content of the standards than about global harmonization or convergence. This is not necessarily a conscious change: in both the Commission and Parliament, most people still see the EU as an internationalist player. But in practice the EU now looks much more like the US, in favor of global standards when it “likes” them and not in favor when it “dislikes” them. The EU’s new position is complicated by the lack of a consistent policy infrastructure to determine whether a standard is “liked” or “disliked.” As a consequence, the process is more often than not vulnerable to special-interest pleading. Meanwhile, global standard-setters have lost the EU as a consistent global champion as it had been in the previous era.

Many EU officials underestimate the potential of the CRD4/CRR legislation undermining the global authority of the Basel Committee. Many other jurisdictions are carefully watching the EU legislative debate. If the EU adopts final legislation that is not compliant with the definition of capital under Basel III, other countries could well introduce deviations of their own, dictated by local special interests.

The United States, in delaying its own proposals for Basel III implementation, has not helped the situation. In November 2011, Federal Reserve Board Governor Daniel Tarullo announced that a public regulatory proposal to implement the Basel III accord in the US would be unveiled in the first quarter of 2012. We are in early May, and still waiting. This is a regrettable failure of US leadership. A published American proposal compliant with Basel III would encourage the EU to comply as well. Also disappointing is the delay by the US Securities and Exchange Commission on adoption of international reporting standards, which has undermined the global credibility of IFRS. Almost everybody accepts that domestic political constraints are preventing the US from adopting all IFRS standards in the short term or even setting a firm date for complete adoption. But the SEC’s “condorsement” concept allows for a lot of flexibility in terms of gradual adoption. The SEC’s inability to commit itself to even a minimalist condorsement schedule undercuts the quest for global financial reform.

The second big issue in the CRD4/CRR debate is more of an internal EU matter. The European Commission favors a “maximum harmonization” that would prevent member states from raising their Pillar I capital requirements above a commonly agreed minimum. The argument is that harmonization in this fashion would minimize competitive distortions inside the EU. But the main distortion by far in the EU market for banking services is the fact that most of the bank supervision /resolution policy framework remains national, pegging banks’ financial health to the situation of their home-country sovereign. This link has disastrous effects these days, particularly in the eurozone. The Commission’s Directorate General for the Internal Market and Services (DG MARKT) has failed to address this distortion. A legislative proposal on bank crisis management and resolution, which is not even published in draft form, should have been advanced forcefully and as far back as mid-2009. Had it been put forward, it could have preempted diverging legislative moves on national resolution frameworks adopted already by many member states.

Given this failure, the Commission’s assertion that higher capital requirements in Sweden or the UK would harm a single market rings hollow. The Basel Committee has explicitly stated that its standards were a mere minimum and that individual jurisdictions were encouraged to go beyond them, as Switzerland has already decided to do. In its comment letter on the CRD4/CRR proposals in March, the European Systemic Risk Board has come up with a balanced proposal that would combine freedom to decide macro-prudential measures in individual member states, including by raising Pillar I capital requirements, with the need for EU-level coordination. These proposals make sense and should be endorsed in the final legislation.