Nicolas Véron

Global Financial Reform and Cross-Border Integration: Is Asian Leadership Needed?

This post was published by Bruegel and the Peterson Institute. It is based on a forthcoming paper presented at the joint conference “Asian Capital Market Development and Integration: Challenges and Opportunities” co-organized by the Asian Development Bank, Korea Capital Markets Institute, and the Peterson Institute, in Seoul on October 24, 2012.

Before 2007–08, most global financial reform initiatives were based on a near-consensus about the benefits from the free circulation of capital across jurisdictions and from free cross-border competition among financial services firms. As a consequence of the financial crisis in the United States and Europe, however, this near-consensus can no longer be taken for granted. One implication is the increasing possibility of a fragmentation of the global financial system.

Such a trend could take many forms. Rating agencies were unregulated in most of the world outside the US before the crisis (South Korea being one exception). But the G-20 recommended that they be regulated and supervised by all major jurisdictions. Implementing that recommendation raises the risk of incompatible or inconsistent regulatory frameworks and supervisory practices among different countries. Rating methodologies could vary even within the same rating agency. Another example of fragmentation could arise for over-the-counter (OTC) derivatives. Trading has until now been cleared bilaterally among market participants. The G-20 has mandated central clearing in regulated clearing houses starting in 2013, however. Many investors fear a division of corresponding markets along the borders of country or currency areas. A third new development would flow from the new standards at international financial institutions, particularly the International Monetary Fund (IMF), governing the adequacy of capital control measures under certain conditions. But these new standards could potentially run counter to the previously received wisdom of the so-called Washington consensus.

Across the globe, supervisors have nudged banks to separate and protect assets and maximize lending in their respective jurisdictions, in some cases pushing for subsidiarization of activities previously conducted through branches. In countries that have run into fiscal difficulties, domestically headquartered banks have been pressed to increase their purchases of national sovereign debt. “Financial repression,” an expression long reserved to economic historians, has reentered the mainstream financial vocabulary to describe the possibility of such pressure. These developments have been striking in the euro area, where countries are in principle committed to total openness to capital flows but where an abrupt U-turn from financial integration to financial fragmentation has been identified by policy authorities, including the European Central Bank (ECB). They are by no means unique to Europe, though, and variations of the same themes have been observed in most if not all main economic regions.

Simultaneously, the pre-crisis momentum for harmonization of global financial standards has run into setbacks in crisis-affected countries. The United States has delayed any decision about the adoption of International Financial Reporting Standards (IFRS), which it had endorsed for US-listed foreign firms in 2007 and had seemed on the verge of extending to US-listed issuers in 2008. In another example, the European Union, after championing the global use of the Basel II Accord on capital standards during the 2000s, now seems set to adopt legislation that the Basel Committee has deemed materially non-compliant with the new Basel III Accord adopted in 2010. For all the G-20 talk about global solutions to global problems, financial reform often seems more driven by politics in the post-crisis context than in the previous period. And as the saying goes, all politics are local.

This new reality poses an unprecedented challenge for Asian policymakers. Asia has gained from dynamic financial development in the past two decades, and is entering a new phase in which cross-border financial openness could improve the allocation of capital and make financing mechanisms more efficient. Asians generally are likely to benefit from the continuation or even the acceleration of global financial integration. Until recently, Asians could take such integration for granted, counting on the commitments to financial openness of both the United States and Europe, which dominate the global financial order as embodied by such institutions as the IMF, the International Accounting Standards Board, or the Basel cluster around the Bank for International Settlements.

But the assumption that the West will continue to champion further cross-border openness of the global financial system can no longer be taken for granted. As a consequence, Asians may have to take more leadership in global financial reform discussions to make sure that global financial integration is not reversed. This would be a new situation. Some Asian policymakers may feel ill-prepared for such a trend, but they could find its implications difficult to escape.

The First Step in Europe’s Banking Union: Difficult but Achievable

This column was published by Bruegel and the Peterson Institute, and also by Vox, the Globe and Mail (Canada), Caixin (China), El Economista (Spain), and RBC Daily (Russia).

The leaders of Eurozone countries made an unprecedented commitment when they issued on June 29 a statement starting with the words “We affirm that it is imperative to break the vicious circle between banks and sovereigns.” This statement officially acknowledged their intention to break the “doom loop” of mutually reinforcing deterioration of credit conditions afflicting weaker member states and banks headquartered in them. Spain is a prime example of the problem. Severing that feedback loop requires a transfer of vast parts of the banking supervision and policy apparatus from the national to the European level, or banking union. It is probably a prerequisite for maintaining the integrity of Europe’s monetary union in any crisis resolution strategy. Equally important, a failure to deliver on this clearly articulated pledge would severely impair investors’ already damaged confidence in the ability of the Eurozone governments to act collectively.

The action plan outlined in the June statement defines a sequence of two explicit steps. The European Central Bank (ECB) should first be endowed with broad supervisory powers and become the anchor of a “single supervisory mechanism” for participating member states. Then, once this mechanism is deemed “effective,” the European Stability Mechanism (ESM), which is the Eurozone’s newly-established intervention fund, would be able to recapitalize banks directly. Corresponding instruments remain to be clarified but would probably include common equity.

This sequence is unsatisfactory. Making European-level crisis management action (including bank recapitalizations by the ESM) contingent on the establishment of a permanent institutional infrastructure (i.e., an effective single supervisory mechanism) looks like a delaying tactic, in denial of the urgency of the present situation. Moreover, the leaders’ proposed sequence avoids essential elements of a credible banking union, such as a European banking charter, resolution authority and federal deposit insurance. This leaves the policy framework incomplete.

In spite of these frustrating flaws, however, the June statement is the boldest reaction so far of European leaders to the Eurozone crisis. They must now urgently transform this pledge into concrete decisions. The European Commission has done its bit by publishing a legislative proposal for the establishment of the single supervisory mechanism, on September 12. Three major issues of contention have emerged in the negotiations among member states.

First, the geographical perimeter: the June 29 statement identifies article 127(6) of the European Union’s Lisbon Treaty as the legal basis for the initiative, which means the new supervisor will be part of the ECB. But some non-Eurozone member states, including in Central Europe and Scandinavia, may legitimately want to join it, and they have a veto over decisions under article 127(6). They should be entitled to a voice in the new system’s governance, and to appropriate safeguards of their taxpayers’ interests. Even though one important member state, the United Kingdom, has unambiguously declared it would not join the single supervisory mechanism, the approach should be as inclusive and flexible as possible.

Second, monetary policy independence: banking policy and monetary policy are linked but ultimately different, which also justifies different geographical perimeters within the EU for currency union and banking union respectively. There is a legitimate concern that adding supervision, a politically charged task, to the ECB’s responsibilities, may compromise its cherished independence. The supervisory function should be strictly separated from the rest of the ECB, with full institutional autonomy possible in future reform steps.

Third, German savings and cooperative banks, which are local banks subject to a different policy regime from commercial banks, oppose their being brought under the new European supervisor’s authority. Given Germany’s pivotal position in all Eurozone discussions, some of its idiosyncrasies may have to be accommodated. There could be a separate European supervisory framework for systems of local non-commercial banks that would meet adequate conditions, for example.

Negotiators also need to ensure that the new supervisor’s governance is less dysfunctional than that of the ill-fated European Banking Authority, whose clumsy decision-making process was hampered by its reliance on diplomatic compromises among member states, in spite of a high-quality staff. Effective supervision requires that controversial decisions be made quickly, while guaranteeing genuine accountability to democratic institutions. At the same time, the legal basis for new arrangements must be robust and include mechanisms for judicial review. Further legal debate is needed on whether this is best achieved under article 127(6) or other Treaty provisions.

Creating Europe’s single supervisory mechanism is only one step on a much longer path towards crisis resolution and banking union. Compromise on it will be difficult but possible. Leaders must not lose the momentum created by their June 29 commitment, and should try to reach a final legislative decision before the end of this year.

Briefing Paper for the European Parliament: Single Supervisory Mechanism

On October 4, I was invited to present a briefing paper at a meeting of the Economic and Monetary Affairs (ECON) committee of the European Parliament, in preparation of their hearing of European Central Bank President Mario Draghi the following week. the paper is about the European initiative to create a banking union and more specifically the European Commission's proposals for A Single Supervisory Mechanism and related reform of the European Banking Authority, published on September 12.

Bruegel later published a lightly edited version of the same paper in its Policy Contribution series, available here. The paper is also available on the European Parliament's website.

December 11 update: an updated and slightly expanded version was also published by the Peterson Institute (PDF version here)