Nicolas Véron

An Update on the G20 and Financial Regulation

This article was published in May in the 20th issue of G20 Monitor, a series of the Lowy Institute in Sydney, Australia. 

The G20 and Financial Regulation: Early Achievements and Structural Gaps

Nicolas Véron^[1]

Financial regulation was very prominent in the initial stages of the G20 as a venue for coordination among global political leaders. This early emphasis led to significant successes, but also to a sense of disillusionment as delivery of consistent outcomes could not be sustained and divergence among key jurisdictions became increasingly noticeable. It is argued here that the causes of the G20’s shortcomings are largely structural, linked to a lopsided architecture of global institutions for the preparation of financial regulatory policy. These structural gaps are inherently hard to correct. Any efforts during the Chinese and German presidencies of the G20 to identify and acknowledge them would help to pave the way for future progress towards fulfilment of the G20’s proclaimed objectives.

The G20’s financial regulatory track record: achievements and disappointments

Following the great financial crisis of 2007–08, G20 summits started with a very strong focus on financial regulatory matters. The first G20 Leaders’ Summit, held in Washington DC on 15 November 2008, listed no fewer than 39 actions to be taken in the area of financial regulation alone, or 83 per cent of the 47 points in the summit declaration.^[2] This was accompanied by highly aspirational rhetoric. Following the Washington Summit, for example, the then French President Nicolas Sarkozy immediately declared that “this summit is historic” and that it had introduced “a new regulation of financial markets so that such a crisis could not happen again” and “a new, more effective and fairer global economic governance”.^[3]

The actual achievements, of course, were more nuanced. The two subsequent summits, held in London in April 2009 and in Pittsburgh in September 2009, resulted in a series of wide-ranging financial regulatory decisions. The assessment of policy reforms is never a matter of universal consensus, perhaps even less so in the area of financial regulation than in other areas of economic policy. Nevertheless, some of the changes resulting from successive G20 summits can be labelled successful.

The prime example for this is arguably the Basel III accord on capital, leverage, and liquidity, initially formulated in December 2010 and updated since by the Basel Committee on Banking Supervision (BCBS).^[4] Compared with the previous Basel II accord of 2004, which it replaced, Basel III considerably reinforces the requirements for banks’ capital as measured as a share of their risk-weighted assets; introduces an additional leverage ratio, thus creating a check against the possibility of risk-weighting manipulations by banks; and creates an entirely new framework for bank liquidity regulation. Basel III has been criticised from various corners, both for being too rigorous^[5] and for being too lax.^[6] But there is no question that it is an improvement on the prior global Basel II regime, and little doubt that it owed its rather quick finalisation to the political impetus provided by the G20.

Aside from Basel III, there are other global financial regulatory reform initiatives that came in the wake of G20 discussions and are unquestionably useful. One of the more significant, though scarcely visible, is a joint effort to improve financial statistics, coordinated by the International Monetary Fund (IMF) and the Financial Stability Board (FSB) and known as the ‘Data Gaps Initiative’. Even though progress in this area tends to be slow and incremental, this has led to an improvement in the quality and quantity of information available to policymakers and to the wider public to analyse financial systems and their evolution. One particularly pioneering aspect of the Data Gaps Initiative is the creation of an International Data Hub on global systemically important banks at the Bank for International Settlements (BIS), in Basel, which to an extent transcends traditional jurisdictional boundaries of banking supervision on a global scale.^[7]

Still, other G20 endeavours, even after more than seven years of discussions, remain largely a matter of work in progress. To start with, the Basel III accord is not yet fully implemented, and some of its requirements will only be fully in place in 2019. International Capital Standards for internationally active insurers have not yet been agreed on, let alone implemented. The FSB’s approach to the orderly resolution of future crises involving global systemically important banks, grandly labelled ‘Ending Too-Big-To-Fail’ since 2011, has not attracted an enthusiastic reception from jurisdictions other than its initial promoters in the European Union, Switzerland, and the United States.[8] The approach to the so‑called shadow banking system has been generally long on rhetoric and short on actual policy, reflecting the imprecision of the concept of shadow banking itself.

There has also been a journey of discovery on many of the reforms, involving initially unforeseen consequences. For example, the G20 in 2008–09 decided to impose profound structural changes on the market for financial derivatives transactions, which until then had been only lightly regulated. One of the key measures was the requirement to move the clearing of many derivatives contracts from bilateral relations to central clearing houses, also known as central counterparties (CCPs). But this leads to massive risk concentrations inside the CCPs, and also raises questions about the possibility of fragmentation of derivatives markets across jurisdictional lines, since CCPs are supervised on a country-by-country basis. It is increasingly clear that these challenges had not been comprehensively evaluated at the time the G20 made its decision, as is apparent from a still widely open policy debate about the future framework for the resolution of CCPs in systemic crisis scenarios.

Yet other G20 initiatives have simply failed to come to fruition. One clear example is the G20’s initially expressed ambition to achieve global convergence of financial accounting standards. In spite of the existence of a tried-and-tested set of such standards, known as International Financial Reporting Standards and adopted by the European Union and many other jurisdictions in the course of the 2000s, accounting standard-setters in the United States and in other countries have successfully resisted pressure to converge towards this global framework. The mantra of convergence towards a single set of high-quality global accounting standards was initially announced by the G20 with a mid-2011 deadline; that deadline was extended several times, then was entirely dropped, and then the mere mention of the commitment to global accounting standards convergence was quietly abandoned.^[9]

Another impactful G20 innovation was a major enhancement of the arrangements to monitor the implementation of reforms from a global perspective. The Basel Committee, in particular, has established a pioneering program to monitor not only which jurisdictions have transposed Basel III into their laws and regulations, but also the precise level of compliance of such transposition with the global accord, and also some aspects of its practical implementation. In this, the BCBS has established strong methodologies to ensure the neutrality of the assessment, and has not shied away from ‘naming and shaming’ — for example, in a 2014 report, the BCBS found the European Union, its biggest jurisdiction in terms of total banking assets, to be “materially non-compliant” with Basel III.^[10] The FSB has regularly collected information about the application of all G20 reforms since 2008, and since 2015 delivers annual reports to G20 Leaders summarising its findings across the entire financial regulatory scope, including some elements of economic impact assessment.^[11]

Unsurprisingly, the G20’s efforts have not put an end to the considerable diversity of financial system structures around the world. Different jurisdictions have diverse histories, levels of development, and political and social arrangements which all stand in the way of cross-border convergence. Even so, there has been a remarkable shift of the policy consensus, in different ways in the European Union, China, Japan, and other jurisdictions, towards a recognition that their financial systems’ present domination by banks (as opposed to a large role for securities markets to finance the economy, as is most notably the case in the United States) may not be in their best interests from the standpoint of both economic growth and financial stability.^[12] This acknowledgment has motivated the ongoing EU policy of ‘capital markets union’ and various other initiatives around the world to develop capital markets. The G20, however, has played no direct role in this shift, and it remains to be seen how much impact it will have on the actual evolution of financial systems.

Overall, the action of the G20 since 2008 qualifies as the most ambitious and impactful coordinated effort ever to overhaul financial regulation at a global level. But its achievements are lopsided, and far from the vision initially expressed by political leaders (especially European ones) of a globally consistent approach to financial regulatory policy.

Institutional imbalances and prospects

The contrasted landscape of G20 successes, half-measures and failures is not only the product of randomness. There is a degree of correlation between G20 achievements and the strength of existing international arrangements. Perhaps unsurprisingly, treaty-based institutions such as the IMF and World Bank have been able to deliver more quickly on the G20’s early initiatives than looser coordination bodies.^[13] Furthermore, it is not a coincidence that Basel III stands out among G20 reforms for effectiveness and impact.

The Basel Committee, created in late 1974, is one of the oldest and most established bodies for global financial regulatory coordination, and is itself hosted by the Basel-based BIS, established by treaty in 1930 and thus the dean of all public international financial organisations. Both the BCBS and BIS, together with other lesser-known bodies such as the Committee on the Global Financial System (CGFS) and Committee on Payments and Market Infrastructures (CPMI), rely on the global community of central banks and central bankers, which is comparatively more cohesive than other networks of national regulatory authorities. By contrast, securities markets authorities, even though they gather in the International Organization of Securities Commissions (IOSCO, created in 1983), have been collectively less effective in the promotion of common standards, as illustrated by the fiasco of G20 efforts to promote accounting standards convergence.

Furthermore, issues which are relevant to both central banks and securities regulators, such as reforms of the over-the-counter (OTC) derivatives markets, have been characterised by a near-complete inability to effectively set standards at the global level. To remedy this gap, there has been a proliferation of initiatives which have not achieved much more than underlining the problem, including an OTC Derivatives Supervisors Group (ODSG) since 2005, an OTC Derivatives Regulators Forum (ODRF) since 2009, an OTC Derivatives Regulators Group (ODRG) since 2011 and an OTC Derivatives Coordination Group (ODCG) since 2012, with largely overlapping compositions and mandates.

It is striking that the financial crisis of 2007–08 has not led to the creation of any significant new global institution for financial regulatory reform.^[14] The G20 itself, as a grouping of countries if not a format of top leaders’ summits, was born of the Asian crisis of 1997–98, as was the FSB (the successor to the Financial Stability Forum). In 2008–09, a number of existing bodies — including the FSB, BCBS, CGFS, and CPMI — expanded their membership to large emerging economies, but there was much less institutional creativity than in the wake of the Asian crisis. It is tempting to correlate this observation with the fact that the 2007–08 crisis affected the core of the global financial system, including the United States and European Union, while the Asian crisis had been more contained from a global financial standpoint, even though it covered a very large area in terms of geography and population.

Even after the shift of Leaders’ Summits to the G20 format and the above-mentioned expansion of membership of several key organisations to include emerging economies, the structure of global financial bodies remains markedly imbalanced. Europe is still significantly overrepresented — especially now that the implementation of the set of reforms known as ‘banking union’ implies that national authorities from the 19 euro area countries no longer have policy autonomy, in either banking supervision or monetary policy.^[15] Furthermore, almost all global financial regulatory bodies are led by westerners, and headquartered in either Europe or the United States.^[16]

Next steps: where to from here

Evidently, it is comparatively easier for the G20 to change the content of financial regulations than the architecture of the institutions which prepare them. Nevertheless, some of the gaps in the current organisational arrangements should be addressed if the G20 is to become more effective at achieving its financial reform objectives. For example, it would be sensible to empower a global body with relevant membership and a clear mandate to issue standards for the global derivatives markets. Some categories of regulated market participants which handle crucial cross-border information, such as credit rating agencies, trade repositories and audit firms, may need to be supervised at a supranational level, as is now partly the case in the European Union.^[17] Even some entities that may require public financial assistance in a crisis scenario, such as CCPs, may require more internationally centralised supervisory arrangements in the future than is currently deemed feasible. Among existing entities, future choices of leadership should tilt much more towards diversity of jurisdictional background (and of gender), and, to ensure better legitimacy and acceptance, the relocation of some away from the North Atlantic should be seriously envisaged.^[18]

Such suggestions run against considerable institutional and political inertia. The G20 itself is a consensus-based venue, but many of the specialised global public financial regulatory bodies are even more driven by the need for unanimity. In other terms, it would be unreasonable to expect the FSB or any of its members to take the initiative of proposing changes to the existing architecture, even changes that are sorely needed — such initiative belongs to the political leaders. The heads of state who will gather in Hangzhou later this year would do well to reserve part of their time for an open-ended discussion on this theme that might crystallise a process of recognition of at least some of the current institutional gaps, possibly leading to a first set of proposals as early as the G20’s German Presidency in 2017. Going forward, incremental and not-so-incremental changes in the set-up and organisation of global public regulatory and oversight bodies will eventually be needed to enable the maintenance of a decently regulated, globally integrated financial system.

 

[1] Nicolas Véron is a Senior Fellow at Bruegel and a Visiting Fellow at the Peterson Institute for International Economics. He is also an independent board member at the Global Trade Repository arm of the Depositary Trust and Clearing Corporation.

[2] Stéphane Rottier and Nicolas Véron, “An Assessment of the G20’s Initial Action Items”, Bruegel Policy Contribution 2010/08, Brussels, September 2010, http://bruegel.org/wp-content/uploads/imported/publications/pc_2010_08_fin_reg.pdf.

[3] Transcript of the joint press conference of Nicolas Sarkozy and José Manuel Barroso, 15 November 2008, accessed at http://www.g20.utoronto.ca/summits/2008washington.html.

[4] See Basel Committee on Banking Supervision, “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems’, December 2010 (revised June 2011), http://www.bis.org/publ/bcbs189.htm, and “Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools,” January 2013, http://www.bis.org/publ/bcbs238.htm.

[5] See, for example, Institute of International Finance, “The Cumulative Impact on the Global Economy of Changes in the Financial Regulatory Framework,” September 2011.

[6] See, for example, Anat Admati and Martin Hellwig, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It (Princeton NJ: Princeton University Press, 2013).

[7] For more information, see Financial Stability Board, “FSB Data Gaps Initiative: A Common Data Template for Global Systemically Important Banks: Phase 2”, 6 May 2014, http://www.fsb.org/2014/05/r_140506/.

[8] See Financial Stability Board, “Second Thematic Review on Resolution Regimes”, 18 March 2016, http://www.fsb.org/wp-content/uploads/Second-peer-review-report-on-resolution-regimes.pdf.

[9] G20, Leaders Statement, Pittsburgh Summit, 24–25 September 2009, http://www.g20.utoronto.ca/2009/2009communique0925.html.

[10] Basel Committee on Banking Supervision, “Regulatory Consistency Assessment Programme (RCAP): Assessment of Basel III Regulations — European Union”, December 2014, http://www.bis.org/bcbs/publ/d300.pdf.

[11] See Financial Stability Board, “Implementation and Effects of the G20 Financial Regulatory Reforms”, 9 November 2015, http://www.fsb.org/2015/11/implementation-and-effects-of-the-g20-financial-regulatory-reforms/.

[12] See, for example, Sam Langfield and Marco Pagano, “Bank Bias in Europe: Effects on Systemic Risk and Growth”, European Central Bank Working Paper No1797, May 2015, https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1797.en.pdf.

[13] Stéphane Rottier and Nicolas Véron, “Not All Financial Regulation Is Global”, Bruegel Policy Brief 2010/07, August 2010, http://bruegel.org/2010/08/not-all-financial-regulation-is-global/.

[14] To the author’s knowledge, the only exception is the Global Legal Entity Identifier Foundation, established by the FSB in 2014 with a fairly narrow remit.

[15] Still, the central banks of Belgium, France, Germany, Italy, Luxembourg, the Netherlands, and Spain remain full members of the BCBS, alongside the European Central Bank (ECB) and its Single Supervisory Mechanism; and the national central banks of France, Germany, Italy, the Netherlands, and Spain all retain representation in the FSB’s Steering Committee, alongside the ECB.

[16] See Nicolas Véron, “Asia’s Changing Position in Global Financial Reform”, in Asian Development Bank and Korea Capital Market Institute, Asian Capital Market Development and Integration: Challenges and Opportunities (New Delhi: Oxford University Press, 2014), http://www.adb.org/sites/default/files/publication/31180/asian-capital-market-development-integration.pdf. In terms of location, the only outlier is the International Forum of Independent Audit Regulators (IFIAR), which in April 2016 announced plans to establish a permanent secretariat in Tokyo.

[17] The European Securities and Markets Authority is the sole supervisor of rating agencies and trade repositories for all 28 member states of the European Union, including the United Kingdom.

[18] Nicolas Véron, “Move the Financial Stability Board’s Secretariat to Asia”, RealTime Economic Issues Watch (Blog), 10 May 2012, https://piie.com/blogs/realtime-economic-issues-watch/move-financial-stability-boards-secretariat-asia.

Italy's Banking Problem Is Serious But Can Be Fixed

This post was published today on the blogs of the Peterson Institute and Bruegel. 

Following the UK vote to exit the European Union, the fragility of the Italian banking system has come into the spotlight. The Economist described it as a “potentially more dangerous financial menace” than Brexit. This characterization is massively overblown. The policy and political challenges associated with Italian banks are complex but far from intractable and need not become a systemic risk for the euro area.

The June 23 referendum was in no way the cause of the problem. It unleashed a decrease in share prices of listed banks in Italy as elsewhere in Europe, which makes it comparatively harder for them to raise fresh capital from private investors if needed. Even if the UK had chosen to remain in the European Union, however, Italy’s banking problem would certainly have become the next focus of attention of market participants in Europe once the all-consuming British referendum campaign was over.

The Banking Problem

Italy’s weak banking sector is the largest remaining pocket of financial fragility in a long series of banking system problems that has blighted Europe since 2007. The seriousness of the situation has been apparent since at least the comprehensive assessment of 130 euro area banks in 2014, which immediately preceded the transfer of supervisory authority from national agencies to the European Central Bank (ECB) as part of the broader reform known as banking union. In that assessment’s results, Italy had the lion’s share of problem banks in the euro area (9 out of 25), but corrective action was not immediately taken. The ECB in late 2014 accepted recapitalization plans from the weaker banks, which in hindsight were inadequate, and when it eventually tightened its capital requirements a year later, the Bank of Italy appeared to resist. Even so, the belated demands from the ECB were followed by the merger between Banco Popolare and Banca Popolare di Milano and by the takeover of Banca Popolare di Vicenza and of Veneto Banca by Atlante, a fund created under the auspices of the Italian authorities.

Weaknesses remain in other banks, particularly Monte dei Paschi di Siena (MPS), the centuries-old Tuscan institution that has already undergone several rounds of recapitalization and restructuring linked with revelations of significant fraud and mismanagement. Even though there is no indication that MPS is insolvent, media reports suggest that it may perform poorly in the stress testing of 53 European banking groups including 5 Italian ones, the results of which will be published on July 29. With 169 billion euros in assets at the end of 2015, MPS is only the 28th largest banking group in the euro area, but it is third largest in Italy’s fragmented banking sector. Furthermore, under the banking union policy framework, only 15 Italian banks are directly supervised by the ECB and subject to its newly demanding supervisory practices; hundreds of smaller banks, together representing between one-quarter and one-third of the system’s total assets, are supervised by the Bank of Italy with only indirect oversight by the ECB. Unresolved problems may be lurking in some of these smaller banks, even if one adopts a sanguine assumption that MPS is the last problem case remaining among the banks directly supervised by the ECB.

Trade-Offs of Burden Sharing

The situation of MPS has crystallized a debate about burden sharing, or in other terms, whether losses should be imposed on some creditors, especially junior ones, as part of the bank’s capital strengthening. Such imposition of losses, also referred to as “bail-in,” may be justified on several grounds. Public guarantees of bank creditors, and their “bailout” when a bank fails, distort competition among banks from different European member states. They are a controversial use of public funds, create questionable incentives for banks, and contribute to the bank-sovereign vicious circle, which threatened the very integrity of the euro area in 2011–12. The European Commission’s competition policy arm (known as DG COMP) has a mandate to keep such state aid in check. Furthermore, the European Union in May 2014 adopted a Bank Recovery and Resolution Directive (BRRD), which attempts to make bail-in the default option when a bank fails. This echoes a global reform effort to mitigate moral hazard in banking systems, labelled “Ending Too-Big-To-Fail” by the Financial Stability Board (FSB), and similar policies adopted in other jurisdictions.

In the United States, despite a lively public debate on “too-big-to-fail” banks, bail-in of bank creditors is an established practice. The US Federal Insurance Deposit Corporation has closed hundreds of banks in the last decade, with junior and senior creditors suffering losses to the extent required by the gaps in their balance sheets. The largest such case happened at a time of extreme financial stress in 2008 with Washington Mutual, a bank that was significantly larger than MPS and whose junior and senior creditors took losses. In the European Union, the imposition of losses on senior creditors has been infrequent, with cases in Denmark in 2010, Cyprus in 2013, Portugal in late 2015, and Austria in 2016, but junior debt bail-in has become widespread in the past five years, not only in the aforementioned countries but also in Greece, Ireland, the Netherlands, Slovenia, Spain, the United Kingdom, and Italy itself.

In the case of Italy, however, a complicating factor is that much (though far from all) of the banks’ junior and senior debt, together with equity, was sold by the banks to their retail customers, with no objection (and until a few years ago, even encouragement in the form of tax incentives) from the public authorities, including the securities regulator CONSOB and the Bank of Italy. This practice can be viewed as massive misselling, since these instruments, and particularly equity and junior debt, are intrinsically risky and should not have been placed as a safe retail investment product, even before the European Union started consulting on the BRRD legislation in the early 2010s. Such dubious practices have also occurred in other European countries but have been uniquely pervasive in Italy.

Finding the Right Balance

In complex situations such as that of MPS, and possible other future Italian cases, finding the right balance between bail-out and bail-in can be tricky. The Cyprus crisis of 2013 is an example of the European Union imposing too much bail-in, which dramatically eroded trust in the financial system and led to the first-time imposition of capital controls within the euro area. It is justified for the EU authorities to show flexibility, as they have by allowing the Italian authorities to invoke Article 32(4)(d)(ii) of BRRD to provide liquidity support to banks. It is widely expected that a related exemption clause, Article 32(4)(d)(iii), could be used for a “precautionary recapitalization” of MPS, in which case the only bail-in requirements would be on junior creditors, as required under the state aid control framework applied throughout the European Union for more than three years. This would mean that no senior creditors or depositors would suffer any losses. There would be no contagion to other euro area countries, since the principle of junior debt bail-in is established and priced-in outside of Italy. Additionally, DG COMP would allow the compensation of those retail junior debt holders that can be considered victims of misselling from bail-in losses, as it did in the case of four Italian banks rescued in late 2015 and similarly in Spain in 2012.

Everyone agrees that holders of equity shares are not entitled to compensation, even though their losses can be painful as well. As a consequence, the discussion on MPS is centred on those junior debt holders who cannot be viewed as innocent victims of misselling, namely well-to-do families, professional investors, and other banks. The Italian government appears to be adamantly opposed to any bail-in of these creditors. But its stance is hard to justify by considerations of financial stability. Banks issue much less junior debt now, and one hopes they sell it only to knowledgeable investors anyway. Assuming minimally competent public communication, there is no risk whatsoever of a bank run. In sum, a reasonable compromise would involve bailing in junior creditors, presumably in the form of a debt-equity swap; compensating the retail victims of misselling; and sparing all senior creditors and depositors under the BRRD’s exemption for precautionary recapitalizations.

Sadly, the domestic and international debate on bail-in in Italy has been largely disconnected from the facts and has become a vehicle for ideological posturing, not without multiple ironies. Domestically, the Italian government’s apparent uncompromising anti-bail-in position advocates the use of taxpayers’ money to reimburse investors well beyond the widows, orphans, pensioners, and other modest households who were abused by banks they shouldn’t have trusted blindly. Internationally, a number of established figures in the financial industry have voiced support for that pro-bailout position, including recently JP Morgan’s chief executive Jamie Dimon on a visit to Rome. The irony here is that many of the same bankers pay enthusiastic lip service to the FSB’s and other authorities’ efforts to “end too-big-to-fail:” not for the first time, the financial industry’s commitments to market discipline evaporate instantaneously when tested in practice as opposed to theory. The same observation, sadly, applies to many voices in the international financial press, still reeling from the UK referendum trauma. The Economist is far from alone here: A Financial Times columnist lambasted DG COMP’s opposition to a taxpayer-funded bailout of all MPS creditors as that of “a truculent EU unwilling to show pragmatism in the face of popular outrage about immigration.” So did Lawrence Summers, belittling the disciplines of EU competition and banking law as “some international agreement,” as if treaties should not be considered binding.

A Comprehensive Approach Beyond the MPS Case

The compromise treatment of MPS outlined above would of course not be enough. A more comprehensive approach to Italy’s banking fragility is overdue, even though political realities may delay it until after a constitutional referendum due in October 2016. The tried-and-tested way to resolve Italy’s banking problem would be a system-wide exercise of “triage,” with an ad hoc balance sheet assessment of banks representing the vast majority of the system’s total assets, and thus including a number of the smaller banks that currently escape direct ECB supervision. The ECB should directly conduct the assessment for it to be credible, and may also involving evaluators from the private sector as was done in several EU countries including Ireland, Greece, Spain, and Cyprus. Banks found unviable should then be resolved using the procedures set out by BRRD, again with adequate compensation of retail victims of misselling. In the unlikely case that EU authorities would opine that this may lead to systemic instability, then the option might be considered of reactivating the possibility of direct bank recapitalization by the European Stability Mechanism, the euro area fund based in Luxembourg, with conditionality for the Italian authorities in a spirit comparable to that of the Spanish program of July 2012. Also, the governance of many Italian banks should be further reformed to prevent them from being captured by local political interests. In parallel, echoing recent recommendations by the International Monetary Fund in two recent papers, the Italian government should pursue reforms and allocate resources to facilitate out-of-court settlements and court judgments in order to facilitate the seizing of collateral on bad debt, and thus increase the currently depressed value of Italian banks’ vast portfolios of nonperforming loans.

Assuming a modicum of cooperation by all public authorities involved, Italy’s banking problem could thus be solved in the first half of 2017 if not earlier. By then, hopefully, the euro area will have almost entirely addressed its legacy of financial fragility from the past years of crisis. This should in turn allow leaders to move towards making the banking union more consistent and resilient, with more risk-sharing and sounder incentives for public authorities and banks. The agenda should include a European deposit insurance scheme, as the European Commission proposed last November; limits on banks’ exposures to individual euro area sovereigns, with a lengthy transition period to avoid disruption in sovereign debt markets; harmonizing bank insolvency law across the euro area, an indispensable complement to BRRD; and perhaps also amending BRRD itself in the light of lessons learned from the Italian experience.

Moreover, that same experience suggests that a sustainable banking union will require additional arrangements to protect customers of financial services. The fact that banks were allowed to sell their own risky debt to retail households as a savings product for so long is disturbing, as is the fact that no one in Italy appears to have owned up yet to this policy failure. EU authorities should draw the right lessons so that similar fiascos do not recur. 

Brexit may (counter-intuitively) revive the Capital Markets Union project

In this piece published today by Bloomberg View, I make the case that Jean-Claude Juncker's project of a European Capital Markets Union (CMU) may be revived by the UK decision to leave the EU. This is because requires CMU stronger EU-wide enforcement institutions, something that couldn't be envisaged in the pre-referendum period. 

Update (September 10, 2016): Bloomberg kindly gave its authorization for reposting the text of the article, shown below. 

A Post-Brexit Opportunity Europe Shouldn’t Miss

If there is a silver lining for the world of finance from the Brexit vote it is this: that the departure of Britain offers the European Union a chance to complete much-needed reforms to the Continent's lagging capital markets. If it can do that, the EU might just be able to demonstrate its ability to serve a purpose and enhance growth across the EU.

Two years ago, European Commission President Jean-Claude Juncker made strengthening Europe's capital markets one of his key priorities. Europe lagged America across the board: in public and private equity financing, bond issuance by medium-sized companies, securitization, corporate transparency, and the ability to work out debt in a downturn. Bank loans represent more than three-quarters of external credit to non-financial companies in the EU, against less than a third in the US. Europe’s small- and mid-sized firms, especially those with a high growth potential, needed better access to financing options.

With Britain's EU referendum looming, Juncker also saw the EU's Capital Markets Union (CMU) as a way of showing that EU policies could be aligned with U.K. interests, since the City of London had a massive comparative advantage in capital markets services.  U.K. Commissioner Jonathan Hill was put in charge of the ponderously titled “Financial Stability, Financial Services and Capital Markets Union” portfolio. But it turned out to be a bit more complicated.

Strong EU capital markets require strong EU institutions to oversee them and enforce existing regulations. As the British Commissioner – and therefore the official primarily tasked with helping the case for the U.K. to remain in the Union – Hill had to rule out any changes in institutional arrangements that might be seen in the heat of the referendum campaign as a “Brussels power-grab.”

Thus, in the past two years the CMU agenda has remained long on rhetoric, and short on policy. Hill made the case for CMU as a way of providing adequate financing to high-growth firms and thus to stimulate growth and job creation on a long-term basis with no fiscal or financial stability downside. But there have been few concrete proposals for reform, the main one being a securitization bill that is currently bogged down in the EU legislative process.

Now that Britain has voted to leave the European Union, a window is opening for a vigorous CMU relaunch. A serious agenda would include things like consistent processes for listing and fund approvals across EU member states, an integrated framework for auditor oversight and public enforcement of accounting standards, consolidated EU-wide supervision of important market infrastructure firms, moves towards insolvency law harmonization, and possibly also some convergence in the taxation of financial investments. All these require pooling of sovereignty. The existing European Securities and Markets Authority could be built upon, as outlined in an EU report last year.

Inevitably, not everyone in Europe is a fan. Opposition against CMU broadly crystallizes along three dimensions. First, pooling sovereignty is always difficult, even outside the U.K. Second, anti-market ideology remains strong in many European countries, as illustrated by the pursuit of the Financial Transaction Tax. Third, a range of special interests seek to defend the status quo. These include protected financial infrastructure firms, such as national stock exchanges which are still (mistakenly) viewed as vital national attributes in a number of European capitals, and other financial institutions whose business model may be challenged by a successful CMU, such as the politically influential German local banks.

But none of these political obstacles is as intractable as the U.K.-specific constraints that hamstrung Commissioner Hill. There are powerful forces on the pro-CMU side as well. Aside from the U.K., member states with strong capital markets already include France, Belgium, the Netherlands and Sweden. The European Central Bank has come strongly in favour of CMU, which it rightly sees as a way to diminish the euro area’s bank bias, increase its shock-absorption capacity, and thus enhance financial stability. So has the President of the Eurogroup, Jeroen Dijsselbloem, with similar arguments. And, in the 19-nation euro area, the steps already taken to build a much-needed banking union have profoundly undermined the case for keeping financial services policy at the national level. Following Commissioner Hill’s resignation, the financial services portfolios will be taken over by the Latvian Vice President of the Commission, Valdis Dombrovskis.

That, ironically, offers a key opportunity. In the wake of Britain's calamitous referendum, few measures would do more to strengthen Europe’s growth, and perhaps rebuild bridges to its now off-shore financial hub in London, than pressing ahead with reform to create more integrated and vibrant continent-wide capital markets.

Italian Banking Sector Fragility in the Wake of the UK Referendum

In this Peterson Perspectives Video with Pedro da Costa, I comment on the situation of the banking sector in Italy and how it has become a focus of attention following the UK referendum of June 23.