Nicolas Véron

Silicon Valley Bank, Credit Suisse, EU banking reform and Basel III

This blog post was published yesterday by Bruegel (text below), and today by the Peterson Institute with minor editorial variations. 

The US and Swiss messes may nudge the EU towards better international bank capital standards compliance

Bank collapses show the importance of strong capital and liquidity positions and should signal to the EU the benefits of closer adherence to Basel III

The collapses in rapid succession of Silicon Valley Bank (SVB) and Signature Bank in the United States, and of Credit Suisse in Switzerland, have reawakened debates on banking policy. In the United States, reports assessing what went wrong are expected from both the Federal Reserve and Federal Deposit Insurance Corporation (FDIC) on 1 May. In Switzerland, the unorthodox engineering of Credit Suisse’s takeover by UBS has generated lawsuits and investigations. 

By contrast, in the European Union as in the United Kingdom, there have been no visible signs of banking-sector weakness. Since more than nine-tenths of EU banking assets are in the euro area and under European banking supervision led by the European Central Bank (ECB), that counts as a success for the single supervisory mechanism – the main finished piece of the EU banking union project, on which the EU embarked in 2012. As emphasised by ECB Supervisory Board Chair Andrea Enria, in a 21 March speech, European supervisors have been focused on both interest-rate risk and business-model risk in recent years, two areas at the core of the SVB and Credit Suisse disasters. This stands in sharp contrast to the pre-2012 period, when banking supervisors in the EU looked unable to get anything right. 

Meanwhile, EU banking union remains incomplete – and it is likely that the absence of banking sector turmoil in the EU will mean that pre-existing political obstacles will continue to prevent its completion any time soon. The two key stumbling blocks are a European deposit insurance scheme (EDIS), for which the Commission’s ill-fated proposal of 2015 has been left unadopted despite protracted negotiations, and the regulatory treatment of banks’ sovereign exposures (RTSE), which has been negotiated in parallel, outside of public view and also without concrete results.

On 16 June 2022, an acrimonious meeting of euro-area finance ministers in the Eurogroup format acknowledged the impasse. Ministers decided to shelve the discussions on EDIS and RTSE and asked the European Commission to make proposals on a more limited reform agenda of crisis management and deposit insurance (CMDI). In doing so, they admitted that the EU framework for the handling of unviable banks, which they had enshrined in 2014 in the bank recovery and resolution directive (BRRD, 2014/59/EU), had not worked as intended.

Closer to the US?

This policy area is hard to grasp, and not only because of its unseemly proliferation of four-letter acronyms. In simplistic terms, the essence of the CMDI project is to move closer to the US system in which the FDIC is the single authority for both deposit insurance and the resolution of failing banks. In that system, all deposits, insured or not, have equal and preferred status to the failing bank’s other liabilities, a feature known as general depositor preference. This creates incentives for the FDIC to finance takeovers of failing banks by sounder peers, protecting all depositors from losses in most cases. A degree of market discipline is nevertheless preserved, since uninsured depositors have incurred losses in a minority of bank failures in recent decades. 

The irony is that, by invoking a systemic risk exception and extending an unlimited guarantee to all depositors of SVB and Signature Bank, the US authorities may have departed permanently from this model, at precisely the time when the EU was considering adopting it. The European Commission had planned to publish its CMDI proposal on 8 March, then procrastinated and eventually published it on 18 April. In the meantime, the US systemic risk exception was triggered on 12 March. 

Basel III

Moving towards a US-inspired system with general depositor preference, as that proposal suggests, still makes sense for the EU. But this may be impossible without simultaneously completing the banking union, because the continued reliance on national deposit guarantee arrangements defeats the purpose of a single Europe-wide framework. In any case, time is short to wrap up CMDI before the end of the current EU legislative cycle in about spring 2024, especially as several EU countries appear unhappy with it. The CMDI proposal will likely end up being useful as a basis for public debate rather than actual legislation.

All is not deadlocked, however. Another rule, which transposes into EU law the international accord known as Basel III Endgame, was proposed in October 2021. Its adoption is expected before end-2023. The current, non-final version is not compliant with the Basel III template. However, the recent banking turmoil has given the Basel framework renewed legitimacy: SVB may not have failed so miserably if it had not been exempted from the Basel framework. As noted by Bundesbank President Joachim Nagel in a speech on 14 April, “it is now all the more important to implement the Basel III rules globally without any concessions”.

The EU should focus on achieving that outcome, even as it leaves its menagerie of other acronyms – EDIS, RTSE and CMDI – unfinished for the time being. By emphasising the importance of strong capital and liquidity positions, the US banking mess could usefully lead EU policymakers to adopt the Basel III Endgame in a compliant manner.

Much of the Global South is on Ukraine's side

This blog post was published yesterday by the Peterson Institute. 

Update (March 15): the post was also published by Bruegel. 

Efforts by the United States, Europe, Japan, South Korea, and other developed economies to rally the world against Russia over its invasion of Ukraine have been only partially successful. Many countries have declined to impose sanctions on Russia. But the record of votes at the United Nations indicates that most of the world, including much if not most of the developing world, is on Ukraine's side in denouncing Russia.

That record stands in contrast to some recent commentary implying that the "Global South" has adopted a position of neutrality in the conflict. That is indeed the case of China and India, the Global South's two economic and demographic heavyweights. But votes at the United Nations General Assembly (UNGA), which adopted a resolution in February demanding an end to the war and an immediate Russian withdrawal, indicate that the rest of the Global South actually leans towards supporting Ukraine.

For simplicity, the "Global South" is defined here on a criterion of gross domestic product (GDP) per capita, using GDP at market exchange rates estimated by the World Bank.[1] All countries with 2021 GDP per capita above US$15,000 are considered part of the "Global North," with the addition of Bulgaria and Romania (GDP per capita $12,221 and $14,858, respectively) as members of the European Union. Under that definition, both Russia and Ukraine are in the Global South, as are China and India. Conversely, some geographically southern countries such as Chile and Uruguay are classified as part of the Global North under this GDP per capita criterion. Thus defined, the Global South represents 85 percent of the world's population and nearly 39 percent of global GDP.

Each country's position on the Russia-Ukraine war is determined on the basis of its UNGA vote on February 23, 2023, whose outcome was broadly similar to those of earlier UNGA votes on Ukraine in 2022. While specific motivations may vary, it is natural to classify votes in favor of the resolution, which demanded that Russia "immediately, completely and unconditionally withdraw all of its military forces from the territory of Ukraine," as favorable to Ukraine, and those against it as favorable to Russia. The other two options, namely abstentions and no-shows, are bundled together as signaling neutrality.

The resulting picture is one of unanimity of the Global North: Its 57 countries all approved the resolution. By contrast, the 136 countries of the Global South embraced a range of positions, with China and India both being neutral, as illustrated by figure 1.

The pro-Ukraine camp represents almost two-thirds of the Global South's countries, and more than a third of its population. In terms of GDP, neutral China dominates the Global South with nearly half of the total (49 percent), but the pro-Ukraine camp, which includes large countries such as Brazil, Indonesia, Mexico, Nigeria, and the Philippines, makes up more than half of the rest (28 percent).

All things equal, a country's support for Ukraine is somewhat correlated with its wealth. But here too, the reality is nuanced. This is illustrated in figure 2, based on the ranking of all UN countries (including those in the Global North) by GDP per capita. All countries in the fourth (richest) quartile voted in favor of the UNGA resolution. But a majority did so in the other three quartiles as well, albeit only by a tiny margin in the first (poorest) quartile. Because of the outsized impact of the world's two most populated countries, both neutral, the share of the pro-Ukraine vote is actually higher in the first quartile than in either the second (which includes India) or the third quartile (which includes China) in terms of both population and GDP.

There is no question that the comparatively rich countries of North America, Europe, and East Asia are more engaged on the side of Ukraine than most of their peers in the Global South, even among those that supported Ukraine at the UNGA, as a recent opinion poll has documented. Strikingly, financial sanctions have been imposed on Russia by all ten richest jurisdictions of the Group of Twenty (G20), and by none of the ten poorer G20 countries. Even so, it would be inaccurate to play down the significant level of support that Ukraine keeps receiving from many of the world's less affluent countries.

Note

1. Source: World Bank, World Development Indicators, last updated December 22, 2022. For countries with nonsovereign dependencies that are reported separately by the World Bank (e.g., China with Hong Kong, the United States with Puerto Rico, Denmark with Greenland), and to the extent data were available, these dependencies are included in the GDP and population numbers. That leaves out jurisdictions without UN representation, such as Taiwan (absent from the World Bank dataset), Kosovo, the West Bank, and Gaza. All population numbers are as of 2021; GDP is as of 2021 for most countries, and 2020 for a few late reporters. In five cases (Eritrea, North Korea, South Sudan, Venezuela, and Yemen), UN estimates have been inserted as the World Bank does not provide recent data.

China’s state vs. private company tracker: now on a half-yearly pace

Following the in-depth analysis which Tianlei Huang and I published nearly a year ago on the respective shares of the private sector and state sector among China's largest companies, and the first update we published in October, the Peterson Institute has decided to publish our findings on market capitalization data as a regular tracker. The blog post below, published yesterday by PIIE, is the first such iteration.  

The private sector’s share of China’s largest listed companies continued to decline to 43 percent in the second half of 2022

The market assessment of economic and political developments in the second half of 2022 does not signal a decisive return to private-sector-led growth in China, even though that period includes the month of December, when China’s party-state unexpectedly ended its prior zero-COVID policy and signaled a more positive stance towards private sector development.

Latest data from PIIE’s semiannual tracker, “China’s state vs. private company tracker: Which sector dominates?”—which tracks market value of China’s top 100 listed companies (ranked by market value)—show a continued decline of the share of the private sector, from 44.5 percent at mid-2022 to 42.8 percent at year-end, continuing the downward trend of the previous two half-year periods from the 55.4 percent peak observed in mid-2021. Still, the private sector share remains higher than it was throughout the 2010s, when it rose dramatically from 8 percent at end-2010 to 36 percent at end-2019 (see figure).

It remains to be seen, then, whether China’s trajectory will be a pivot back to a Maoist-style economy that represses the private sector, or merely a new phase of market-driven development under changed political conditions. Building on our PIIE Working Paper published in 2022, the data presented here inform on the trend in the dynamism of China’s private sector beyond the rhetoric in China and the United States. The tracker focuses on the respective shares of state-sector and private-sector companies among China’s largest companies and thus provides a half-yearly market-based indicator of the private-state balance among Chinese companies. As in a previous update, the data at end-2022 suggest that President Xi Jinping’s “corporate rectification campaign” started in the summer of 2021 has dealt a heavy but far from lethal blow to China’s hitherto fast-rising private sector.

Recent discussions have focused on hybrid firms or ambiguous boundaries between private and state control. But the divide between the state sector and the private sector remains highly meaningful in analyzing contemporary China. As PIIE’s Nicholas Lardy and others have documented, the performance patterns and economic contributions of private-sector companies have differed from those of state firms since the early emergence of the former and restructuring of the latter during the bumpy era of the 1980s and 1990s. Large listed companies provide a decent proxy for the broader category of China’s largest companies, as more than half of the latter’s total revenue is made in listed entities. Stock prices are intrinsically forward-looking, subject to the whims of the market and occasional state intervention but not to political censorship or accounting manipulation.

The measures in PIIE’s semiannual tracker are not linked to general market price movements or index levels: If stock prices of state-sector listed firms rise or fall as much as those of private-sector listed firms, the relative shares that we track remain flat. As such, the respective shares of the private and state sectors can be viewed as decorrelated from cyclical growth and stock market dynamics, albeit somewhat related to structural growth trends if, as Lardy and others have argued, China’s growth is driven by private-sector expansion.

The measures in the tracker are based on the same methodology as in our 2022 PIIE Working Paper. All listed mainland Chinese companies are considered, including those that use mystifying variable-interest-entity arrangements, and are grouped into three categories: “state-owned enterprises” (SOEs) in which the state owns more than half of equity; “mixed-ownership enterprises” (MOEs) in which the state owns between 10 and 50 percent; and “nonpublic enterprises” in which the state owns less than a tenth of total equity, a conservative definition of China’s “true” private sector. In the definition used here, the state sector includes both MOEs and SOEs. Still, MOEs and SOEs are worth tracking separately, because state and party control is generally less direct and complete in the former than in the latter.

Even though market capitalizations can be observed in real time, these observations are intended to inform on structural trends rather than high-frequency fluctuations. To that effect, the data has been compiled yearly from 2010 to 2020 and half-yearly since 2021, as shown in the figure.

In 2022, additional quarterly monitoring indicated a pattern of small fluctuations rather than a monotonous soft decline: The share of the private sector fell to 42.1 percent at the end of the first quarter, then rose to 44.5 percent at mid-year, then fell back to 40.8 percent at the end of September (the lowest observation since end-2019), then rose back to its latest observed level of 42.8 percent at end-December. These additional quarterly data are not shown in the figure because that higher-frequency observation is not planned in future.

To sum up, the tug of war between the state and private sectors, as observed through the prism of market data presented here, remained largely static during a year that was otherwise rich in dramatic developments. Future updates will shed light on how the recent apparent signals of greater party-state friendliness towards the private sector are altering market participants’ assessment of its prospects relative to the state sector. 

China’s private sector advance pauses, but the trend is unclear

This blog post, coauthored with Tianlei Huang, was published today by the Peterson Institute. 

Update: the same text was published by Bruegel on October 19. 

After rising at an almost continuous pace for at least a decade, the share of private sector ownership among China’s largest companies has dropped since 2021. It is tempting to infer that President Xi Jinping’s statist policies have brought an end to the age of private-sector expansion in China. But such a conclusion would be simplistic and premature. Several factors beyond China’s turn toward state dirigisme are driving the recent pause in the rise of the private sector, including global commodity price increases and China’s property crisis.

To be sure, China’s policy has in recent years promoted the power of the state and of the state sector within the economy. Among its initiatives was the regulatory crackdown in the summer of 2021, which wiped out hundreds of billions of dollars from the market capitalization of some of China’s most prominent private companies. Such arbitrary state interventions in private business over the last decade have led many to conclude that the days of expanded influence by private companies in China are gone.

A recent drop in the advance of the private sector is illustrated by figures 1 and 2, which provide an update to what was documented in a PIIE Working Paper published in March 2022. The latest data builds on research showing a near-continuous increase of the share of private-sector companies among Chinese companies listed in the Fortune Global 500 rankings by revenue since 2005, and in the market value of those that were listed and among the 100 most valuable since 2010.[1] In the revenue data until 2020, there had only been a temporary dip in 2017; the market value series until end-2021 reflected a slight drop from the peak in end-2020.

Figures 1 and 2 use more recent data, and for market value, a higher frequency of observation, both indicating the recent decline. Among all the Chinese companies on the Fortune Global 500 rankings, the private sector’s share of their aggregate revenue decreased slightly in 2021 from the level in 2020 (figure 1). As for market value, the private sector’s share among the 100 largest publicly traded Chinese companies declined from a peak at 55.4 percent of the total as of mid-2021 to 42.1 percent by the end of March 2022, followed by a slight rebound to 44.5 percent as of mid-2022 (figure 2).[2] The private sector’s share also dropped in most other metrics in 2021 (figure 3).

 

A closer look at sector-specific dynamics shows the drop is caused by several parallel events

As in the working paper, each company was assigned to one of 14 sectors for a more granular understanding of the dynamics. The shares of the private-sector and state-sector contributions in each sector were calculated relative to the aggregate total, indicating variations over the past year.[3] The three largest (positive or negative) variations are shown in tables 1 and 2. The tables also distinguish how much of each variation is a result of changes in the revenue or market value of the same companies that feature in both the mid-2021 and mid-2022 rankings (“same-scope” variation). These variances are indicated as opposed to those companies that entered or exited the sample during the period because their gain or loss of revenue or market value made them cross the size threshold for inclusion (“entry/exit”). In the rankings by revenue (table 1), there were also four companies that did not report their 2021 financial data (“no-shows”) and thus not included in the latest Fortune ranking, as detailed below.

Tables 1 and 2 tell different stories. This difference is not surprising, since market value is a forward-looking indicator (the sum of discounted expected future free cash flows, minus net debt), while revenue reflects activity during a given year. Market values are also inherently more volatile than revenue numbers, as illustrated by the significantly larger variations in table 2 than in table 1.

The revenue story (table 1) has two main drivers, neither of which appears to represent a long-term trend. First, surges in global commodity prices translated into higher revenue of companies in two of the 14 sectors (oil, gas, and chemicals; steel, metals, and minerals), most of which are state-owned. This phenomenon shows up in same-scope variation (e.g., Sinopec’s revenue grew more than 40 percent in 2021) and in entry/exit variation (with four oil, gas and chemical state-owned enterprises and three others in the steel, metals and materials sector just entering the Fortune ranking this year). This driver is dominant, representing more than twice the variation in the aggregate share of the private sector (3.96 percent for the two sectors combined, versus 1.64 percent for all sectors).

In addition, four private-sector companies were “no shows” in the latest ranking, namely real estate developers Evergrande and Sunac and conglomerates Yango Longkin and Cedar Holdings. That driver also has significant impact: three-quarters of the aggregate net decrease of the share of the private sector for the two real estate developers alone (1.22 percent out of 1.64 percent). “No-shows” were similarly prominent drivers of the previous private-sector drop in 2017 and included the highly leveraged conglomerates Anbang, CEFC Energy, Dalian Wanda, and HNA, all of which stopped being listed by Fortune from that year. Neither of these two main revenue drivers looks permanent. Commodity prices go up and down; and only two private-sector developers (and one private-sector conglomerate) in the latest list that could become “no-shows” in the future.

The market value story is different (table 2). The largest driver by far is that the market value of platform companies went sharply down, their future profitability cast in doubt by the regulatory crackdown by the Chinese government. Their revenue kept rising in 2021, though less than in most other sectors. The relative decline of platforms’ market value explains most of the change in the respective shares of public and state sectors in total market value (8.29 percent out of 10.85 percent).

In sum, the drop’s drivers are diverse, and different for figures 1 and 2. They tell a more nuanced story about factors at work beyond the role of statist policies suppressing private-sector dynamism. The rise in commodities prices is exogenous. The property crisis is directly triggered by the “three red lines” policy of forced deleveraging in that sector introduced by the government in August 2020. But the property downturn also reflects a deep-rooted systemic problem driven by the financing needs of local governments dependent on property related revenues. Even Beijing’s regulatory crackdown on private-sector platforms appears to have been motivated by more than just a retaliation against the power of large private businesses. Altogether, the drop in the previous private-sector advance should not be viewed as the start of a new trend of continuous decline, at least not yet. Further updates will be published periodically in the future.

The authors are grateful to Abigail Dahlman for excellent research assistance.

Notes

1. We adopt a restrictive definition of the private sector as those companies in which the state owns less than 10 percent of equity capital. Our definition of the state sector includes all other companies, with a distinction between majority-owned state firms, and those in which the state owns between 10 and 50 percent of capital which we label “mixed-ownership enterprises.” Our taxonomy is thus entirely based on ownership, irrespective of various forms of political influence, which are harder to quantify. In terms of date cutoff, our series in the working paper covered the period until the (calendar) year 2020 for revenue, and until end-2021 for market value. The two datasets we analyzed are not exactly synchronous, since market value can be observed in real time, whereas revenue numbers and the Fortune rankings are published with a lag. Details of our methodological choices and definitions are to be found in the working paper.

2. We checked changes in ownership categories over the last year for all the companies featured in the latest rankings by revenue and market value and we found none, or in other words, neither “nationalization” nor “privatization.” This is in line with previously observed stability of these categories for China’s largest companies, as documented in more detail in the working paper.

3. More precisely, we observe the variation between calendar years 2020 and 2021 for revenue, and between mid-2021 and mid-2022 for market value.

China's top ranked corporations are not as opaque as they may seem

This blog post, coauthored with Tianlei Huang, was published last week by the Peterson Institute. It is based on our March 2022 working paper on China's largest companies. 

Update (September 28, 2022): the same post was also published yesterday by Bruegel. 

Since 2020, more companies from China have made the annual Fortune Global 500 ranking than any other country, including the United States. Over two-thirds of these companies are not publicly traded, i.e., their shares are not listed on a stock exchange, and most of them are state-owned enterprises (SOEs). In contrast, most large companies in the rest of the world are listed.[1]

This contrast leaves the impression that most large Chinese firms, especially the SOEs, are not as interested in raising capital from public investors as their international counterparts. It also implies lesser transparency, since listed companies are subject to rigorous and mandatory disclosure and auditing requirements that do not apply to unlisted ones.

But this picture does not tell the full story. In fact, more than half of the combined revenue of the 130 Chinese companies on the 2021 Fortune Global 500 is created in listed entities that are majority-owned subsidiaries of the unlisted parent groups and are in general more transparent and subject to greater market discipline. Private and foreign shareholders have a nontrivial interest in many of these listed entities under state-owned parent groups. The upper rank of China's corporate world, therefore, is not as opaque as it may seem.

Unlisted Chinese SOEs in Fortune Global 500 make nearly 60 percent of their revenue in majority-owned listed subsidiaries

In our March 2022 PIIE Working Paper we show that the distinction between listed and unlisted large SOEs in China is less a dichotomy than a continuum. Most of the unlisted Chinese SOEs in the Fortune rankings are organized in a multilayered group structure, with the unlisted parent group at the top, typically owned by the State-owned Assets Supervision and Administration Commission (SASAC) of the State Council or Central SASAC, National Social Security Fund (NSSF), and/or other government agencies. In many cases, the next layer comprises one or several subsidiaries listed on Chinese, Hong Kong or/and US stock exchange(s) and majority owned by the parent group, often along with other noncontrolled subsidiaries and affiliates. We identified at least one significant majority-owned listed subsidiary in 45 out of 75 unlisted SOEs among Chinese companies in the 2021 Fortune Global 500 ranking.[2]

Among these unlisted SOEs with significant listed subsidiaries, a whole range of situations can be observed. Take the two largest groups in the Fortune ranking, namely China National Petroleum Corporation (CNPC) and State Grid, both of which are wholly owned by Central SASAC. For 2020, PetroChina, CNPC's main listed subsidiary, disclosed revenue amounting to 99 percent of the CNPC group revenue reported by Fortune, while State Grid's largest majority-owned listed subsidiary, NARI Technology, represented only 1.5 percent of State Grid's group revenue. While these two cases are close to the extreme opposites in the range, the median case was China Post Group, an unlisted group company 90 percent owned by the Ministry of Finance and 10 percent by NSSF, whose listed subsidiary China Postal Savings Bank accounted for 70 percent of the group revenue in 2020. In aggregate, 57 percent of the revenue of all unlisted Chinese SOEs in the Fortune Global 500 ranking in 2021 comes from significant majority-owned listed subsidiaries.

Creating a taxonomy to better understand the activities unlisted companies conduct in listed entities

In our Working Paper, we divided all 130 Chinese companies in the 2021 Fortune Global 500 ranking into four categories:

• A "listed group" is a company whose parent entity (as appears in Fortune Global 500) is listed (e.g., People's Insurance Company of China).
• A "quasi-listed group" is a company whose parent entity is unlisted but one or several significant majority-owned listed subsidiaries represent more than 80 percent of the group's revenue (e.g., CNPC).
• A "partially listed group" is a company whose parent entity is unlisted but one or several significant majority-owned listed subsidiaries represent between 20 and 80 percent of the group's revenue (e.g., China Post Group).
• A "nonlisted group" is a company in which the share of group revenue made in significant majority-owned listed subsidiaries (as far as we could identify these) is less than 20 percent (e.g., State Grid).

Since the listed subsidiaries' shares of group revenue naturally fluctuate over the years, we base the categorization on their average across all years in which the group has been included in Fortune Global 500. 

Figure 1 shows the revenue composition of all Chinese SOEs and mixed-ownership enterprises (MOEs)[3] included in Fortune Global 500 over time. The latest 2021 ranking (based on 2020 revenue) has 98 SOEs and MOEs, and 75 of them, considered at the parent-company level, are unlisted SOEs (all MOEs are listed at the parent-company level). Applying the typologies above yields only 42 nonlisted, implying that nearly half of the companies that are unlisted at the parent-company level have a significant portion of their revenue created through majority-owned listed subsidiaries. The respective shares of different listing status have been strikingly stable even as the corresponding set has considerably expanded over time, from 15 SOE and MOE group companies in 2004 to 98 in 2020.

The lower line in figure 2 shows the share of the total revenue of all Chinese Fortune Global 500 companies made in group companies that are listed at the parent level. The upper line includes majority-owned listed subsidiaries of unlisted groups whose revenue accounts for 5 percent or more of the group revenue. The upper line has been consistently higher than 50 percent since 2007.[4]

Why are there so many unlisted SOEs with significant listed subsidiaries?

The reason for the high number of unlisted SOEs with large listed subsidiaries may be found in the circumstances of the corresponding stock exchange listings, most of which happened in the late 1990s and 2000s. Landmark initial public offerings (IPOs) of that era included the ones of China Mobile (October 1997) in Hong Kong, PetroChina (April 2000) in the US, China Unicom (June 2000) in Hong Kong and the US, Sinopec (October 2000) in Hong Kong, and China Telecom (November 2002) in the US. In his book Dealing with China, former US Treasury Secretary Henry Paulson described how he once led the Goldman Sachs advisory team that prepared the IPO of China Mobile, which, he noted, then-Premier Zhu Rongji "meant to become the template for revamping other SOEs." As Paulson described it, "in conventional terms, there was as yet no actual company to underwrite." A "listable" company had to be built by assembling various assets that previously resided directly within the Ministry of Posts and Telecommunications. Similarly in other cases, the listed subsidiary included the most commercially marketable activities of a broader group under an unlisted entity.

Though a simplification of a complex history of the separation of these companies from their government superstructures, this captures the gist of why so many SOEs are only partially listed: It is not that the authorities did not want to list the entire group, but rather they could not—or at least not as quickly as the partial-listing option would allow for.

By contrast, most centrally administered state-owned or mixed-ownership financial institutions, whose IPOs took place in a later wave, were restructured first so that the entire groups got to list at the parent-entity level. These include, for example, Bank of Communications (June 2005), China Construction Bank (October 2005), Bank of China (June 2006), ICBC (October 2006), Agricultural Bank of China (July 2010), and People's Insurance Company of China (December 2012). Most SOEs and MOEs that are directly listed at the group parent level in Fortune's Global 500 rankings (14 out of 23 in 2021) are financial services companies.

To conclude, even though most large Chinese SOEs, and most of the largest Chinese companies more broadly, are not listed at the parent-company level, they generate most of their revenue from their listed subsidiaries. This is good news for researchers who seek to better understand the Chinese corporate landscape, since much more information is publicly available about listed companies than unlisted ones.

Notes

[1] Of the 130 Chinese entities in the 2021 Fortune Global 500 ranking, 93 (71.5 percent) are unlisted, of which 75 are state-owned. By contrast, among the 130 largest non-Chinese companies in the same Fortune ranking, only 5 are unlisted (of which only one, the US Postal Service, is an SOE).

[2] Our threshold of significance is that the revenue of the subsidiary is at least 5 percent of the total group revenue.

[3] We use "mixed ownership" as shorthand for companies in which the Chinese state is a significant minority shareholder, with an equity stake between 10 and 50 percent, and reserve the term SOE for majority-owned state enterprises. See section 1.1 in our PIIE Working Paper 22-3.

[4] The upper line underestimates the share of revenue coming from listed subsidiaries, since revenue from minority-owned listed subsidiaries and small majority-owned listed subsidiaries is not included in our calculation. In other words, the actual listed share of revenue should be somewhat higher than what is plotted in figure 2.

Now Is Not the Time to Confiscate Russia’s Central Bank Reserves

This blog post jointly authored with Josh Kirschenbaum was published by Bruegel on Monday (May 16). 

Since Russia’s invasion of Ukraine, all significant jurisdictions that issue convertible reserve currencies have acted decisively to freeze their respective shares of the international reserves of the Bank of Russia. As the costs of Ukraine’s resistance mount, there are increasing calls to confiscate these frozen reserves to finance Kyiv’s war and reconstruction effort, as well as sceptical counter–arguments. In the European Union, the Polish government has advocated confiscating the reserves, and has received support from EU foreign policy chief, High Representative Josep Borrell. This idea is seductive. It is also unnecessary and unwise.

The Bank of Russia’s reserves are public money, and thus altogether different from though occasionally conflated with the frozen assets of sanctioned Russians (often simplistically though conveniently referred to as oligarchs). Some oligarchs’ assets are presumed to have been ill-gotten, but they nevertheless benefit from the protections accorded to private property. Conversely, Bank of Russia reserves are public money that benefit neither from such protections nor, in the context of sanctions, from sovereign immunity. But their acquisition by the Russian state, in principle on behalf of the Russian people, cannot be generally assumed to have been illegitimate. The Bank of Russia’s frozen reserves, at around $300 billion across participating jurisdictions, are also substantially greater than the oligarchs’ frozen assets.

There are at least five, partly overlapping, reasons why Ukraine’s supporters should hold off from confiscating Bank of Russia reserves at the current stage of the war.

First, confiscating the reserves would not tilt the balance of tangible capabilities between Russia and Ukraine. This may be the most important point, given the urgencies of war. The debate on confiscation could distract from other actions that are actually urgent and consequential, such as reducing European oil and gas imports from Russia and providing direct financing to the Ukrainian government.

Unlike these, confiscating the Bank of Russia’s reserves would not further Ukraine’s immediate objectives in terms of ending the war and securing withdrawal of Russian forces, Russian recognition of Ukraine’s territorial integrity and a lasting peace agreement. Russia’s central bank’s foreign assets are already frozen, and moving from freezing to seizing them will not weaken President Putin further. Neither the US nor the EU are financially constrained to the extent that they would need to appropriate the Bank of Russia’s money to do what they have to do. For both, the obvious procedurally quick and legally ironclad option is to continue to transfer large sums of money from national treasuries to the government of Ukraine. The US Congress is in the process of passing a $40 billion package of additional security, economic and humanitarian aid for Ukraine, and the EU is considering a new round of joint bond issuance to fund its short-term assistance to Kyiv.

Less leverage

Second, if they confiscated the Bank of Russia’s reserves now, Ukraine’s allies would deny themselves options that could prove valuable in terms of offering Russia a way out or gaining leverage in future negotiations. Nobody knows what may be at stake in discussions with Russia – and with what kind of Russia – in developments still to come. In some scenarios, the possibility of returning the Bank of Russia’s reserves could be a powerful bargaining chip. Removing that option upfront makes little sense. It is possible, of course, that using the frozen reserves to finance Ukraine’s reconstruction ends up being the best option, but that point has not been reached yet.

Third, a unilateral US move to confiscate the reserves could introduce harmful disunity in the pro-Ukraine camp, whose consistency of purpose has been a major strength until now. Notwithstanding Josep Borrell’s opinion, it is unlikely a consensus could soon be reached among EU countries (not to mention other pro-Ukraine countries) on reserve confiscation, if only because of concerns about systemic financial stability and the international rule of law. The EU is also evidently more exposed than the US to direct Russian retaliation, given its geographical proximity, security vulnerability and density of economic linkages with Russia, even though many of these are being dismantled rapidly. US Treasury Secretary Janet Yellen has signalled that the US Treasury would only recommend confiscation of the Bank of Russia’s reserves if it was supported by America’s partners in the pro-Ukraine coalition. She is right: action by the US alone could erode trust, or even provoke material damage if it included extraterritorial provisions.

Fourth, confiscating Russia’s reserves could entail unnecessary risks to the strength and stability of the international financial system. Similar arguments were made about freezing the Bank of Russia reserves in the first place, and are pervasive in both Russia and China. It is too early to know for sure to what extent these arguments have substance. But moving from freezing to confiscation would be a more radical step in terms of the safe-asset status of foreign reserves. The implications would be uncertain even if one takes into account the enormity of Russia’s assault against international norms and its apparent war crimes.

Conceding the moral high ground

Fifth, at a more intangible but no less consequential level, confiscating Russia’s reserves would mean conceding some of the moral high ground the pro-Ukraine coalition has largely occupied so far. When the US and its partners talk about defending the international rules-based order, there are already many perceptions of hypocrisy and double standards, particularly in developing and emerging economies.

The key point here is one of principle: credibly standing for a rules-based order is worth more than the billions that would be gained from appropriating Russia’s money. Countries place their reserves in other countries trusting they will not be expropriated in situations short of being at war with each other – and the jurisdictions holding Bank of Russia reserves, even though they actively support Ukraine, are not currently at war with Russia. Russia’s breach of international norms, grievous as it is, does not justify unlimited punishment.

It is apparent that international reserves enjoy some protection under international law (as noted by Paul Stephan), even though this may not include sovereign immunity from judicial processes, as mentioned above, and precedents are scarce. The moral high ground is also worth defending in relation to Russian public opinion, even though the perceptions in Russia are currently distorted by massive and ruthless domestic propaganda. Seizing Russia’s collective property runs the risk of entrenching Russian perceptions that the opposite side’s aim is really to harm Russia, rather than to defend Ukraine. That is likely to favour a revanchist orientation of the Russian public, plausibly against the best interests of Ukraine, its allies and world peace.

Legal obstacles

Moreover, using sanctions to confiscate the Bank of Russia’s reserves while the US is not at war is likely to be illegal under US law – the 1977 International Emergency Economic Powers Act (IEEPA). The only case of confiscation of government assets through sanctions under IEEPA was in 2003, during the US invasion of Iraq. Prior examples would have used authority under legislation that can only be applied in wartime (the Trading With the Enemy Act of 1917). Neither the Afghan nor the Venezuelan case have precedent value in this debate: in the former, the disposition of the central bank’s reserves may be justified by a past ruling that found the Taliban liable to the victims of the September 2001 attacks; in the latter, there was no confiscation but rather a release of previously frozen assets to the government viewed by the US as legitimate.

Even if Congress passes new legislation to authorise confiscation of assets in situations where the US is not at war, it could be found to be unconstitutional in future court cases. Such an aggressive expansion of executive powers might even cause the US judiciary to revisit the deference it has historically granted the government when exercising blocking or other sanctions authorities. Also, with confiscation unshackled, a future US president may use the non-wartime authority in a reckless manner, for example in a trade or tariff dispute. Similar arguments can be made in the EU and elsewhere.

The choice is not between confiscation and complicity. Of course, things would change entirely if the US, the EU or other members of the pro-Ukraine coalition were to become belligerents themselves, and quite possibly also if there is dramatic escalation by Russia. For now, Ukraine’s supporters should weigh which options are most likely to achieve their goals, even if they are less emotionally satisfying in the short run.

The EU should sanction Sberbank and other Russian banks as it ponders banning Russian oil and gas

This blog post co-authored with Joshua Kirschenbaum was published today by Bruegel and by the Peterson Institute; the latter also featured part of it as a PIIE Chart. 

The European Union (EU) had a vigorous early response to Vladimir Putin's aggression in Ukraine, aimed at disrupting Russia's financial system and economy. Ending EU imports of Russian hydrocarbons would be a powerful next step and is an absolute priority. But other actions can and should be taken now while an oil and gas ban is being debated. Specifically, the EU should extend harsh sanctions to most or all of the largest Russian banks, including the largest one that plays a central role in Russia's financial system, Sberbank. There is no good reason for the EU not to do so immediately.

On April 6, the United States Treasury announced full "blocking" sanctions on Sberbank and on Alfa-Bank, Russia's fourth-largest bank, meaning US entities cannot conduct any transactions with them, and their US assets are frozen. Together with previous actions announced on February 22 and February 24, this action largely or completely prevents six out of Russia's top 10 banks, representing more than 60 percent of total Russian banking assets, from conducting any transactions subject to US jurisdiction. While the United States could do even more, its actions are much more than equivalent EU actions. Of those same top 10 banks (leaving aside the Central Bank of Russia), the EU has blocked only four (not including Sberbank and Alfa-Bank), adding up to only a quarter of total Russian banking assets, as illustrated in the figure.

The notion of European timidity on banking sanctions may sound awkward, given how the EU has been rightly praised for its bold actions on the financial front, just two days after Russia's invasion of Ukraine on February 24. The sanctions on the Central Bank of Russia, applied by the EU together with the United States, the United Kingdom, Canada, Japan, and other jurisdictions, have shattered the myth of a financial "fortress Russia" and forced the central bank to raise policy rates and impose capital controls, with severe negative impact for Russian credit and growth prospects and notwithstanding Russia's single-minded effort to shore up the ruble.

When it comes to individual banks, however, the EU so far has concentrated its financial fire on only seven Russian financial institutions: VTB (Russia's second-largest bank by assets as of October 2021), Promsvyazbank (#6), Otkritie (#8), Sovcombank (#9), Rossiya Bank (#16), Novikombank (#24), and the investment company VEB.RF, which is not licensed as a bank but has assets that would place it in the top 10 if it were. Three of these were the targets of EU blocking sanctions on February 23, the day before the invasion. Then on March 1, the EU excluded all seven from access to SWIFT, the Belgium-based global payment messaging system. (Three Belarusian banks were added a week later.) Finally, on April 8, the remaining four also came under full blocking sanctions, which puts an end to a rather senseless loophole that allowed for the continuation of correspondent banking services without using SWIFT. These sanctions have been imposed by the entire EU (actually the European Economic Area), not just the euro area. But they leave the vast majority of Russia's banking system untouched.

Why has the EU been so cautious?

The initial round of sanctions on the central bank was without precedent for a country of Russia's size and systemic importance, and it may have been appropriate for the EU not to add further financial stress at the same time out of financial stability concerns. That motivation for prudence, however, no longer applies. The European Central Bank, in its role as euro area banking supervisor, has carefully monitored possible contagion channels and suggested, in a letter to European parliamentarians on April 6, that there is currently no reason for alarm from euro area banks' exposures to Russia. EU banks with large Russian operations have either signaled their forthcoming exit from the country, or in the case of Société Générale, announced it. All this considered, it does not appear that intensifying EU sanctions on individual Russian banks would materially threaten European financial stability.

The current EU stance of maintaining significant purchases of Russian oil and gas is not a reason to delay such intensification either. Put succinctly, EU buyers of Russian hydrocarbons do not need Sberbank to purchase the stuff. They can operate through a much narrower banking channel, either one Russian bank (large or small) that is left unsanctioned for that purpose, or even through a sanctioned bank using an authorized facility carved out of sanctions to allow oil and gas transactions. That bank may be Gazprombank (and/or its cousin the Russian Regional Development Bank, an affiliate of Rosneft), or another institution as may be deemed fit. Even assuming that some ongoing oil or gas supply contracts are currently serviced through Sberbank (or Alfa or another bank that has not yet been on the EU sanctions list), that banking relationship can presumably be switched to another institution without that constituting a breach of contract. Funnelling all energy sales through one approved banking facility (or a small number thereof) will have the added benefit of making monitoring of volumes easier across the EU, increasing the likelihood that member states will agree and adhere to reductions, if not the elimination of imports in the near future.

If the Russian authorities take that as a pretext to stop deliveries, so be it—but that risk exists no matter what, even though the late-March test of will over the separate issue of payment in rubles suggests it is rather low. In order to prevent humanitarian damage from the sanctions on banks, and to preempt Russian propaganda blaming the EU for imaginary such impact, the regime should include "humanitarian channels"—approved facilities set up to facilitate the sale of medicine, medical devices, and food- and agricultural-related goods from the EU to Russia. Additional channels could be provided for entities from non-EU countries to keep buying from Russia, even if the Russian bank involved in the transaction has been cut off from SWIFT; in that case, they would only need to use a different, presumably less efficient, messaging system.

Imposing blocking sanctions on Sberbank and the other large Russian banks currently left untouched by EU sanctions—namely Alfa-Bank, Russian Agricultural Bank, Credit Bank of Moscow, Bank Saint Petersburg, Tinkoff Bank, and more—may not dramatically change the environment of Russia's economy and would definitely be a less momentous decision than stopping EU oil and gas purchases from Russia. Even so, it would create pervasive impediments to hitherto unsanctioned international business for a wide range of economic actors in Russia and would also make it incrementally more difficult for Russian entities to circumvent some of the other sanctions already in place. Importantly, it can be done without delay, and at no major cost to the EU or like-minded countries. Given the atrocities committed by Russia and its disruption of Europe's fundamental security norms, there is much more risk in doing too little than in doing too much.

The authors gratefully acknowledge Egor Gornostay's help with Russian balance sheet data. Graphic design and production by Nia Kitchin and Oliver Ward.

Putin’s Russia is a Minnow Compared to the Cold War Soviet Bloc

This blog post was published today by Bruegel, and yesterday by the Peterson Institute in their PIIE Chart series. The Bruegel version has interactive graphics from which the charts below are copied and pasted. 

It has become commonplace to analyse Russia’s invasion of Ukraine, and its antagonism with the United States and its pro-Ukraine peers, through the prism of the Cold War. This framing makes sense, but it is important to keep in mind that today’s bloc centred on Russia, even including Belarus and Syria, is much smaller than the Soviet Bloc used to be.

The following charts are based, for the late Cold War era, on membership of the Council for Mutual Economic Assistance (Comecon) and Non-Aligned Movement, and for the present moment, on United Nations General Assembly (UNGA) votes on the war in Ukraine (see methodology note below). At the end of the Cold War, the Soviet Bloc represented 9% of the world’s population and 10.5% of its economy, measured at purchasing-power parity (PPP). The equivalent numbers for Russia and its allies (the ‘Putin Bloc’) in 2020 are 2.5%  and 3.5%. If measured at market exchange rate, even before accounting for the ruble’s recent depreciation, the Putin Bloc’s share of GDP is even lower: 1.8% versus 6% for the Soviet Bloc at the end of the Cold War. The Putin Bloc’s population is about 60% lower, at 197 million, compared to 483 million in 1990 for the Soviet Bloc. This is the combined result of reduced geographical scope, and of the remaining group’s declining demographics and poor economic performance.

In these charts, China is counted in the Soviet-unfriendly group at the end of the Cold War (even though the China-Russia relationship was at an early stage of revival with Mikhail Gorbachev’s visit to Beijing in 1989, and the Tiananmen crackdown had temporarily cooled the China-US relationship). In 2020, China is counted among the fence-sitters, based on its UN voting behaviour. That could change of course, with opinions varying on that critical matter. But for the time being at least, based on the non-military metrics considered here, Moscow’s global heft is a shadow of its former Soviet self. 

 

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Note on methodology and data: GDP is computed at purchasing power parity, as estimated by the World Bank. End of the Cold War data is for 1990. The Soviet Bloc at that date is defined as the member countries of the Council for Mutual Economic Assistance (Comecon). For the present, the Putin Bloc is defined as the five countries that voted against the latest UNGA resolution asking Russia to immediately cease hostilities in Ukraine, adopted on 24 March 2022. ‘Fence-sitters’ at the end of the Cold War are the countries that attended the summit of the Non-Aligned Movement held in Belgrade in September 1989 (minus Cuba and Vietnam, since these were also in the Comecon). For the present, it is the countries that either abstained from or did not vote on the 24 March UNGA resolution. The ‘Soviet-unfriendly’ and ‘Putin-unfriendly’ groups refer to countries that do not belong to the previous two groups. For the present, that means all countries that voted in favour of the 24 March UNGA resolution. Non-UN-represented dependencies are included with the sovereign jurisdiction on which they depend, eg Hong Kong with the United Kingdom at the end of the Cold War and with China now. Countries that have become independent since 1990 are disaggregated for the present, but counted with their predecessor at the end of the Cold War, eg South Sudan. Germany is divided schematically at the end of the Cold War: one-fourth of the German population and GDP are attributed to the German Democratic Republic, and the rest to the Federal Republic. World Bank GDP data has gaps, including not providing data for Taiwan, but these are too small to significantly alter the aggregates presented.

Is the private sector retreating in China? Not among its largest companies

This blog post, co-authored with Tianlei Huang, was just published by the Peterson Institute and is based on our simultaneously published working paper on China's largest companies. 

Update (April 1): the Peterson Institute highlighted the first chart below as a PIIE Chart. 

Update (April 5): a lightly modified version of the same text was just published by Bruegel, together with their version of the working paper. 

Update (April 7): a slightly abridged version was published today by Caixin. 

Update (April 22): Caixin also published a version in Chinese. 

China's wave of regulatory restrictions on private-sector businesses in 2021 has been widely interpreted as reflecting a decisive turn, driven by President Xi Jinping for several years, toward a new economic regime with a greater role played by state-owned enterprises (SOEs). But is China's private sector truly being crushed? Evidence presented in a new PIIE Working Paper tells a different story—that among China's largest companies, the private sector is expanding rapidly and at a faster rate than SOEs.

The new PIIE paper has collected and analyzed data on the changing shares of the state sector and the private sector among China's largest companies for more than a decade. The data show that China's private sector has grown not only in absolute terms but also as a proportion of the country's largest companies, measured by revenue or (for listed ones) by market value, from a very low level when President Xi was confirmed as the next top leader in 2010 to a significant share today. SOEs still dominate by revenue among the largest companies, but their preeminence is eroding. To be sure, the Communist Party has attempted to develop its presence in the corporate world, including in the private sector, through various means. But equity ownership structures matter. China's private-sector companies are focused on profit maximization and value creation in ways SOEs are not.

The Chinese idiom "state advances, private sector retreats (国进民退)," which has been widely used to describe China's economic trends does not, therefore, represent the main picture of what has been going on under President Xi in China's business world so far, even in the most recent years.

Rapid Rise of Private Sector among China's Largest Companies

Unlike in most countries, shares of many of China's largest companies are not listed on a stock exchange. That is the case for the state sector as well as the private sector, even though many unlisted SOEs have much of their activity conducted in their majority-owned listed subsidiaries. Thus, the paper examines both listed and unlisted companies, using two partly overlapping rankings of China's largest companies.

The first sample is ranked by revenue, a proxy for a company's activity. The data derive from the research conducted by the business magazine Fortune for its yearly Fortune Global 500 ranking, from which the paper extracts the companies from mainland China. This group has grown fast, from 15 companies in the 2005 ranking (based on 2004 revenue) to 130 in the 2021 ranking (based on 2020 revenue). Their aggregate revenue grew from $2.8 trillion in 2010 to $8.8 trillion in 2020, a similar rate as the expansion of China's nominal GDP, which reached nearly $15 trillion in 2020.[1] Their aggregate headcount was 21 million in 2020, slightly under a twentieth of China's total urban employment, a ratio that has been fairly stable over the past decade.

The paper's second sample is limited to mainland Chinese companies whose shares are listed on a stock exchange, typically in Shanghai, Shenzhen, Hong Kong, and/or New York, including companies like Alibaba and Tencent that have adopted variable-interest-entity arrangements to circumvent China's onerous regulations on foreign ownership in certain sectors such as internet services. The paper constructs yearly top 100 rankings of Chinese listed companies from 2010 through 2021, based on year-end market capitalization. Their aggregate headcount and revenue levels are significantly lower than those of the first sample, as would be expected since they do not include some gigantic yet unprofitable unlisted SOEs, and conversely they include some high-growth young companies that hold much promise but are still relatively small. Together, these largest 100 listed companies represent about two-fifths of the entire market capitalization of all Chinese listed companies.

The ownership of these largest Chinese companies involves a range of investor categories. These include, among others, the Chinese state at the central and local (e.g., provincial or municipal) levels, directly through government ministries or departments (such as the Ministry of Finance of the central government) or indirectly through specialized agencies (such as the State-owned Assets Supervision and Administration Commission or SASAC at the central and local levels), state investment entities (such as Central Huijin Company, China Securities Finance Corporation, and the National Integrated Circuit Industry Fund), or SOEs that mix commercial and investment activities (such as China National Tobacco Corporation); founders and/or their relatives, management, and corporate pension funds of private-sector companies; private-sector companies like Alibaba and Tencent acting as venture capitalists; and foreign investors, e.g., diversified entities like Japan's Softbank or Thailand's Charoen Pokphand, and global asset managers like BlackRock or Canadian pension funds.

The paper includes case studies to illustrate the diversity and complexity of ownership patterns of some prominent Chinese companies such as Ping An of China and ZTE. It also has two appendices that detail the latest rankings (respectively, of Chinese companies in the 2021 Fortune Global 500 ranking and of Top 100 listed Chinese companies as of end-2021) with indication of each company's most significant shareholders.

For the purposes of this study, the private sector is defined as those companies, labeled "nonpublic enterprises" in line with Chinese practice, in which state entities hold less than 10 percent of equity capital. Within the state sector, a distinction is drawn between SOEs, in which the state owns a majority stake, on the one hand, and "mixed-ownership enterprises," in which the state holds only a minority position, i.e., between 10 and 50 percent, on the other hand. The methodologies, as well as numerous additional findings, are presented in detail in the paper.

These definitions refer to equity ownership, leaving open other, less easily quantifiable notions. The Chinese Communist Party is clearly striving to develop its influence in China's private sector, even though that influence remains considerably less direct than among SOEs. It would be an exaggeration, however, to say that China is unique in this respect. Government influence occurs with the private sector in Europe, Japan, South Korea, Taiwan, and other advanced economies—even occasionally in the United States. Such influence is surely greater in China, but that does not erase the importance of the divide between the state sector and the private sector. Ownership matters greatly for economic development outcomes, even under pervasive Party control of political matters. The advance of the private sector, which the paper documents, is thus of structural significance for China.

With these definitions in mind, figures 1 and 2 illustrate the rise of the private sector among China's largest companies, measured, respectively, by revenue (all companies) and market value (listed companies). As is clear in figure 1, SOEs still dominate by revenue among the largest companies, much more so than in the Chinese economy as a whole. But the share of the private sector has been steadily rising, from zero in the mid-2000s to 19 percent of the total ($1.7 trillion out of $8.8 trillion) in Fortune's 2021 ranking, which is based on 2020 revenue.

As for market value of the largest listed firms (figure 2), the private sector represented merely 8 percent in 2010 but soared above the 50 percent threshold in 2020, and retreated only slightly in 2021, to 48 percent. Thus, the state crackdown in 2021 on certain private-sector-dominated industries, such as internet platforms and after-school tutoring, has had some impact but stopped well short of reversing the prior advance of the private sector using the market value indicator.

Figure 3 shows similar rising trends for other metrics, based on the same respective samples of companies.

Not Privatization, but Displacement of SOEs by Better-Performing Private Firms

The advance of the private sector among China's largest companies does not appear to result from long-term planning or top-down decisions, but rather from bottom-up dynamics. Deng Xiaoping, the Chinese leader who was the main architect of China's embrace of markets starting in 1978, had predicted in 1980 that "whatever the proportion of the private investment will be, this will cover only a small percentage of the Chinese economy. It will by no means affect the socialist public ownership of the means of production." In the 1990s, facing the need to restructure the loss-making state sector, China under Premier Zhu Rongji made a deliberate choice to keep the largest concerns under state control, even as many smaller SOEs were liquidated or privatized. That policy became widely known by the four-character idiom "grasp the large, let go of the small (抓大放小)," preserving "public ownership as the mainstay (公有制为主体)" of China's economic model. In line with these choices, the first large Chinese companies to enter global corporate rankings, whether by revenue or by market value, were all from the state sector until the late 2000s.

Privatization has been virtually nonexistent among China's largest companies. Nor has the state gone out of its way to confer a comparative advantage on the private sector. On the contrary, President Xi declared in 2016 that SOEs must become "stronger, better and bigger." What explains the observed trend, instead, is that private-sector companies have been more dynamic and profitable than those in the state sector. What PIIE scholar Nicholas R. Lardy has described as the "displacement of SOEs" by private-sector companies has occurred despite a policy environment that clearly does not favor them.

The emergence of private-sector champions reflects the spectacular growth of internet content and e-commerce platforms, but also other areas where the private sector is strong, including manufacturing (e.g., electronics, electric cars, batteries, steel, and chemicals), consumer products and services, pharmaceuticals, and life-science companies. Some of the largest Chinese property developers are also private, though the real estate sector is currently ailing with the shakiness of China's property market and the failure of Evergrande among other developers. By contrast, financial services, telecoms, energy, and transportation remain dominated by SOEs. But the growth of large companies in those state-dominated industries has been comparatively less rapid. In terms of market value, some have even declined in absolute terms, e.g., telecoms and energy.

Of course, the structural trend of private-sector advance, which has characterized the decade of China's development under President Xi so far, may not be a guide to what will happen next. But claims of a pivot back to state-sector dominance have been made multiple times before, with reference to policy shifts in 1989-1990, 2003, the mid-2000s, 2008, 2009, 2010, 2012, 2017, 2019, and early 2020. Meanwhile, China's private sector has kept advancing. There is no compelling indication that this time is different.

1. Whereas it makes sense to compare the respective growth rates, the companies' aggregate revenue is not a measure of their value added or collective contribution to GDP, and thus cannot be directly compared with GDP figures.

Six reasons why backstopping Russia is an increasingly unattractive option for China

This blog post co-authored with Alan Wolff was published today by Bruegel. 

Since Russia invaded Ukraine on 24 February, China has been ambiguous about its position on the conflict, while providing rhetorical support for the Russian narrative. At the United Nations, China stands out as the dominant economy that has not declared itself either against or in favour of Russia’s onslaught. It is clear China will not align with the NATO-led pro-Ukraine camp. But the opposite extreme, of providing a backstop to Russia’s war effort, is becoming increasingly unattractive for China. Even though we cannot predict which way China will go, there are a number of self-interested reasons why it should adopt a constructive stance on Ukraine’s future and global stability.

While the relationship between China and Russia has been through historical ups and downs, it has become notably close in recent times. The much-publicised meeting between Xi Jinping and Vladimir Putin at the start of the 2022 Winter Olympics showcased a strong political partnership, while Russian troops were massed on the border of Ukraine. Plausible accounts suggest that Moscow informed Beijing in advance of its intent to attack Ukraine, if not of the full scope of the prepared invasion.

Significantly, these accounts imply that the Chinese leadership, like its Russian counterpart, anticipated a lightning conflict that would quickly lead to a Russian-dominated Ukraine, enabled by a divided West. In fact, Ukrainian resistance has been fierce, and the United States, the European Union and other countries accounting for most of the world economy have shown resolve in their support for Kyiv. The degree of hostility throughout much of the world to Russia’s indefensible aggression and its apparent war crimes threatens to spread to any of those seen to be allied with Moscow. Meanwhile, the Russian military performance has been underwhelming and the war is unlikely to come to a conclusion any time soon.

Six good reasons

While it is plainly impossible to observe the Chinese leadership’s decision-making process from outside, let alone to make predictions about its outcome, it is possible to identify parameters that are likely to play a role in Beijing’s calculations. None of these point towards China gaining any benefit from aligning more closely with Russia. On the contrary, doing so would have clear costs.

First, China in recent decades has displayed a preference for stability. Its primary engagement with the world at large has been as a trading partner and major investor in infrastructure. As the war grinds on, the invasion of Ukraine looks increasingly like a reckless gamble that will disrupt and break many relationships, including trade and financial ones. By supporting Russia, China can only prolong the conflict, actively contributing to continued destabilisation of the international order. A return to stability can only come with an early peaceful resolution in Ukraine.

Second, China has promoted a geo-economic vision for Eurasia, in which it stands at the eastern end of a trading network that extends all the way to Western Europe. China has invested heavily in its relationships with the countries to its west, including Russia and Ukraine. With the EU now firmly on the side of the Ukrainian government, the new reality is that Ukraine will emerge more closely integrated with the rest of Europe. If China stands on the Russian side in a prolonged conflict, it would undermine its Eurasian vision of the Belt and Road.

Third, China has a longstanding diplomatic doctrine that emphasises five “principles of peaceful coexistence”: mutual respect for sovereignty and territorial integrity; mutual non-aggression; mutual non-interference in each other’s internal affairs; equality and mutual benefit; and peaceful coexistence. A quick Russian operation that delivered a stable puppet government in Ukraine could have allowed China to formulate a narrative in which these principles were upheld, but the evidence of Ukrainian patriotism in a war of resistance renders this impossible. To be seen to be discarding the foundational principles of its diplomacy would be costly for China, not least in its relations with its Asian neighbours.

Fourth, China wants to reunify Taiwan with the mainland. A quick Russian victory in Ukraine might have provided support for a Chinese strategy of seizing the ‘23^rd province’ by force. By contrast, a protracted conflict in which the Ukrainian side achieves impressive feats of resistance is a reality from which China may want to distance itself as much as possible. By propping up Russia, China could solidify the pro-Ukraine camp into a durable coalition that could provide a similarly unified response to any Chinese move against Taiwan.

Fifth, China is energy-dependent. The oil price inflation resulting from the war in Ukraine is bad news for the Chinese economy – even assuming it can buy more oil and gas from Russia at a discount. Furthermore, the war-induced price increases in commodities such as wheat, which are basic to the well-being of many developing countries, could subtract from the goodwill built up via the Belt and Road Initiative if China’s actions are viewed as prolonging the conflict.

Sixth, China’s extraordinary growth has been critically supported by access to markets and a continuing flow of international investment. Were China to materially support Russia’s aggression, the pro-Ukraine camp’s sanctions could begin to apply to Chinese interests. Russia’s increasingly murderous attacks against civilians add to the challenge. If China supports Russia, the implied reputational damage may lead to boycotts and lost investment, not to mention moral revulsion among the Chinese population as well. A scenario of significant decoupling of pro-Ukraine countries from China would do direct harm to China’s economic interests.

Balance of interests

Providing support for Russia might allow China to acquire some Russian assets on the cheap, but the Chinese leaders know this would be unpopular with the Russian public and could generate a dangerous political backlash. Worse, China would be faced with a Russian expectation of massive economic assistance, with uncertain likelihood of repayment.

To be sure, even if China recalibrates its balance of interests, it will not join quickly with the US and EU in supporting Ukraine. China has recently been the target of US and European sanctions, and of US tariffs. It bears scars from what it views as over a century of domination and humiliation by the West and Japan, from 1840 to 1949. But China has also become too large and visible to maintain a neutral stance. It can deprive Russia of support without ostensibly coordinating its action with the United States. Chinese rhetoric and propaganda may continue to take Russia’s side on the initial causes of the invasion. But what China does is more important than what it says.

Time is not on China’s side in terms of offering support to President Putin. Continuing Russian atrocities against civilians in Ukraine will be further enabled if China sides with Moscow. That would increasingly derail a return to the conditions that made China’s economic growth possible – a global trading system based on non-discrimination that welcomed China as a participant. A misreading of the pro-Ukraine camp’s resolve could impair China’s economic prospects to an extent that cannot be possibly offset by reliance on domestic (or Russian) demand. Rather than the US rolling back some of the Trump-era anti-China tariffs, these could become a foundation on which new restrictions are built, and could be emulated by other economies.

China has demonstrated pragmatism over time in building its economic position in the world. Prolonging its embrace of Russia would be a major misstep, with likely massive economic costs.

War in Europe: The Financial Front

This blog post, coauthored with Josh Kirschenbaum, was published on Monday by both Bruegel and, in a marginally different version (below), by the Peterson Institute. 

Since Russia's invasion of Ukraine started on February 24, much has happened in the financial sector, and events keep unfolding at a rapid pace. At the time of writing, Russia is reeling from the impact of massive financial sanctions inflicted by a very broad pro-Ukraine coalition. The Ukrainian financial system is battered but remains functional; and the European Union (EU) financial system has rather easily absorbed the initial shock, as has the global financial system more broadly.

Because it is war, it is impossible to convincingly disentangle what is happening on the financial front from the broader, primarily military-driven environment. We also do not analyze here other major economic developments, such as trade policy measures and withdrawals from Russia by nonfinancial companies. Even so, the financial sector action has been broad enough to deserve specific attention.

The pro-Ukraine camp's financial sanctions have included three main planks. First, a dramatic expansion of sanctions against specific Russian individuals. Second, a series of sanctions against individual Russian banks, including—but far from limited to—the much-hyped ability of the EU to mandate their disconnection from SWIFT, the international interbank messaging system which is based in Belgium and thus under EU jurisdiction, now also known as "de-SWIFTing". And third, the incapacitation of the Central Bank of the Russian Federation's (CBRF) use of its international reserves in a number of jurisdictions that critically include the US, EU, UK, Canada, Japan, Australia, and Switzerland, namely all the core reserve-currency jurisdictions of the world bar China (China's share of the world's aggregate central bank foreign reserves remains in the low single digits, even though its share of the CBRF's reserve is significantly higher). The third action, targeting the CBRF, unambiguously counts as systemic and affects the entire Russian financial system and economy. The first is about individuals. The second occupies a middle ground: If only a relatively small share of Russian banks is affected, it is nonsystemic, but if most are, it becomes systemic. From that standpoint, the EU's de-SWIFTing actions are still nonsystemic, since only seven institutions representing about a quarter of the Russian banking system are on the latest list. More could follow, however. In addition to these governmental decisions, some key financial firms are restricting their Russian services on their own initiative, such as VISA and MasterCard, adding to the general disruption.

The impact of the systemic CBRF-targeted sanctions on Russia's currency and economy is devastating, in part because they were so unexpected, and despite the continued ability of Russia to achieve a current-account surplus as long as it keeps exporting hydrocarbons. In the past, the United States has sanctioned other central banks, e.g., in 2019 Venezuela and Iran. What has never happened before, however, is coordinated action by all Group of Seven (G7) jurisdictions against a central bank, let alone one as large and internationally active as the CBRF. In fact, none of the 63 central banks that are members of the Bank for International Settlements (BIS) in Basel has ever been the target of financial sanctions. The CBRF is a member not only of the BIS club but also of its more exclusive subsets, e.g., the Financial Stability Board or the Basel Committee on Banking Supervision. It was hard to anticipate that it could be blackballed so promptly. Astonishingly for observers of the ostensibly soft-spoken, consensus-driven central banking community, the BIS announced on February 28 that it would itself follow sanctions "as applicable," which was widely understood as alignment with the G7 stance. This has no precedent since the establishment of the BIS in 1931, even during World War II. In recent years, the CBRF had diversified its international reserves away from US dollars and British pounds, but largely into euros (as well as Chinese renminbi and gold). In other words, it appears that the scenario that unfolded on February 26 had not featured on the risk map that underpinned the build-up of financial "Fortress Russia" since the invasion of Crimea in 2014. In hindsight, this was a clear miscalculation by the CBRF's otherwise highly competent governor and her team.

Ukraine, by contrast, is being devastated physically by the Russian military aggression, but is still very much standing financially. On March 1, the Ukrainian government issued $270 million in war bonds; since February 24, the country's central bank has benefited from a swap line of the National Bank of Poland, granting it a degree of access to international liquidity; more powerful assistance could come in the future from the International Monetary Fund, and possibly also from the European Central Bank, even though the latter is far from sure at the time of writing. In the war zones, of course, financial services are disrupted, as is everything else.

In the European Union, the initial shock has already been largely absorbed by the safety cushions created since the previous great financial crisis—thank goodness for Basel III. The presence of Russian banks in the EU is being promptly terminated in an orderly manner. The largest such entity, Sberbank Europe AG in Austria, has been liquidated in the immediate aftermath of the invasion after its Russian parent decided not to give it liquidity support; the second-largest, VTB Bank (Europe) SE in Germany, is likely to go the same way. On the other side of the divide, several EU banks, most prominently including Raiffeisen, Société Générale and UniCredit, have substantial operations in Russia and other financial exposures to its economy. Their stock price has suffered, but not collapsed, and it currently appears that their capital base is sufficient to absorb the shock. Unexpected damage could surely pop up in other corners of the system. But that risk does not currently appear large enough to threaten financial stability at a systemic level.

What happens next is, of course, anyone's guess and will keep depending on military developments. Further escalation of financial sanctions is possible. For example, the EU could de-SWIFT more Russian banks—possibly including Sberbank, which is already subject to harsh US sanctions, namely a correspondent accounts cutoff that prohibits it from clearing payments through the United States. The EU could also sanction Russian banks more strongly, e.g., banning all transactions with them and freezing their assets (full "blocking" sanctions) as the United States already does, for example, with VTB. Perhaps most important, pro-Ukraine jurisdictions could move towards banning energy purchases from Russia, which are currently allowed under their respective financial sanctions regimes.

On a more long-term, structural basis, only time will tell if the recent action against Russia has contributed to strengthening the international financial system, by punishing destructive behavior, or fragmented it into increasingly decoupled competing blocks. It bears noting, once again, that the recent financial sanctions have been far from unilateral, but on the contrary have been adopted, certainly with local variations, by an extremely wide group of financial jurisdictions that goes beyond "the West." Russia's transgression of international norms is so radical that it remains to be seen to which extent the international response to it, radical as it has been as well, has precedent value.

After Orderly Brexit, A New European Financial Landscape Starts to Emerge

This blog post was published on March 11 by Bruegel, and in a slightly modified version (below) on March 19 by the Peterson Institute. 

The United Kingdom’s exit from the European single market on January 1 has sent trade in goods plummeting amid much confusion. By contrast, Brexit was carried out in an orderly manner in the financial sector, despite significant movement of trading in shares and derivatives away from the City of London. After five years of radical uncertainty, it has become clear that the European Union and the United Kingdom will be taking separate paths on financial regulations, a financial “decoupling” that means significant loss of business for the City. Whether the EU financial sector can gain much of what London loses will depend on the European Union’s willingness to embrace further financial market integration.

Smart sequencing ensured orderly Brexit for the financial sector

Like the Y2K problem, the Brexit transition could have gone worse. It took more than luck to avoid financial instability along the way. First, financial firms on both sides of the Channel (and of the Irish Sea) worked hard and were able to pre-empt most of the operational challenges. Second, despite all the recurring high-stakes drama between the UK government and the European Commission, the technical cooperation between the authorities actually in charge of financial stability, primarily the Bank of England and the European Central Bank (ECB), appears to have run smoothly.

Third, the negotiators phased the process in a smart way. The Brexit Withdrawal Agreement of January 2020 helped reduce uncertainty by ensuring that the UK government would meet its financial obligations to the European Union, avoiding what would have been akin to selective default. That agreement kept the United Kingdom in the single market during the transition period beyond the country’s formal exit from the European Union on January 31, 2020. It also set a late-June deadline for the British government to extend the transition period beyond December 31, 2020. As London decided not to do so, that left six months of effective preparation. To be sure, whether an EU-UK Trade and Cooperation Agreement (TCA) would be concluded remained unknown until late December. But that mattered comparatively little for financial services, since trade agreements typically do not cover them much. By one count, the 1,259-page TCA (which is still unratified by the European Union) contains only six pages relevant for the financial sector.

The resulting legal environment for financial services between the European Union and the United Kingdom is unlikely to change much any time soon. Contrary to occasional portrayals in the United Kingdom, no bilateral negotiations on financial services are going on, except for a memorandum of understanding expected this month that is not expected to bind the parties on substance. From the EU perspective, the United Kingdom is now a “third country,” in other words an offshore financial center, following decades of onshore status. UK-registered financial firms have lost the right, or “passport,” to offer their services seamlessly anywhere in the EU single market. From a regulatory standpoint, they have no better access to that market than their peers in other third countries such as Japan, Singapore, or the United States.

The European Commission is unlikely to grant equivalence status to most UK financial market segments any time soon

Some segments of the financial sector in these other third countries actually have better single market access than British ones, because they are covered by a category in EU law allowing direct service provision by firms under a regulatory framework deemed “equivalent” to that in the European Union. The equivalence decision is at the European Commission’s discretion, even though it is based on a technical assessment. As a privilege and not a right, equivalence can be revoked on short notice.

So far the Commission has not granted the United Kingdom any such segment-specific equivalence, except in a time-limited manner for securities depositories until mid-2021 and clearing services until mid-2022. For the moment the Commission appears to be leaning against making the latter permanent. In most other market segments, the Commission will not likely grant equivalence to the United Kingdom in the foreseeable future. This may appear inconsistent with the fact that almost all current UK regulations stem from the existing EU body of law. But the UK authorities (including the Bank of England) have declined to commit to keeping that alignment intact.

The Commission’s inclination to reduce EU dependence on the City of London is understandable. No comparable dependence on an offshore financial center has existed anywhere in recent financial history. Such dependence entails financial stability risk. In a crisis, UK authorities would not necessarily respond in a way that preserves vital EU interests. Think of the Icelandic crisis of 2008, when Reykjavik protected the failing banks’ domestic depositors but not foreign ones. It is hardly absurd for the European Union to try to reduce such a risk, even if—as appears to happen with derivatives—some of the activity migrates from the United Kingdom to the United States or other third countries as a consequence, and not to the European Union.

At the same time, the argument that keeping EU liquidity pooled in London is more efficient than any alternative is unpersuasive given the European Union’s own vast size. In addition, the Commission also follows mercantilist impulses to lure activity away from London, even though these generally do not make economic sense. Added up, these factors provide little incentive for the European Commission to grant equivalence status to more UK financial market segments, unless some other high-level political motives come into play. None are apparent right now.

The UK is unlikely to regain lost advantage in the EU through financial regulatory competition

How the European Union and the United Kingdom will decouple will not be uniform across all parts of the financial system. Regulatory competition between them may become a “race to the bottom” or “to the top,” depending on market segments and the circumstances of the moment, without a uniform pattern. In any case, such labels are more a matter of judgment in financial regulation than in, say, tax competition. In some areas the European Union will be laxer, in others it will be the United Kingdom, as is presently the case between the European Union and the United States. For example, the European Union is more demanding than the United States on curbing bankers’ compensation but easier when it comes to enforcing securities laws or setting capital requirements for banks. At least some forthcoming UK financial regulatory decisions may be aimed at keeping or attracting financial institutions in London, but they are still not likely to offset the loss of passport to the EU single market.

All these permutations suggest that the medium-term outlook for the City of London is unpromising, although the COVID-19 situation makes all quantitative observations more difficult to interpret. Once an onshore financial center for the entire EU single market, and a competitive offshore center for the rest of the world, the City has been reduced to an onshore center for the United Kingdom only and has become offshore for the European Union. That implies a different, in all likelihood less powerful, set of synergies across the City of London’s financial activities.

The few relevant quantitative data points available reinforce this bleak view. Job offerings in British finance, as tracked by consultancy Morgan McKinley, have declined alarmingly since the 2016 Brexit referendum. The ECB (as bank supervisor) and national securities regulators coordinated by the European Securities and Markets Authority are tightening requirements for key personnel to reside mainly on EU territory rather than in the United Kingdom. As noted by Financial Times columnist Simon Kuper, many financial firms’ Brexit policy until this year had been to “sit tight and do nothing until post-Brexit arrangements for finance forced [their] hand.” That phase has ended. Firms that drag their feet face regulatory disruption, as happened to broker TP ICAP in late January. Tussles between regulators and regulated entities, rather than between the European Commission and the UK government, are where most of the financial-sector Brexit action is likely to be in 2021. These disputes typically happen behind closed doors, and the regulators typically hold most of the cards.

For all the optimistic talk in London of “Big Bang 2.0 or whatever,” the United Kingdom’s comparative advantage as the best location for financial business in the European time zone is unlikely to recover to its pre-Brexit level. The macroeconomic losses could be moderated or offset by cheaper currency and less expensive real estate in London, making the city a more attractive place to do nonfinancial business. Even so, a gap will likely remain for the UK government, which has for years depended heavily on financial-sector-related tax revenue.

The European Union stands to gain financial activity as a consequence of Brexit. How much and where is not clear yet. As some analysts had predicted, Amsterdam, Dublin, Frankfurt, Luxembourg, and Paris are the leaders for the relocation of international (non-EU) firms. Dublin and Luxembourg specialize in asset management, Frankfurt in investment banking, and Amsterdam in trading. But EU success in terms of financial services competitiveness and stability will depend on further market integration, the pace of which remains hard to predict. The European banking union is still only half built, because it lacks a consistent framework for bank crisis management and deposit insurance. The grand EU rhetoric on “capital markets union” has yielded little actual reform since its start in 2014. Events like the still-unfolding Wirecard saga may force additional steps toward market integration, even though a proactive approach would be preferable. The one near certainty is that London’s position in the European financial sector will be less than it used to be.

European banking reform should embrace a unitary approach to failed banks

This blog post coauthored with Anna Gelpern was published last Thursday by Bruegel, and this morning (in slightly modified version, below) by the Peterson Institute. 

Update (January 2021): a lightly edited version was republished in CESifo Forum, also in PDF (downloadable here here if the previous link is broken).  

Six years after starting a reform process to protect its banking system against financial crises, the European Union (EU) has reiterated its members’ commitment to “make further concrete progress on the Banking Union by the end of the year.” EU officials are right not to let COVID-19 derail necessary debates over this objective. But the reinvigorated discussion has become increasingly confused when it comes to dealing with failed banks. There is a danger that the EU could cite the experience with the US Federal Deposit Insurance Corporation (FDIC) to make its already fragmented regime even more fragmented. That would be a mistake. A closer look at the FDIC model highlights the value of a unitary process for resolving all deposit-taking banks, no matter how large or small.

The banking union is intended to pool the instruments of banking sector policy at the European level. Otherwise, bank failures can require expensive bailouts that wreak havoc on national budgets in a crisis, undermining the integrity of the euro area. The implementation of the banking union began in 2014, with the assumption of bank prudential supervision by the European Central Bank (ECB). The pandemic posed a major test, but ECB banking supervision has passed it so far by quickly granting banks leeway to absorb pandemic-related losses, while suspending their dividend distributions to preserve their capital.

EU bank failures need to be much better managed

Still, the bank crisis management framework remains a halfway house. Most of it is enshrined in the Bank Recovery and Resolution Directive (BRRD) of 2014. In a number of bank failures since that legislation went into effect, the BRRD has fallen short of its principal goal of forestalling taxpayer bailouts. Hence the growing consensus for more significant reform.

Several officials, including at the Bank of Italy, the German finance ministry, and the Single Resolution Board (SRB)—the Brussels-based EU agency that acts as a hub for BRRD implementation in the euro area—have proposed a new EU bank liquidation regime as a centerpiece of reform, with implicit or explicit references to the FDIC model. There is an inescapable irony to invoking the FDIC for that.

Established in the 1930s, the FDIC insures deposits, undertakes bank supervision, and oversees the apportioning of costs to creditors, investors, depositors, and others when a bank fails, a process known as bank “resolution.” Its success had helped inspire the process established by the BRRD in the first place. But unlike in the US, EU legislators decided that the BRRD resolution procedure would apply only to banks judged to implicate the public interest after a “public interest assessment” (PIA).

That assessment is guided by the vaguest of criteria. Whereas the FDIC is the sole resolution authority, regardless of the size or systemic importance of a bank, or whether it has a state or federal charter, the BRRD left it up to national regimes to resolve a failing bank that receives a negative PIA. The FDIC is also responsible for the as-yet untested Orderly Liquidation Authority for systemically important nonbank entities, including large bank holding companies. For banks, the FDIC has no equivalent to the BRRD’s PIA process that might allow it to hand over the failing institution to a less squeamish undertaker.

The incentive structure behind recent bank failure controversies reflects the sort of dysfunction of a multiplicity of potentially overlapping regimes.

Dealing with a failing bank is thankless business, especially if one lacks access to unlimited public resources to bail out the various stakeholders. The resolution process under BRRD severely restricts bailout options. Some national insolvency regimes are less stringent and leave the door open to generous bailouts. This process puts pressure on the authority in charge of making public interest assessments to make a negative PIA and keep the ailing bank out of EU resolution.

For example, in June 2017, the SRB gave a negative PIA on two mid-sized banks in the Veneto region of Italy, followed by their administrative liquidation under Italian law. The latter process was managed by the Bank of Italy, with generous financial support from the Italian government. This was in line with the letter of BRRD but at odds with its spirit: When presenting that legislation on June 6, 2012, European Commission President José Manuel Barroso stressed that it would “help protect our taxpayers (…) from the impact of any future bank failure.” It defies common sense to declare that a bank does not implicate the public interest only to have it benefit from more, not less, public financial support.

Unlike the SRB, the FDIC cannot wash its hands of a failing bank—there is no one else to handle the mess. The unitary structure lends itself to formal and informal public accountability and has led to continual reform and gradual improvement in FDIC’s practice over several cycles of bank failures that now span more than eight decades. For its part, the SRB not only has defended its decision on the two Veneto banks but also has elevated it to a point of general policy, with the SRB chair emphasizing that BRRD resolution was “for the few, not the many.” This position leaves many significant banks in the banking union beyond the reach of one of its key institutions, contrary to the expressed initial intent of BRRD legislators.

The absence of a common deposit insurance authority in the euro area compounds the regime arbitrage problem. As its name indicates, the FDIC manages deposit insurance for all banks in the United States. By contrast, the 21-country banking union (19 countries in the euro area, plus Bulgaria and Croatia) has national deposit insurance regimes (in some countries, several of them), national resolution authorities, national institutions in charge of insolvency processes, plus the SRB: countless cooks in the bank failure kitchen, where the United States has only one.

EU reformers should take the time to draw on the core strengths of the US FDIC model

We used the FDIC as a starting point for our analysis, further detailed in a paper published last year for the European Parliament. This blog post does not aim to address all dimensions of the technically complex matter. We nevertheless submit three suggestions for the EU reform debate.

First, policymakers should not rush for a piecemeal solution at a time when pandemic-related risks loom large. Completing the banking union before the pandemic was arguably the most important priority of the European commissioner for financial services. But now, the more immediate priority is to address the COVID-19 crisis, including by implementing the Next Generation EU blueprint for pooled borrowing by the EU and financial transfers to its neediest members. If recovery stalls and economic deterioration leads to bank failures or requires bank recapitalization, that will probably be before any significant banking union reform can be enacted, so they will have to be handled with the existing legislation anyway.

Second, EU reformers should consider the tradeoffs embedded in the design of the FDIC and its evolution over time, including stronger protection of all deposits, even uninsured ones, but also lesser implicit protection of other creditors—the FDIC’s track record establishes that its pledge not to bail these out is credible, at least for institutions up to a fairly significant size (Washington Mutual, resolved in 2008, had around $300 billion in assets).

Third, the EU should take away the right lesson from the FDIC’s history and pursue an integrated approach to the banking union: a unitary regime to handle all bank failures, amending and improving the BRRD resolution concept, encompassing reform of mandatory deposit insurance that would integrate it under the SRB. All things equal, a European system that would match the FDIC’s performance would entail a lower future fiscal impact of banking crises. To be sure, it would still entail financial risk-sharing through the deposit insurance and resolution mechanism and its necessary public backstop, but Next Generation EU will facilitate that by giving the EU financial firepower of its own.

The advocacy of a new EU bank liquidation regime, somewhere between EU resolution and national insolvency procedures, evokes the ill-starred Council of Pisa in 1409, which decided to elect a third Pope to solve the conflict of two competing Popes and in so doing exacerbated the Western Schism. The solution came several years later at the Council of Constance, where all three papal claimants resigned and gave way to a single newly elected Pope. European reformers should go directly for the Council of Constance approach, drawing on the core substantive strengths of the FDIC model. If that requires more time for careful debate and preparation, it will be time well spent.

Government-guaranteed Bank Lending, Six Months On

This blog post, written jointly with Julia Anderson and Francesco Papadia and updating our findings first published in July, was published today by Bruegel. 

In March and April 2020, European governments announced massive credit support programmes. After an initial surge, take-up appears to be stabilising (with a lag in Italy), despite second wave shocks in some countries. More recent data confirms that fiscal capacity has not visibly constrained national governments in the support they have provided so far.

Credit-support measures, such as loan guarantees, have been one of the main tools to soften the economic blow of COVID-19. Early in the pandemic, European governments deployed unprecedentedly huge credit support to mitigate the liquidity shock facing businesses during lock downs. Concerns about the effects of these programmes quickly followed their announcements.

An often-expressed worry was that less-indebted countries would have more fiscal capacity to help their businesses, and thus unequal support would distort competition in the EU single market, providing an unfair funding advantage to firms in countries with more fiscal space.

Our preliminary findings, published in July, suggested that these concerns had already become somewhat obsolete (relatedly, André Sapir found that low fiscal capacity did not worsen counties’ economic contractions; he concluded that the European Central Bank’s pandemic emergency purchase programme, which was launched in March 2020, has been successful). Firms in less-indebted countries did not appear to disproportionally benefit from national credit support schemes. Updated September numbers confirm these findings: German firms are still collectively the lowest users of the scheme as a share of GDP, whereas by the same yardstick, Spain still tops the chart and Italy is now ranked second (Figure 2).

Figure 1: Government-backed credit support for businesses, € billions

Figure 2: Government-backed credit support for businesses as percent of 2019 GDP

Figures 1 and 2 show that the amount of support provided has gradually levelled off in most of the covered countries, from weekly growth rates of 6%-7% in June, to 1% in September. The exception is Italy, which is still catching up from a late start. But even there commitments are stabilising – growing at a mere 3% per week in September compared to 30% in June.

This stabilisation trend has been apparently unaffected by health-related shocks: there has been no spike in commitments in Spain or France to match the dramatic rise in cases witnessed over the summer. This could indicate that firms were sufficiently buffered or, if not, that most eligible firms had already benefited from the maximum amounts allowed under the scheme. Alternatively, firms might be unwilling or unable to take on more debt.

Our ongoing research project on credit support programmes attempts to clarify some of these trends. We will publish frequent updates of government commitments in this new Bruegel dataset. Please refer to the note accompanying the dataset for more information on our methodology and the programmes included in Figures 1 and 2.

Recommended citation:
Anderson, J., F. Papadia and N. Véron (2020) ‘Government-guaranteed bank lending six months on’, Bruegel Blog, 29 September

Government-guaranteed Bank Lending in Europe: Beyond the Headline Numbers

This blog post, coauthored with Julia Anderson and Francesco Papadia, was published on July 14 by Bruegel and yesterday (with updated figures) by the Peterson Institute. 

In response to the COVID-19 shock, European countries have introduced unprecedented programs of loan guarantees and other forms of credit support for their businesses. In March 2020 the European Commission relaxed its strict rules on state aid, allowing EU member states to channel needed funds through these unprecedented national coronavirus aid schemes. Concerns have since been raised that richer, less indebted member countries have the fiscal capacity to help their businesses more. Unequal support would distort competition in the EU single market, providing an unfair advantage to firms in better-endowed countries, for example, in the form of cheap funding. At the extreme, the crisis would wipe out all but the most-subsidized firms.

Preliminary findings of a research effort to understand implementation of these programs indicate that, contrary to widespread concerns, firms in richer or less indebted countries do not appear to disproportionally benefit from these schemes. This observation suggests that guarantee programs may not have the feared distortionary impact on the European single market, at least so far. When it comes to actual access by businesses to government-backed credit facilities, cross-border market distortions driven by differing fiscal capacities in EU countries appear to have been largely avoided. This is welcome reassurance in an otherwise challenging environment.

Loan guarantees, complemented in some countries with government purchases of corporate bonds, have been one of the main instruments with which European countries have provided liquidity to affected businesses during the COVID-19 lockdowns. In many countries, such programs represent more than half of the announced rescue funds (footnote 1). They form a complex picture since they are typically provided through a number of different national programs in each country, and in some countries these programs are managed on a highly decentralized basis. Our ongoing research seeks to understand this picture at a granular level in France, Germany, Italy, Spain, and the United Kingdom.

With a few exceptions, these programs have been reported as headline announcements. For example, early in the COVID-19 sequence of events on March 23, the German federal government announced two guarantee programs, backed by a €756 billion envelope (footnote 2), as part of its broader coronavirus package. One day later, the Spanish government made a similar announcement, with the headline number of €100 billion for guaranteed loans (see details in table 1).

Our early findings suggest that such headline numbers are not necessarily correlated with actual commitments to individual companies. Nor are these aggregate individual commitments aligned with the amounts estimated by the European Commission in its state aid control capacity. For example, in mid-May the Commission announced that overall state aid provided by Germany would be a disproportionate 51 percent of the EU total (of which guarantees were a large share), prompting the Commission's executive vice president Margrethe Vestager to express concern about the potential cross-border competitive distortions. As noted earlier various observers have since March also expressed concern that more highly indebted member states would be fiscally constrained to extend business assistance, thus putting companies established in their territory at a competitive disadvantage.

In fact, as figure 1 illustrates, as of June 29, 2020, the distribution of funds appears reassuringly (from a single-market standpoint) uncorrelated with government debt burdens or perceptions of sovereign fiscal space. In particular, the amount of credit support Germany has committed so far appears to be comparatively small—amounting to 1 percent of its 2019 GDP as of June 29 (figure 2). This is the lowest share among the countries that were surveyed. The picture may be incomplete due to the lack of data on regional programs, but adding the missing data may not change the picture dramatically (footnote 3).

Figures 1 and 2 show the evolution of government-backed credit support under the various programs in the different countries. This support is mostly in the form of loan guarantees, except in the United Kingdom, where the corporate debt purchase program amounts to a third of all credit support to businesses. In Spain, guarantee programs cover both bank loans and promissory notes, though the latter is relatively small (footnote 4). Table 1 lists all the programs included in figures 1 and 2.

For credit guarantee programs, figures 1 and 2 report the full nominal amount of the credit covered by the public guarantee—i.e., 100 percent of the credit (e.g., loan) amount even if the guarantee covers, say, only 70 percent of it. The numbers presented in figures 1 and 2 exceed the amounts of guaranteed loans actually paid out, because businesses may obtain a bank's commitment for a guaranteed loan but then opt to not use it. In Germany, for instance, about a third of KfW-guaranteed loans that have been approved have not yet been used.

We have yet to fully analyze what drives the patterns in these findings. It is notoriously difficult to disentangle the respective roles of supply of and demand for bank credit in driving lending volumes, especially in times of turmoil like at present. On the supply side, issues of administrative capacity and program conditionality probably play a part and can be identified only through highly granular analysis. On the demand side, the availability of liquidity buffers and other sources of public support—such as grants and wage replacement schemes—are likely important drivers. With all that in mind, it seems clear that national fiscal capacity has not played the main role so far.

There is also no positive relation between the headline envelope of programs as initially announced and their later take-up (figure 3). (That is not to say that the size of the envelope does not matter: Large headline envelopes may have been set to reassure markets.)

Table 2 compares loan guarantee commitments with the total flows of bank loans to nonfinancial corporations (NFCs) in the observed countries, from March to May 2020. Since the start of the crisis in March, bank loans to NFCs accelerated significantly, and loan guarantees are a significant share of that growth. In all observed countries but the United Kingdom, loan guarantees capture most of or more than the year-over-year lending growth. This finding is consistent with a recent survey by the European Central Bank (ECB) where banks reported that government loan guarantees played a significant role in maintaining favorable credit standards.

In the next steps of our analysis, we will continue to assemble and interpret granular information about these programs, i.e., examining size, design, bank incentives, sectors/types of firms benefiting from the guarantees and compatibility with EU frameworks. We also plan to record how these programs may be modified over time to adapt them to the exit from lockdown and the possibility of more corporate insolvencies, with consequences, for example, in terms of corporate governance, fiscal cost, and banking sector implications. We aim to better understand these and other dynamics in forthcoming publications.

Footnotes

1. Such is the case in France, Germany, Italy, Spain, and the United Kingdom.

2. The envelope includes two elements: (1) a €356 billion increase to the guarantee fund of the public financial institution Kreditanstalt für Wiederaufbau (KfW) and (2) €400 billion for guarantees to large firms through the Economic Stabilisation Fund (WSF, for Wirtschaftsstabilisieroungsfonds), which was approved by the European Commission on July 8. We do not include the €100 billion allocated to support KfW in case it fails to raise funds on capital markets, which has not been activated.

3. We were not able to collect figures for all German regions (Länder). Based on observations in some Länder, we estimate that, taken together, German regional credit support via regional development banks (Landesförderinstitute) amounts to a maximum of €10 billion. Other regional guarantee programs, e.g., via regional guarantee banks (Bürgschaftsbanken), combine to an additional €2 billion (as of June 20, 2020). Regional programs also exist in other countries, e.g., in Italy, but we estimate them to be comparatively small.

4. The Spanish guarantee program on promissory notes has an allocated envelope of €4 billion. For simplicity, the smaller €0.5billion counterguarantee program (provided to mutual guarantee societies by the Compañía Española de Reafianzamiento S.A., or CERSA) is not discussed here.

The Wirecard Debacle Calls for a Rethink of EU, not just German, Financial Reporting Supervision

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

Wirecard AG, the Munich-based payments and financial services company that was a member of the DAX index of Germany’s 30 leading blue chip stocks, collapsed spectacularly and filed for insolvency on June 25, 2020. Among many lessons, this disaster has revealed major gaps in audit regulation and accounting enforcement in Germany and by extension in the European Union (EU). Like in other areas of financial supervision, having only national-level oversight of financial reporting in an integrated EU market generates perverse incentives that impair supervisory effectiveness. The policy response to this challenge should be to pool the relevant supervisory mandates at the EU level.

This blog focuses on the financial transparency aspects related to Wirecard as a publicly listed company, leaving aside other important policy issues such as whether Wirecard should have been more tightly supervised as a payment services provider. The quality of listed companies’ financial reporting is critical to protecting investors and to the integrity and efficiency of securities markets.

Twin Failures of Audit Regulation and Accounting Enforcement

In what is publicly known of the Wirecard story, none of the lines of defense that exist to prevent accounting misstatements appears to have functioned properly. Not the internal controls, the effectiveness of which “is monitored by the Supervisory Board of Wirecard AG,” according to the company’s 2018 annual report, the last it published. Not the auditors, who in the same report state that Wirecard’s financial statements “give a true and fair view of the assets, liabilities, and financial position of the Group as at 31 December 2018.” (It appears that financial reporting malpractice at Wirecard started several years ago and that the auditors omitted to perform basic controls.) And not the national accounting enforcement authorities, who are empowered to remedy any failures of publicly listed companies like Wirecard to publish financial statements that are compliant with the relevant standards, namely the International Financial Reporting Standards (IFRS) as adopted by the EU. The latter two lines of defense are matters of public policy.

Auditors act under a public mandate, enshrined in national legislation, which is only spottily harmonized at the EU level. They are also subject to public supervision. Following the high-profile bankruptcies of Enron and WorldCom, the US Sarbanes-Oxley Act of July 2002 established the Public Company Accounting Oversight Board (PCAOB) as the US audit regulator, with a mandate to inspect auditors and penalize those that conduct improper audits. EU countries have established their own audit regulators, in part to cooperate with the PCAOB to support US stock market listing of companies based in their respective territories. (China is the global outlier in terms of cooperation with the PCAOB, but this may be changing.) Germany’s audit regulator is the Auditor Oversight Body (Abschlussprüferaufsichtstelle), a tiny entity that is incongruously lodged in the Federal Office for Economic Affairs and Export Control (Bundesamt für Wirtschaft und Ausfuhrkontrolle), an agency under the Federal Ministry for Economic Affairs and Energy.

As for accounting enforcement, in most EU member states it is in the hands of the national securities regulator, mirroring the United States, where the task belongs to the Office of the Chief Accountant within the Securities and Exchange Commission (SEC), the federal securities regulator. Germany has an idiosyncratic “two-stage” accounting enforcement framework, with two entities in charge: the Financial Reporting Enforcement Panel (known as DPR for Deutsche Prüfstelle für Rechnungslegung, or colloquially as the Bilanzpolizei—the balance sheet police) as a “first stage”; and BaFin (Bundesanstalt für Finanzdienstleistungsaufsicht), a public agency whose many tasks include securities regulation, as a “second stage,” which steps in when the DPR’s first stage is viewed as having failed to resolve a problem. The DPR is a private-sector entity that brings together national employers’ associations, trade unions, and industry associations of banks, insurers, and accountants, among other members. It operates with a small budget, €5.5 million in 2019.

Economic Nationalism and National Supervisory Incentives

On the basis of publicly available information, it appears that this system failure to prevent Wirecard’s accounting malpractice was at least partly the result of a consensus among these various players to defend the company as Germany’s foremost financial technology success—“this delicate homegrown plant that needed to be protected,” as left-wing parliamentarian Fabio De Masi described it recently in the Financial Times. BaFin’s past behavior seems to support this narrative. In April 2019, BaFin went as far as filing a complaint against the Financial Times journalists who had begun investigating Wirecard’s alleged irregularities, even after the agency had asked the DPR to start an investigation of its own. In other words, economic nationalism—the impulse to protect and promote national corporate champions whose success is somehow deemed to be aligned with the national interest—twisted the incentives of authorities and led them to neglect their primary mandate, in this case the protection of investors and of the integrity of the German securities market. As De Masi further put it, “[a]nyone asking awkward questions [about Wirecard] was seen as trying to run down Germany and its finance sector.” One suspects that such perverse incentives were exacerbated by the fact that most of Wirecard’s competitors were outside Germany, particularly in the context of the EU internal market, which has eliminated many cross-border barriers to entry. In a closed national financial system, national authorities have reasons and means to resist a supervisory race to the bottom, but that is much less the case in the EU single market.

This pattern is not unprecedented. The combination of EU integration and national public oversight has distorted national authorities’ incentives to the point of making them neglect their core mandate in cases including the prudential supervision of banks and anti-money laundering (AML) supervision. In both cases, economic nationalism and related dynamics led to system failures, respectively, in the early and late 2010s. In both cases, the policy response has involved changing the incentives through supervisory centralization: respectively, European banking supervision (also known as the Single Supervisory Mechanism) entrusted to the European Central Bank (ECB), initiated in 2012; and an ongoing process of pooling AML supervisory entity in a single EU agency. Whereas European-level authorities can suffer from being less cognizant of national specificities, they are structurally less subject to capture.

Suggestions and Prospects for EU Reform

In light of the Wirecard debacle, financial reporting supervision calls for similar thinking on the policy response. The public mandates of both audit oversight and accounting enforcement should be pooled at the EU level, replacing the existing loose coordination structures. This could be done either directly within the European Securities and Markets Authority (ESMA), an autonomous EU agency that was created in 2011 and has legal capacity to make enforcement decisions of its own, or through a new specialized EU entity, possibly placed under ESMA’s oversight, like the SEC oversees the US PCAOB. It would also help in bringing the reality of EU financial supervision closer to the bloc’s proclaimed vision of a capital markets union.

As ever, there are powerful obstacles to such reform. They include some member state governments’ defensive approach to sovereignty, according to which dysfunctional national supervision is preferable to more effective EU-level supervision; protection by incumbent national authorities, audit regulators, and accounting enforcers of their existing turf; and lobbying by private-sector participants that prefer lax local supervision driven by economic nationalism to what is likely to be a more demanding approach by an EU authority. The German government’s initial reaction appears to consider change only at the margin, for example, replacing the DPR with another entity or merging it with BaFin. But the cases of prudential and AML supervision demonstrate that such obstacles can be overcome. They also represent relevant precedents from which to draw lessons on how to best design an effective EU framework. The European Commission’s announcement of an ESMA investigation of BaFin is a start, but the discussion will need to be broadened to supervisory structures.

To be sure, no supervisor is perfect, and pooling these mandates at the EU level would not be a panacea. The efficacy of audit regulation, in particular, remains debated. Even in the United States, where the PCAOB has vastly more resources than all its EU counterparts taken together, auditors may still have lapses. But the reforms suggested here would undoubtedly represent a significant improvement in the quality and credibility of supervision and ultimately of financial reporting by listed EU companies. The Wirecard shock should serve as a wake-up call.

Disclosure: The author is an independent nonexecutive director of the global trade repository arm of DTCC, which includes EU operations that are supervised by ESMA.

Banking Regulation in the Euro Area: Germany Is Different

This blog post was published last Thursday by Bruegel, and this morning by the Peterson Institute. 

Despite progress in recent years toward a single banking policy framework in the euro area—a banking union—much of the German banking system has remained partly sheltered from uniform rules and disciplines that now apply to nearly all the area’s other banks. The resulting differences in regulatory regimes could generate vulnerabilities in the still-incomplete banking union, which is being tested in the COVID-19 pandemic.

Two reports published in early 2020 shed new light on this challenge. The European Central Bank’s (ECB) risk report on less significant institutions is the first of what is intended to be an annual series. The other report is the European Commission’s impact assessment study on the most important differences between accounting standards used by banks in the banking union, which was prepared by legal consultants for the Commission’s Directorate-General for Financial Stability, Financial Services and Capital Markets Union (DG FISMA). The reports provide comparative quantitative information that was not previously available in the public domain.

The new data highlight differences in rules and oversight in different euro area countries that matter in the context of efforts to achieve an EU single market and banking union. From a single-market perspective, the fact that many German banks are subject to a different supervisory, state-aid, and accounting framework raises the possibility of competitive distortions, even though a subset of these banks only have local activity and don’t compete outside Germany. German stakeholders might misjudge and underestimate the extent of EU-imposed discipline in the banking sectors of other member states, by wrongly assuming that national discretions and exceptions in those countries are similar to those in Germany. Conversely, in euro area countries other than Germany, a politically corrosive perception of unfairness can arise from differences in regulatory and/or supervisory treatment. From a banking union perspective, the exceptions could, at least in certain scenarios, contribute to fragmentation of the euro area financial space and thus to the risk that bank-sovereign vicious circles become worse, and potentially unmanageable.

The history that led to this situation is too long to summarize here. In a nutshell, the banking systems of a number of euro area countries previously displayed significant idiosyncrasies, memorably expressed by former Italian prime minister Giuliano Amato’s description of Italy’s banking system in 1988 as a “petrified forest.” But in Italy as in other euro area countries, successive waves of reform have eroded such idiosyncrasies. Germany has reformed less than most others, largely because circumstances have not compelled it to do so. It also has unique leverage over EU legislation, which could have played a role in the creation or persistence of legislative loopholes. Furthermore, Germany’s public bank community is uniquely intertwined with its political community.

 

Smaller German banks, including those in mutual support groups, are the main exception from direct ECB supervision

The ECB risk report gives, for the first time, a national breakdown of the assets of significant versus less significant institutions in the euro area. This distinction matters for assigning supervisory authority within the banking union. Significant institutions (SIs) are all euro area banks with more than €30 billion in total assets, plus a few more that are below this threshold but fulfill other criteria that include cross-border activity and prominence within a single country. Less significant institutions (LSIs) are all the other euro area banks. The ECB deems only a small number of banks as SIs for reasons other than total assets above €30 billion (31 in the ECB’s latest listing compared with more than 2,600 LSIs), so the asset-size criterion primarily, though not entirely, determines the boundary between SIs and LSIs. The ECB directly supervises SIs, while national supervisory authorities carry out most supervisory tasks related to LSIs (though the ECB has authority over banking licences and other infrequent procedures). The ECB also exercises oversight over the national supervision of LSIs.

A fact that jumps out from the ECB report is that LSIs are found disproportionately in Germany (figure 1). At end-2018, German LSIs represented 55 percent of total LSI assets in the euro area, whereas Germany accounted for 25 percent of total euro area bank assets (LSIs and SIs).

The vast majority of German LSIs, however, are not fully on their own, even though they are managed on a decentralized basis. They benefit from mutual support arrangements known in EU prudential law as institutional protection schemes (IPSs), labeled “virtual groups” by the ECB’s then second most senior supervisor, Sabine Lautenschlaeger, at the start of her tenure in 2014. LSIs within an IPS support each other: If and when one becomes unviable, its peers generally rescue it. As a consequence, the group as a whole, rather than its individual member banks, is the relevant level of observation for financial stability purposes. As figure 1 shows, not all LSIs belong to an IPS. Conversely, all existing IPSs include at least one SI.

There are two IPSs in Germany: the Savings Banks Finance Group (Sparkassen-Finanzgruppe) and the Volksbanken Raiffeisenbanken Cooperative Financial Network (Genossenschaftliche Finanzgruppe Volksbanken Raiffeisenbanken, hereafter “Cooperative Group”). Entities in the Sparkassen-Finanzgruppe belong to the public sector and are controlled by different subfederal levels of government under various legal forms and ownership patterns. Such entities include local savings banks (Sparkassen) and regional wholesale banks (Landesbanken). Individual cooperative members ultimately own entities in the Cooperative Group.

As of end-2018, based on data from the German central bank, LSIs in the Sparkassen-Finanzgruppe represented 45 percent of total German LSI assets. Those in the Cooperative Group, including buildings and loan associations, represented another 39 percent. In recent years, both groups have published group-level financial statements (using accounting methods, respectively, of aggregation and consolidation), which indicate that, taken together including their SI members, they are among the largest banking players in the euro area. Indeed, in 2018 the Sparkassen-Finanzgruppe in aggregate had more assets than any euro area bank (figure 2).

On the basis of publicly available information, it is difficult to assess the specific differences, if any, between the supervisory regimes of the ECB (applicable to SIs, including those in IPSs) and of national authorities (applicable to LSIs, including those in IPSs). Successive EU capital requirement directives and regulations have largely harmonized the legislative framework for supervisors, which has come close to the aspirational vision of a “single rulebook.” Thus, differences that may remain despite the above-mentioned ECB supervisory oversight, are mostly in supervisory enforcement and discretion. There are indications that at least some banks prefer being labeled LSIs. For example, L-Bank (full name Landeskreditbank Baden-Württenberg Förderbank), a public bank in southern Germany, unsuccessfully sued the ECB over its SI determination. New legislation later removed the bank from the scope of application of EU banking law altogether (together with two other former German public SIs, NRW.Bank and Landwirtschaftliche Rentenbank), and it is no longer under direct ECB supervision.

 

German unlisted public-sector banks are the main exception from strict state-aid control disciplines

European banks are subject to state-aid control conditions, enforced by the European Commission. The application of these disciplines, however, takes a distinctive form for unlisted public-sector banks, for which the boundary between an arm’s-length recapitalization (with the government providing funds as a shareholder) and state aid (the government transferring funds in a nonmarket transaction) is less well defined than in cases when there are shareholders other than public-sector entities. The leeway that results from full government ownership was put under the spotlight in the recent case of Norddeutsche Landesbank (or NordLB), a public bank in northern Germany, which was recapitalized by its public-sector shareholders in a transaction that the European Commission deemed “market conform” in December 2019 but that was widely viewed as distortionary by external observers. The NordLB decision itself had precedents, particularly in the cases of Portugal’s Caixa Geral de Depósitos in 2017 and Romania’s CEC Bank in October 2019. The upshot is that the state-aid regime appears to be different for unlisted public-sector banks than for other banks, in practice if not in theory.

Possibly for the first time, the ECB’s risk report on LSIs, combined with data on assets of individual SIs and a few no-nonsense assumptions, permits a tentative mapping of such banks in the euro area. Figure 3 shows the results of these calculations. They suggest that, as with LSIs, unlisted public-sector banks in the euro area are predominantly located in Germany. Namely, the Sparkassen-Finanzgruppe includes all of Germany’s unlisted public SIs and most, if not all, of its unlisted public LSIs.

 

German unlisted banks are the main exception from International Financial Reporting Standards adopted by the European Union

In landmark legislation adopted in 2002, the European Union mandated the use of International Financial Reporting Standards (IFRS) for all companies listed on public stock exchanges, starting in 2005. For unlisted companies, however, including unlisted banks, the choice of accounting standards was left to the discretion of individual member state authorities. This stands in contrast to most of the world’s jurisdictions outside the European Union, where all (listed and unlisted) banks generally have to comply with IFRS or, in the case of the United States, Generally Accepted Accounting Principles (US GAAP).

The DG FISMA report on banks’ accounting practices includes an overview of which banks (aggregated by country and by assets) use which set of accounting standards, IFRS or national standards. Germany stands out with 52.1 percent of bank assets reported under national standards. The next highest ratio is much lower, in Austria (22.7 percent), followed by the Netherlands (5 percent), and under 2.5 percent in all other member states. Figure 4 illustrates these findings.

Figure 4 implies that only two systems of accounting standards remain in wide use in the euro area banking system: IFRS and German national standards. Whether one is more demanding than the other depends on the issue; the DG FISMA report gives a wealth of detail on the differentiated outcomes. For example, for credit loss accounting, IFRS require expected loss provisioning as mandated by the Group of Twenty (G-20), while German standards preserve more flexibility to maintain the prior practice of incurred loss provisioning.

 

Conclusion

It is too early to assess the extent to which the COVID-19 pandemic may influence future debates and decisions on the still-unfinished banking union. By providing additional data on structural quirks of the euro area banking system, the two reports analyzed in this post contribute to a trend of greater supervisory transparency. Further efforts in that direction will hopefully contribute to better-informed policymaking when dealing with the difficult challenges ahead.

The German Federal Constitutional Court's Ruling on the ECB's Public Sector Purchase Programme

This brief reaction to the German Federal Constitutional Court (GFCC)'s landmark ruling of May 5 was just published on the Atlantic Council's Blog. 

The GFCC’s latest ruling is best viewed as part of a long sequence that started a generation ago in the wake of the Maastricht Treaty. As such, it should not be overdramatized. All players involved are playing a complex game of quest for institutional dominance. To use an American word, this week's ruling stops well short of outright nullification. The GFCC does not directly question the primacy of EU law.

Even so, this step marks an escalation, if only because it’s the first time that the GFCC labels a decision of the Court of Justice of the European Union (CJEU) to be ultra vires, beyond its powers. It also has impact on euro-area monetary policy. To a large extent, the ECB is taking stray bullets from the raw turf warfare between the GFCC and CJEU. The GFCC is not substantially interested in monetary policy, nor does it ostensibly understand it.

In the immediate short term, the pressure is on the Bundesbank, which has three months to decide on which side it stands, possibly subject to other players’ moves in the meantime. If it keeps participating in the Eurosystem’s Public Sector Purchase Program, it risks being blamed and possibly sued for non-compliance with the GFCC’s instructions. But if it exits the program (arguably only then), Germany could be sued by the European Commission for infringement of EU law.

This case raises profound questions about the sustainability of the euro and beyond it, of the European Union itself. But don’t expect these questions to be settled anytime soon. Rather, expect more lawsuits.

Is the United States Reneging on International Financial Standards?

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

The financial shock surrounding the COVID-19 pandemic has prompted the US Federal Reserve to temporarily loosen an important capital-to-asset ratio requirement for American banks. In so doing, the US is walking away from a decade-long commitment to global financial reform that it made in the wake of the global economic meltdown of 2008-10.

This breach, together with other recent US government actions, might signal a broader departure from the Trump administration’s general adherence in its first three years to international financial standards, an area in which it had so far not acted against the global rules-based order. The motives for the breaches are not compelling enough to offset the downsides for the global financial system and for the United States itself.

The new Fed rule breaches the Basel III Accord

On 1 April, the Federal Reserve announced a temporary change to a regulatory requirement on banks, known as the supplementary leverage ratio (or simply the leverage ratio). The leverage ratio, calculated as regulatory capital (or own funds) divided by unweighted assets, supplements the more refined ratios of capital to risk-weighted assets, which are the mainstay of bank capital regulation. While a crude measure of capital strength, the leverage ratio is an apt response to the incentives banks have to underestimate risk-weights. It acts as a simple sanity check, thus the epithet ‘supplementary.’

The new change, which the Fed adopted unanimously, exempts banks’ holdings of US sovereign debt (Treasuries) and deposits at the Fed from the assets total in the ratio calculation, until end-March 2021. This exemption reduces the denominator, making it easier for banks to meet their minimum-ratio requirements during that period. By exempting sovereign exposures, the rule deviates from the internationally agreed definition of the leverage ratio that is part of the Basel III accord, initially published in 2010 by the Basel Committee of Banking Supervision on the back of a mandate given by the G20 in 2008-09.

The Fed’s decision echoes separate congressional action in the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which was signed into law on 27 March 2020. Section 4014 of CARES gives banks the option of ignoring an accounting obligation known as current expected credit loss (CECL) provisioning. Most banks started implementing this obligation in January 2020. CECL was introduced in response to a 2009 mandate from the G20, which was implemented in 2016 by the US Financial Accounting Standards Board (FASB), and separately earlier in 2014 by the International Accounting Standards Board (IASB), whose standards are applied in most jurisdictions other than the United States. By opting out of CECL, banks can avoid booking losses that are expected from the dramatic deterioration in the economic outlook from the pandemic and can thus make their capital positions look correspondingly more flattering.

The Fed’s rule change and the Congress’s action in the CARES Act suggest an incipient trend of US departures from the comprehensive package of global financial standards enacted by various bodies under the G20’s authority since 2008. One earlier signal of this came in November 2019, when the Fed and other federal bank regulators made a change – also in breach of Basel III – to an arcane rule on measuring counterparty credit risk in certain transactions.

To be sure, the United States is far from the only offender, let alone the worst. Most notoriously, in 2014, the Basel Committee found the European Union “materially non-compliant” with Basel III, the only jurisdiction in that category – partly for similar counterparty-credit-risk shenanigans as with the US rule of November 2019. Nor are the recent American breaches wholly unprecedented, if one goes far enough back. In the years before the 2008-10 financial crash, US authorities were reluctant to adopt the previous Basel II accord, for prudential reasons that the subsequent crisis experience largely vindicated. But from the first G20 summit in late 2008 up to recent months, the United States was the leading champion of G20 financial reform, and that compliant stance was maintained under the first few years of the Trump administration. Even as some financial rules were relaxed, they were kept above the minimum levels set in international accords. Indeed, the final bits of Basel III were agreed in December 2017 after Randal Quarles, a Trump appointee, replaced his Obama-era predecessor Daniel Tarullo as the Fed’s point person in Basel Committee discussions.

The motivations for these changes are unconvincing

The US departures from global standards respond to specific demands from the US banking industry and some federal agencies, but whether they are in the US national interest is questionable. The experience so far of the COVID-19 crisis is precisely that strong capital standards, such as Basel III, are helpful protections against unforeseen events. Globally-applied minimum prudential standards ensure a degree of international financial stability from which the United States benefits. Standards also prevent the most blatant competitive distortions in international banking markets – a key driver of the first Basel accord in the 1980s. It is not clear that the leverage ratio breach has benefits that offset the loss of such advantages.

The motivations for the Fed’s new rule appear to include the fact that the pandemic-induced volatility has disrupted the Treasuries market and has also resulted in a sudden influx of deposits into US banks. If banks are less constrained by the leverage ratio limit, so the thinking appears to go, they can buy more Treasuries and thus contribute to more orderly markets. But it is doubtful that leverage-ratio-related constraints played any role in the recent Treasuries market turmoil. As for the incoming deposits, banks can place them into deposits at the Federal Reserve, rather than Treasuries. A temporary exemption for such central bank deposits from the leverage ratio would not have breached Basel III in its current form. Moreover, the exemption for US sovereign exposures creates a highly problematic precedent that other jurisdictions with less creditworthy sovereign issuers might now be tempted to emulate, against the Basel Committee’s efforts to move its members towards consensus on a more rigorous recognition of the risks that such exposures might carry. Similarly, concerns about procyclical impacts of CECL could and should have been addressed by using the standard’s embedded flexibilities, similar to what was recommended outside the United States by the IASB and implemented by the euro area and the United Kingdom, among others.

By breaching G20 standards, these decisions contribute to institutional erosion at the global level and domestically. The breaches of Basel III are especially galling since Quarles now chairs the Financial Stability Board, an umbrella body whose permanent secretariat is located in the same building in Basel as the Basel Committee. On the domestic front, the Fed also acted alone, as the other federal banking regulators, including the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation, did not endorse its new rule as is customary. The congressional override of FASB (and, in the same move, of the US Securities and Exchange Commission, which delegates to the FASB standard-setting authority), also is without precedent in nearly half a century.

The United States would lose from abandoning global financial standards

Possibly the recent breaches are one-offs, not the start of a broader trend of divergence. In a formal sense, both the Fed’s action on leverage ratio and Congress’s on accounting are temporary measures, even though they could be extended. They could, however, mirror a broader current pattern of the United States undermining the global rules-based order, from which the financial services area has been somehow ring-fenced until now. Be that as it may, these breaches are bad news for the authority of the G20, the Financial Stability Board and the Basel Committee, but are probably not crippling. Just as US agencies did not implement Basel II, and the FASB has declined to converge its standards with the IASB’s global standards, global financial standard-setting bodies can probably live with US lapses of compliance, at least for some time. It remains to be seen, however, how the implementation of the final piece of Basel III, which the Basel Committee has recently decided to delay by a year because of the COVID-19 pandemic, will be ultimately affected by an eclipse of US leadership in that area.

If the noncompliance trend is confirmed, the most damaging consequences could be to the United States itself. The chair of the foundation that hosts and oversees the FASB, in a letter that unsuccessfully attempted to persuade Congress not to pass Section 4014 of the CARES Act, argued that the action “fundamentally undermines the longstanding and time-tested approach in the U.S. to transparent, rigorous and independent accounting standard-setting, which market participants rely upon and that plays a critical role in supporting our capital markets and broader economy.”

The United States has benefited immensely from upholding best-in-class financial standards and regulations. If these standards are lowered, US economic achievements, all things equal, might be undermined as well.

Banks in the Pandemic Turmoil: Capital Relief Is Welcome, Supervisory Forbearance Is Not

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

Economic disruptions due to the COVID-19 pandemic have compelled bankers on both sides of the Atlantic to call for relaxation of accounting standards that were introduced in the wake of the global financial crisis. These standards, known as expected credit loss provisioning, were intended to limit procyclicality, namely the exacerbation of shifts in asset prices as a result of the application of accounting and/or regulatory requirements. Policymakers and accounting standard-setters should refrain from changing the applicable standards in haste and should ignore the bankers’ admonishments. There is no perfect accounting thermometer for credit risk in banks’ loan books, but breaking the current thermometer in the midst of a crisis would do more harm than good.

Expected Loss vs Incurred Loss Provisioning

Because there are two main sets of accounting standard in the world, the debate on expected credit loss provisioning is actually two different debates echoing each other. In the United States, accounting standards are set by the US Financial Accounting Standards Board (FASB), a nonprofit body overseen by the Securities and Exchange Commission (SEC). The relevant FASB standard is Accounting Standards Update (ASU) 2016-13, Measurement of Credit Losses on Financial Instruments. ASU 2016-13 just entered into force for large listed banks, since it is to be applied on financial statements starting on or after December 15, 2019. Following a further update in November 2019 by the FASB, the corresponding date for smaller banks (all large US banks being publicly listed) is December 15, 2022.

In the rest of the world, most large banks use International Financial Reporting Standards (IFRS) set by the International Accounting Standards Board (IASB), a global standard-setting body hosted by the nonprofit IFRS Foundation. The relevant IFRS standard is IFRS 9 on Financial Instruments, issued by the IASB in November 2013 and endorsed three years later by the European Union, among other jurisdictions. IFRS 9 has been implemented for some time since it became effective for annual periods starting on or after January 1, 2018.

The FASB and IASB issued these standards on expected loss provisioning in response to prodding from public authorities through the Financial Stability Forum (now the Financial Stability Board, FSB) as early as March 2009 as the global financial crisis was raging. At that time central banks and financial ministries felt that the existing method, known as incurred loss provisioning, was leading to excessive procyclical effects when losses were indeed incurred. It is better instead, the concept went, to book a provision early on, as soon as the loss is foreseeable even if no repayment has been missed yet. There was controversy from the start on whether that might lead to a different but equally problematic pattern of procyclicality. After several years of debating it, however, the two standard-setters obliged, and research published in 2017 by the Bank for International Settlements (which hosts the FSB secretariat in Basel) concluded that the new standards had indeed been the right thing to do.

Predictably, however, banks were never enthusiastic about having to book losses earlier than under the previous methods and lobbied heavily against it on both sides of the Atlantic. Such lobbying has been predictably revived by the coronavirus shock, together with calls for more general suspension of credit loss provisioning—in other words, the recognition that loans are becoming bad, namely nonperforming loans (NPLs).

Various political and institutional figures have relayed these calls, including at the EU level the president of the European Economic and Social Committee, an advisory body. In the United States, the Federal Deposit Insurance Corporation (FDIC) has endorsed them in a March 19 letter to the FASB, with support from the Conference of State Bank Supervisors. The FDIC suggests both further delaying the implementation date of ASU 2016-13 for smaller banks and giving larger banks an “option to postpone [its] implementation.” Importantly, the other major US federal bank regulators, the Federal Reserve and Office of the Comptroller of the Currency, appear not to have echoed these calls, at least in the public sphere—which is worth noting as other recent statements on prudential policy have been made jointly by all federal regulators, as is customary.

Hasty Changes to Accounting Standards and Supervisory Forbearance Are the Wrong Responses

Such calls should not be heeded. As of mid-March in both the euro area and the United States, banks have been granted very significant capital relief—namely, they can let losses eat into their capital buffers as these have been built up significantly over the last decade in application of the global prudential accord known as Basel III. This welcome action implies that banks have a considerable capacity to absorb losses in the near future, without breaching their regulatory and supervisory capital requirements. No miracles will (or, in fact, should) happen in terms of credit expansion, given the parlous economy, but credit will not unduly contract as an effect of procyclical regulatory constraints, and financial stability is protected. These decisions were made swiftly—not least in the euro area, where European Central Bank (ECB) Banking Supervision was able to act at a pace that would have been impossible in the pre–banking union era, given challenges of coordination and stigma effects. Banking union remains of course unfinished and has not achieved its stated aim of breaking the bank-sovereign vicious circle, but this episode demonstrates its tangible benefits.

Because the capital relief allows banks to absorb losses, changing the loan loss provisioning method now is unnecessary. It is also undesirable, because there is significant value in reassuring investors and the broader public that banks are not allowed to hide bad news and move stealthily towards “zombie” status. At a more basic political level, this is not the time to give banks special favors if these can be avoided. Longstanding experience suggests that supervisory forbearance—namely, allowing banks to pretend they meet regulatory requirements when from an economic standpoint they don’t—should be considered only as a last resort. It is not justified under the present circumstances. (Loan forbearance by the banks themselves, namely letting borrowers miss scheduled payments without triggering collateral execution, is a separate matter.)

In the euro area, there is an additional dimension given the ongoing discussion about cross-border risk-sharing and solidarity. While political difficulties abound, there is willingness to share some of the burden of fighting the pandemic and preventing economic collapse—but that cannot be expected to extend to bank rescues. Italy is at the center of current concerns, because of both its high sovereign indebtedness and its tragic exposure to the pandemic. The Italian Banking Association has lobbied for supervisory forbearance. Italy’s true priorities do not lie there.

In the euro area, the ECB has complemented its March 12 capital relief decision with additional guidance on March 20, allowing banks to provision as few losses as possible within the constraints of IFRS 9 and providing favorable interpretations on related matters, e.g., not classifying loans in arrears as NPLs if they are covered by a government guarantee. Simultaneously, the ECB has made it explicit that it rejects “forbearance for NPLs” and that “[i]t remains crucial, in times of distress, to continue identifying and reporting asset quality deterioration and the build-up of NPLs in accordance with the existing rules, so as to maintain a clear and accurate picture of risks in the banking sector.” In the United Kingdom, the Bank of England has taken a similar stance.

In the United States, the FASB should resist the FDIC’s pressure to exempt large banks from implementation of ASU 2016-13. Smaller banks are a less critical concern, with potential space for compromise on implementation schedules.

The Basel III Experience

The last few days have spectacularly illustrated the ancient wisdom that bank lobbying on capital and accounting should generally be resisted in the public interest. Banks had lobbied tooth and nail against Basel III, its multiple buffers, and related constraints on capital, leverage, and liquidity. But having these buffers in place is precisely why authorities have been able to provide a credible response (so far) to concerns about banking sector stability in the pandemic crisis.  

Authorities should implement Basel III’s remaining items in due course and steadfastly resist appeals for supervisory forbearance. The banking system is critical to society and requires due attention and support. But in doing so, tough love is preferable to complacency.

A European AML Supervisor: From Vision to Legislation

This blog post co-authored with Josh Kirschenbaum was published today by the Peterson Institute. 

Update (January 24): the same text was published today by Bruegel. 

The European Union is moving toward implementing a policy to strengthen anti–money laundering (AML) supervision across its Single Market, namely enforcing requirements on banks and other firms to ensure they do not facilitate transactions involving proceeds from illegal activities. The European Commission, in charge of the next steps, should act fast to capitalize on the political momentum toward creating a central AML supervisory authority, the only credible response to the bloc’s AML challenges. It should present a full proposal to EU co-legislators (i.e., European Parliament and Council) by the summer of 2020.

A joint paper published in November 2019 by six EU finance ministers paved the way for progress. The finance ministers of all EU member states, in the conclusions of their ECOFIN meeting on December 5, “invite[d] the Commission to explore…conferring certain responsibilities and powers for AML supervision to a Union body with an independent structure and direct powers vis-à-vis certain obliged entities chosen by the EU body in accordance with a risk-based approach.” They asked the Commission “to present legislative proposals in that regard in parallel to efforts to achieve a higher level of harmonization through an AML regulation.”

The ministers’ language is clear enough to guide the Commission’s drafting and avoid protracted technical deliberations. Ten key questions call for straightforward answers.

1. Should there be an EU body with a direct AML supervisory mandate? Yes, because an EU-level “supervisor of supervisors” by definition acts too late, as we concluded in a 2018 PIIE Policy Brief. Under the current system, the Paris-based European Banking Authority (EBA) is the EU-level supervisor of national AML supervisors for banks. But it has not prevented or stopped large-scale AML violations and even failed to impose remedial measures in the ill-starred case of Danske Bank. The EU AML supervisor should have the ability to impose fines and business restrictions on noncompliant firms, a tool the EBA lacks even after the recent strengthening of its AML duties.

2. Should this central authority be the European Banking Authority or a new agency? A new EU agency is preferable. The EBA’s existing capacity is too small to make a difference: no more than a dozen AML staff in the current budget. A radical overhaul of its governance and decision-making structure would be required for it to become effective as AML supervisor. Such an overhaul could be more complicated than creating a new agency, because the structure would also need to accommodate the EBA’s other duties as banking regulator. An AML supervisor should also cover nonbank financial firms and even nonfinancial firms someday. Creating another EU agency should not be undertaken lightly, but AML supervision is important enough to justify it.

3. How should that new agency be designed? It should be an authoritative and independent supervisor that can judge each case’s merits without regard to diplomatic balancing acts. Independence will likely lead to more aggressive supervision, larger fines, and greater deterrence. A compact decision-making board of at most half a dozen members would be appropriate, following the precedent of the Single Resolution Board (SRB), which was established on the same EU Treaty basis.

4. Where should it be located? This is ultimately a political decision. A city with an active labor market for financial and legal specialists—perhaps a medium-sized financial center in post-Brexit European Union—would make sense.

5. How should it be funded? As is customary for financial supervisors, the agency’s funding should be raised via a levy on the financial industry under due EU parliamentary scrutiny, separate from the general budget of the European Union. To succeed, it probably needs a staff of  500 to 1,000, including dedicated “country desks” to enable proper communication with the judiciary and law enforcement communities in each member state, a feature that was not deemed necessary for the SRB or the European Central Bank’s prudential supervisory arm known as the Single Supervisory Mechanism (SSM). This would make the new AML agency staff a bit smaller than the SSM staff of about 1,100 at the ECB.

6. When should it start? As soon as is practical but not rushed, because it must be fully operational from day one. At least two years of preparation may be needed after the legislation is enacted. Assuming a Commission proposal in August 2020 and 18 months of legislative discussion, the transfer of supervisory authority could take place in the first half of 2024.

7. Which entities should be directly supervised by the central body? This is a potentially contentious issue, but the ECOFIN conclusions’ language already addresses the key choices. The SSM has set a mostly quantitative and nondiscretionary boundary between banks that are directly supervised by the ECB and those that remain under national supervision with only indirect ECB oversight. But a new AML supervisor should be able to make its own determinations, based on its risk assessment utilizing both quantitative and qualitative factors, with no presumption from pre-set mechanical criteria that would be easily circumvented by malicious actors. This different reading of the principles of proportionality and subsidiarity is justified because prudential supervisors examine the haystack, but AML supervisors look for the needles: The worst behavior is often channeled through small institutions. If the incentives are right, the new EU agency should focus its time and resources on problematic firms, market segments, and member states (large or small). Conversely, it may choose to conduct no direct supervision whatsoever in member states where the national authority does an excellent job and AML risks are assessed to be low. Proper drafting of the legislation can establish such risk-based differentiation while complying with EU jurisprudence on decision-making autonomy by EU agencies, especially the Meroni and ESMA short selling cases.

8. Should there be an AML Regulation to complement or replace the existing AML Directives, and what should it include? Harmonization is needed, as the December ECOFIN conclusions hint, by way of an AML Regulation (immediately applicable EU law) and modification to existing directives that would create the “single rulebook,” which the new AML supervisor would enforce. This must include requirements on supervised firms in terms of AML program, customer due diligence, and reporting obligations, as well as fines for noncompliance. The legislation should also lift any legal obstacles to proper information sharing between the new supervisor and its counterparts in the member states, including Financial Intelligence Units (FIUs). Even so, the best can be the enemy of the good, and the regulation should only cover items that are indispensable to set up the new body. Other harmonization efforts that are desirable but not critical may be left to a later legislative phase.

9. Can that AML Regulation and the legislation establishing the new AML supervisor be enacted simultaneously? Yes—in fact, they could be pooled in a single legislative act. A sequential approach would lose momentum and risk jeopardizing the entire reform effort. Here again the ECOFIN conclusions send the right signal by recommending the proposal for the new agency “in parallel” to harmonization.

10. Should the reform include an EU-level Financial Intelligence Unit? No, because such a step is less urgent and more complicated than creating a central AML supervisor. The major AML lapses of the past few years in the European Union have ostensibly involved failures of AML supervision, rather than of the FIU functions of collecting, transmitting, and analyzing information on suspicious transactions. Centralizing the FIU function may be desirable in the longer term but trying to do so now would burden and possibly cripple the urgent effort to establish an effective European AML supervisor.

The European Commission should consult widely in the spring and propose legislation this summer, no more than nine months after the December ECOFIN conclusions. As for precedent for such a timetable, the Commission was unexpectedly asked for a proposal to establish the SSM on June 29, 2012 and published it on September 12, and that project ventured into much less charted waters than AML supervision. If the Commission further delays, it would risk losing the current reform opportunity. That would be bad for the EU financial system’s integrity, and for all of Europe.

A Major Step Toward Combating Money Laundering in Europe

This blog post co-authored with Joshua Kirschenbaum was published today by PIIE. 

Update (November 25): the same text was published today by Bruegel. 

The struggle to combat money laundering in Europe took a momentous step forward on November 8 when the finance ministers of France, Germany, Italy, Latvia, the Netherlands, and Spain put forward a joint position paper. Their proposal is likely to pave the way for strong European Union legislation, buttressing the credibility of the new European Commission led by Ursula von der Leyen.

Adopting this proposal would create, for the first time, a centralized anti–money laundering (AML) supervisor with EU-wide authority in Europe. It is an apt response to a recent series of embarrassing revelations of AML failures. These highly publicized lapses started with the collapse of Latvia’s ABLV Bank after the US Treasury determined in February 2018 that it was “of primary money laundering concern.” Following that wake-up call, other AML shortcomings have emerged involving European banks. These include large ones like ABN Amro, Danske Bank, ING, Raiffeisen, and Swedbank, and smaller banks in Cyprus, Estonia, Malta, and Latvia, among others.

The six countries’ joint paper came after an initial policy response that was quick by EU standards, but sadly underwhelming. In September 2018, the European Commission president Jean-Claude Juncker proposed strengthening the AML coordinating role of the European Banking Authority (EBA), an EU agency that brings together banking supervisors of all EU member states. The corresponding legislation was approved a few months later. But it left two major flaws uncorrected. First, the EBA is a “supervisor of supervisors” that only steps in (if at all) after national supervision failures become evident, too late to deter misbehavior, and that offers national supervisors little incentive to cooperate. Second, the EBA’s intergovernmental governance is weak when it comes to remedial action, as the EBA’s board of supervisors demonstrated when it rejected in April 2019 a staff recommendation to pursue the Danske Bank case.

That episode strengthened the backbone of several key participants. The Dutch government led by proposing a European AML supervisor in July 2019—the joint paper borrows substantially from this proposal. Later in July, the European Commission candidly reported recent AML failures and hinted at further reform. Meanwhile, senior policymakers including then-ECB President Mario Draghi, top ECB banking supervisor Andrea Enria, and European Commissioner Valdis Dombrovskis have called for a European AML supervisor. As we argued in a Policy Brief last year, an authoritative AML supervisor at the European level is a necessity if the EU is to be effective and credible in this area.

The combined political heft of the EU’s largest countries, other than the United Kingdom, now adds to this momentum with the finance ministers' joint paper. Its main thrust is to call for a “supervisory mechanism,” akin to the Single Supervisory Mechanism (SSM) that exists for the prudential supervision of banks, and thus “featuring a European central supervisor cooperating with national supervisory authorities.” That European AML supervisor could be either a new EU agency, with Article 114 of the Treaty on the Functioning of the European Union (TFEU) its presumed legal basis, or the EBA. In the latter option, however, the joint paper makes it clear that a comprehensive overhaul of the EBA’s governance would be needed “to guarantee the required level of independence” as the paper delicately puts it—a task arguably as complex as a new institutional creation. The political issue underlying the choice between the two options, as with any EU agency, is location. The EBA would presumably remain in Paris, while a new agency could be in any member state.

As with the SSM, the EU supervisor would have direct authority over some financial firms and would thus not be a mere supervisor-of-supervisors on the current EBA model. The joint paper states that:

“Establishing a central supervisor that can supersede national supervisors and can independently conduct supervision is necessary to ensure consistent and effective European [AML] supervision. […] the European supervisor, having performed a thorough risk assessment in cooperation with the national supervisors, would concentrate its direct supervision, resources and efforts on the riskiest institutions as well as on the member states and areas where national supervision is apparently insufficient or inappropriate.”

As this text makes clear despite the convoluted syntax, the EU supervisor itself would choose which firms are supervised directly. Importantly, it would therefore not have to rely on the crippling process of achieving consensus with national authorities or on uniform criteria easily circumvented by bad actors.

On the latter point, the joint paper improves on the Dutch contribution in July, which called for “objective criteria” to characterize risk. Observable metrics should of course enter the assessment, but the decision on which entities to supervise should rest on the European supervisor’s judgment. The context is very different from the SSM’s, where smaller banks are generally left to national supervision. A proportionality-based approach that may be apt for prudential supervision cannot apply in AML supervision, because major AML violations often happen in smaller firms that have otherwise no systemic relevance. Prudential supervisors look at the haystack, but AML supervisors have to look for the needles.

Direct supervisory authority also implies that the EU supervisor could impose administrative fines for violations of the AML framework, big enough to dissuade bad behavior, though the joint paper does not state that explicitly. There is established precedent: The European Securities and Market Authority (ESMA) imposes fines on entities it supervises, based on the same Article 114 TFEU.¹

The joint paper also suggests further harmonization of the AML regulatory framework in EU law. A directly applicable EU regulation would replace some legislation that currently requires transposition into national law. This step makes sense, but it should not be used to delay the establishment of the European central supervisor. Both tasks would be best addressed together.

These actions will not be a panacea. Later endeavors could include more coordination of the financial-intelligence-unit function at the EU level, and linkages between AML and EU sanctions. These must be preceded by improvements of the police, judiciary, security, and intelligence capabilities at the EU level. The establishment of a European AML supervisor will help pave the way for such future, more complex changes.

As for the UK, for as long as it stays in the single market it must be included in the EU AML supervisory mechanism. If and when it leaves the single market, a lower probability than leaving the EU, tailored arrangements will be needed. Unfortunately, the UK did not co-sign the joint paper, but one hopes it will play a constructive role in the next steps.

Given the impetus from the joint paper, EU member states can and probably will formalize a strong European AML supervisory mechanism before year-end, and the European Commission could make a legislative proposal in the first half of 2020. Since AML supervision is as much a security challenge for the European Union as a regulatory one, it will buttress the von-der-Leyen-led European Commission’s credibility as a “geopolitical Commission.” It may also help create momentum for further shoring up the EU financial supervisory architecture, including the reform of ESMA to transform it into a truly independent supervisor and the completion of the banking union. The joint paper is bad news for money launderers and good news for Europe.

1. Note: One of the authors (Véron) is an independent non-executive director at DTCC Derivatives Repository plc, an entity under the direct supervision of ESMA.

Brexit and Finance: Brace for No Impact

This text was published last week by Milan-based think tank ISPI on the occasion of its Forum on Multilateralism. 

Updates: the same text was just republished by Bruegel (October 14) and by PIIE (Oct. 15). 

Amid the daily high drama of Brexit, it is easy to lose track of the structural shifts, or lack thereof, that may be associated with the UK’s possible departure from the European Union. One of them, and not the least, is the potential impact on the European and global financial system. London is currently the undisputed financial hub of Europe of the broader region encompassing the Middle East and Africa; together with New York, it is one of the two still-leading financial centers worldwide, despite the ongoing rise of Asia and especially China. How does an event as momentous as Brexit interfere with this critical regional and global role of the United Kingdom?

The answer so far is: not much, and looking forward, probably not much more. Massive as the political shock of Brexit is, the European and global financial systems are intriguingly resilient to it.

To understand why, it is necessary to go beyond the in/out dichotomy that dominates the Brexit debate, and to understand at a more granular level what changes or doesn’t at different points of the different scenarios. Seen through the lens of the financial sector, the complex arborescence of possible UK futures boils down to two relatively simple observations.

First, the really decisive choice for the UK, from a financial-sector standpoint, is not whether or not to leave the European Union, but whether or not to leave its Internal (or single) market. The single market is closely associated with the EU construct and is defined by compliance by EU law, but its boundaries are broader than the Union’s. For example, Norway is in the single market without being an EU member state, and the same would be true of the UK during the transition period defined by the Withdrawal Agreement endorsed almost a year ago by Theresa May’s government. While being or not in the Union makes a major difference for UK officials who will no longer sit at the EU policymaking table if the UK leaves, it makes little differences to financial firms as long as single market membership is preserved, with the regulatory “passports” that come with it. So far, beyond responding to specific requests from supervisory authorities, most financial firms have appear to act on the baseline assumption that the UK is staying in the single market over their business planning horizon, and have correspondingly not made major changes to their operations even as they have sought new licenses to operate in the European Union outside of the UK.

Second, leaving the European single market would be severely detrimental to the UK as a regional and global financial hub. The loss of passporting rights would mean, to summarize a complex arrays of different situations, that the UK will no longer be the best place in its time zone to conduct financial business. In the benchmarking with the best competing locations within the post-Brexit European Union, the comparative advantages of the UK, significant as they are in matters such as language, culture, and the legal environment, would not be enough to offset the disadvantage of not being in the single market. As a consequence, new investment would be overwhelmingly directed elsewhere than to the UK, and there would most likely also be some direct transfers of activity from London to other European locations – in contrast to what has happened so far.

As a consequence, it appears highly likely that the UK will remain in the single market, even if it ends up leaving the European Union. The 2016 referendum was about leaving the EU, not the single market. Leaving the single market is too much pain for too little gain. And if the UK stays in the single market, its financial sector can and probably will keep its leading position regionally and globally.

If however, by an improbable twist of political dynamics, the UK does leave the European single market – a “hard Brexit” as the expression tends to be used – then the consequences may be dire for the UK, but will not be disruptive from a European let alone global perspective. Summarizing again a lot, this is because the core of the City of London is a set of firms that are not structurally dependent on the UK: most are international arms of firms headquartered in the United States, or in Asia, or indeed in Continental Europe. For these firms, if London loses its edge, relocating elsewhere will be annoying and costly but by no means impossible. And one can be confident that European and other authorities will do what is needed to facilitate an orderly transition, because they have no interest in financial instability.

There are a number of challenges in today’s world which could turn out to be transformative for the global financial system. Brexit is not one of them.

Questions on financial services policy for Valdis Dombrovskis

This blog post was published on Monday by Bruegel, ahead of the European Parliament's hearing of Executive Vice-President-designate of the European Commission Valdis Dombrovskis scheduled for October 8. 

Update (october 7): a near identical version was published by the Peterson Institute. 

Completing the banking union is the dominant task in the financial services area for the next five years. In the short term, the Commission should affirm its leadership by pushing for the creation of a credible EU anti-money laundering supervisory agency.

Mr Dombrovskis’s designated portfolio as “Executive Vice-President for an economy that works for people” covers a wide array of issues, including economic and monetary affairs and trade which are covered in separate blog posts in this series, as well as jobs and cohesion policies. Nevertheless, the allocation of supporting services gives him direct and sole authority over DG FISMA (the European Commission’s Directorate-General for Financial Services, Financial Services and Capital Markets Union), and his mission letter from President-elect Ursula von der Leyen confirms that this area has a special status within his portfolio.

This post, echoing the memo on the same scope that was recently published by Bruegel, is thus focused on financial services policy. In this area, Mr Dombrovskis can hit the ground running, as he took it over from Commissioner Jonathan Hill in 2016 following the latter’s resignation.

As the memo makes clear, the reform agenda is dominated by the unfinished banking union, whose completion is highlighted by Ms von der Leyen both in her political guidelines and in Mr Dombrovskis’s mission letter. Mr Dombrovskis should not aim at upgrading the current halfway house of banking union to an incrementally better halfway house, but at genuinely finishing the job – i.e. breaking the notorious vicious circle between banks and sovereigns, which in 2011-2012 has been correctly identified by policymakers as the true engine of the euro crisis. This is a difficult task that will require a lot of dedication: if it is not granted clear priority, it will fail. Fortunately, it is far from impossible: completing the banking union (which means not eliminating all structural differences among member states in terms of banking services, but only decorrelating banking credit from sovereign credit) can be achieving without treaty change, and without any major steps towards fiscal union.

In comparison, the “capital markets union” (CMU) is a valuable vision, but should not be a diversion from the main task of banking union. A true CMU can only be viewed as a very long-term project, and cannot really start as long as banking union remains unfinished.

An exception to this order of priorities, however, could and should be made for the fight against money laundering, given the issue’s recent salience and its resonance with Ms von der Leyen’s ambition of a “geopolitical Commission”. This makes a strong case for an early initiative. Thus the following questions.

1. Will you create a credible EU Anti-Money Laundering (AML) supervisory capability?

The current AML supervisory system in the EU is failing for structural reasons, as the Commission’s own analysis has compellingly established. The time is not for another incremental attempt at tweaking the existing system, as was done a year ago, but at a structural solution. The priority is the architecture for AML supervision, namely making sure that banks and other obliged entities have the right systems in place and operate them properly. The creation of a European AML Supervisory Authority is the simplest and most compelling answer to this challenge and should be undertaken without delay.

2. What is your strategy to complete the banking union?

Even as the Juncker Commission has not achieved major legislative steps towards a more complete banking union, there has been progress in the past five years. The initial banking union package of Single Supervisory Mechanism (SSM) and Single Resolution Mechanism (SRM) has entered into force, with early successes and failures that help to better identify the missing bits. There has also been a lot of debate that has brought further analytical clarity. The agenda can thus be distilled around three sub-questions.

2.1 How will you address the challenge of concentrated sovereign exposures?

The home bias in banks’ sovereign exposures is a well-known problem, but in recent years there has been a reluctance to tackle it head-on as the euro-area-specific challenge it is. If “domestic” banks can still be persuaded by governments to grant them preferential credit, there can be no political consensus on further euro-area-wide risk-sharing. To lift this roadblock, the Commission may consider the introduction of sovereign concentration charges. By specifically targeting sovereign concentration risk, these address the bank-sovereign vicious circle while avoiding the difficulties associated with an explicit regulatory recognition of sovereign credit risk, an issue that unlike the home bias is not specific to the euro area.

2.2 How will you build a credible European-level safety net, so that national public guarantees on banks can be effectively dismantled?

One lesson of the Great Financial Crisis is the necessity of a public safety net for the banking system. This should be kept to the minimum necessary, and set the right incentives. For the banking union to be completed, it needs to exist at the European (essentially, euro-area) level. That entails a genuine European Deposit Insurance Scheme – i.e. one that does not in any way make the insurance of deposits up to €100,000 conditional on national decisions – but also instruments to manage systemic crises, such as liquidity guarantees for sound banks. Correspondingly, the regime for non-viable banks, which includes the resolution framework but also national bank insolvency proceedings and the state aid control regime, must be reformed holistically to become more consistent and predictable.

2.3 How does the reformed framework remove the current disincentives against cross-border banking integration?

The persistence of a national mandate for deposit insurance and bank crisis management is the key reason why banks are prevented by regulators from adopting a seamless banking-union-wide management of their capital and liquidity.

3. Will you reform the governance and funding of ESMA?

The European Securities and Markets Authority (ESMA) is positioned to become the catalyst of CMU, but it was not initially designed to be a credible supervisor of financial markets and entities such as financial infrastructures, a role it is playing increasingly and should play even more in the future. Building on the experiences of the SSM and SRM, its governance and funding must be comprehensively reformed so that it becomes a genuine independent agency to oversee Europe’s capital markets. By contrast, reforms of the sister agencies EBA (European Banking Authority) and EIOPA (European Insurance and Occupational Pensions Authority) are less urgent.

4. Will you honour the EU’s commitments to global financial standards?

In line with the vision of the “geopolitical commission”, the EU should bolster its leadership as the “guardian of multilateralism”, again quoting from Ms von der Leyen. It should fully adopt the Basel accord on banking regulation, including its latest developments, and phase out the remaining “carve-outs” from its adoption of International Financial Reporting Standards. It should also streamline its representation in international bodies such as the Financial Stability Board and the Basel Committee, reflecting the institutional changes generated by the pooling of bank supervisory policymaking within the SSM.

Banking, FinTech, Big Tech: Emerging challenges for financial policymakers

This text was published yesterday on Vox following the prior publication this week of the Geneva Report 22. 

Update (October 7): the same text was reposted in late September by Bruegel and the Peterson Institute. 

FinTech (financial technology) firms, generally start-ups that offer a specifically targeted financial service, and Big Techs, globally active technology firms with a relative advantage in digital technology that may add financial services to their range of offerings, are both increasingly – though differentially – stepping on banks’ traditional turf. Currently, financial services are only a small part of Big Tech’s global business. However, given their size and customer reach, Big Techs’ entry into finance has the potential to spark rapid change in the industry. They may even become dominant through their collection of valuable data and their large, established networks (BIS 2019). This has potential wide-spread implications, such as for monetary policy transmission and financial stability (Cœuré 2019), and even the political economy of central banking as we know it (Tucker 2017). The 22nd Geneva Report on the World Economy focuses on the challenges generated by new technology-enabled entrants to the global banking industry and the public authorities that oversee it (Petralia et al. 2019).

Banks have been challenged on their established turf before. In the 19th and 20th centuries, various types of cooperative banks and credit unions grew outside of the traditional banking industry, before being mostly absorbed into the mainstream banking policy framework. More recently, mutual funds have competed with the bank’s deposit-taking function as a safe place to park money. 

The disruption of banking services by FinTech and Big Tech offerings is still at too early a stage to know whether it is just as transformational as such past episodes have been, or something more radical. The speed at which they develop new services in line with customer preferences, their ability for hypergrowth and hopping across jurisdictional borders, and in the case of Big Tech, their potential for leveraging massive established networks of users are awe-inspiring. 

Even so, some features of banking are remarkably stable. Banking assets remain overwhelmingly concentrated in only a handful of jurisdictions. Traditional banking activities still account for more than two-thirds of total revenues of financial institutions, although some of these activities are now performed by non-banks and profits margins are squeezed by the low rate environment. Banks remain dominant in lending and deposit-taking, even as payments is an increasingly contested space. 

While technology and market forces are central to the ongoing disruption, however, they will not be the only or even the main driver of outcomes. Banking is ultimately about money, and money is about public authority – this is why, for centuries, banks have been licensed when they weren’t direct creations of the state. Governments and central banks may be challenged by tech-enabled new entrants, but will not be sidelined by them. The globally coordinated reaction of financial authorities to the Facebook-sponsored Libra initiative demonstrates the point. 

But to respond adequately to the FinTech/Big Tech challenge, authorities will also need to raise their game and enter uncharted territories. We identify three main dimensions to the effort, which are relevant to all jurisdictions even as they take highly diverse forms in different places. 

• Financial stability, which refers to the policies that protect the soundness of the financial system and, by implication, of the monetary system itself, is critical to any sustainable retail banking innovation. It is still unclear how new technologies may generate (or indeed mitigate) financial crisis scenarios, but the massive speed and scale associated with them will open new areas for vigilance if not outright regulation. 
• Competitionis the aim to promote market success, development and efficiency in markets. Recent EU enforcement actions and ongoing debates in the US illustrate how Big Tech will increasingly force fundamental changes in the framework for competition policy, not to mention cross-border security concerns. Competition policy has often been only selectively applied to the banking sector, but the interaction with tech firms is likely to prompt a rethink. 
• Data rights. Banks have traditionally branded themselves as paragons of discretion about their clients’ operations, but the very notions of data privacy, data ownership, and data value are evolving at a rapid pace. While recent events have brought data privacy and protection to the forefront of policy discussion, the world is still far from global agreement on the most appropriate market or societal mix of data rights and access with respect to financial services policy. The EU General Data Protection Regulation (GDPR) is only a harbinger of public debates and legislation to come on how to protect individuals and legal entities from new risks inherent to the data economy. 

For public authorities such as central banks and supervisors, the associated challenges we identify are at least three-fold. 

• First, they must keep pace with technological change – understand it, embrace it in their own organisations, and correspondingly adapt their skillsets and mindsets. Authorities may be faced with the difficult balance between a culture of prudence and attention to detail, which is often essential to delivering on their mandate, and the ability to adapt their frameworks rapidly to a fast-moving environment.
• Second, they will increasingly have to work collaboratively with their peers across the globe as well as with non-financial peers in areas such as competition and data rights, in order to adequately respond to increased salience of Big Tech in the financial system. Alongside their peers, financial authorities will have to define new modes of cross-border coordination and, in some cases, possibly pooling of their mandates when these cannot be effectively fulfilled at the level of each individual jurisdiction. Perhaps more challenging, financial authorities will have to find ways to work with authorities with whom they may have had little or no interaction, or with entities which simply did not exist previously.  The experience of the last two decades in the EU, where financial authorities have had to gradually accept and internalise the growing role of the European Commission’s state aid control, may give a taste of more frictions and adjustments to come. 
• Third, they may increasingly need to consider institutional experimentation to remain able to oversee firms that evolve fast and hop jurisdictional borders. These could include forms of direct supervision that encompass several (if not necessarily all) jurisdictions at once, based on binding legal arrangements beyond the ‘soft law’ or voluntary cooperation that prevails in existing international financial bodies. Here too, the recent EU experience, where supranational supervision has become a reality even though it had long been considered utopian, may provide useful pointers for future initiatives. 

All the same, banking sector policy, like digital services, will certainly stop short of complete global uniformity. The terms of debates on financial stability, competition, and data rights, will not converge in the foreseeable future across jurisdictions such as China, Japan, the EU and the US. International initiatives should aim at finding the right balance, preventing unnecessary fragmentation while adapting their tools to the diversity of collective preferences and political systems. 

References

• Bank for International Settlements (2019), Annual Economic Report, June.
• Coeuré, B (2019), "Update from the Chair of the G7 working group on stablecoins", 18 July.
• Petralia, K, T Philippon, T Rice and N Véron (2019),Banking Disrupted? Financial Intermediation in an Era of Transformational Technology, Geneva Reports on the World Economy 22, ICMB and CEPR. 
• Tucker, P (2017), "The political economy of central banking in the digital age", SUERF Policy Note 13, June.