Nicolas Véron

European Parliament Election Results: The Long View

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

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

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

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

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

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

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

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

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

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

Germany's Savings Banks Are Uniquely Intertwined with Local Politics

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

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

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

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

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

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

1. Elected Politicians Chair Most Sparkassen.

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

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

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

Table 1: Presence of Politicians among Sparkassen Boards and Chairs

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

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

2. Most County Heads Are Involved in Sparkassen.

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

Table 2: Presence of Sparkassen Board Chairs among County Heads

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

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

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

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

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

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

Euro Area Comparative Perspective

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

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

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

 

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

The European Union Must Defend Andreas Georgiou

This post was published today by the Peterson Institute. 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Selected contagion channels between banks and sovereigns in the euro area

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

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

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

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

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

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

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

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

Breaking the Stalemate on European Deposit Insurance

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

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

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

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

EDIS as part of a broader policy package

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

A fully integrated institutional setting

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

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

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

A funding framework that recognizes national differences

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

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

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

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

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

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

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

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

A winning option for all euro-area member states

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

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

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

 

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

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

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

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

Bad News and Good News for the Single Resolution Board

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

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

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

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

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

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

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

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

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

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

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

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

Europe Must Tackle Its Banks’ Sovereign Exposures

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

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

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

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

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

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

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

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

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

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

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

EBA Relocation Should Support a Long-term ‘Twin Peaks’ Vision

This blog post, co-authored with Dirk Schoenmaker, was published today by Bruegel. 

Update (April 10): the same post was also published by the Peterson Institute. 

The European Commission recently published a consultation on the operation of the European Supervisory Authorities (ESAs), the three EU financial regulatory agencies established in 2011. This debate is timely. In the short term, Brexit will force a relocation of the European Banking Authority (EBA), which is currently based in London. Separately, but also as a consequence of Brexit, the European Union needs to rethink its capital markets oversight framework. Following the recent pooling of euro-area banking supervision at the European Central Bank (ECB), it should further separate prudential oversight from the protection of savers, investors and market integrity, thus implementing an institutional concept known in financial regulatory debates as “twin peaks.” In this blog post, we tentatively explore how to bring these strands together in the European Union’s next legislative steps.

The three ESAs are the EBA, the European Insurance and Occupational Pensions Authority (EIOPA), and the European Securities and Markets Authority (ESMA). This sectoral approach of having separate bodies for banking, insurance and securities is a historical legacy. The European Union had set up sectoral committees in the 1990s and 2000s: first came the Forum of European Securities Commissions (FESCO) in 1997, followed by the so-called Lamfalussy Level-3 Committees of the 2000s. After the financial shock of 2007-08, the Larosière Report of February 2009 crystallised a consensus to move one step further towards EU-level policy integration and a “single rulebook.” However, given widespread lingering differences among member states, the Larosière Report opted for the path of least resistance for institutional design, namely to keep the sectoral scope and intergovernmental governance of the three Lamfalussy Committees while transforming them into fully-formed EU agencies with their own legal personality.

In fact, the apparent institutional parallelism between the three agencies was slightly misleading from the start. Not only do they cover different sectors, they also have different roles. Notably, ESMA was quickly granted directly binding powers over several market segments: it is the sole supervisor of credit market agencies and trade repositories,[1] and it also has authority to recognise third-country Central Counterparties (CCPs) for their operation in the European Union. In 2015, ESMA created a dedicated Supervision Department to handle these tasks. The EBA and EIOPA have no comparable competencies.

Almost a decade later, after major developments like banking union and Brexit, it is time to re-examine the ESA architecture. It should be reframed in a long-term vision for EU financial oversight, and this vision should bebased on the ‘twin peaks’ concept. Twin peaks is shorthand for the separation of conduct-of-business supervision from prudential supervision, originally proposed by Michael Taylor in a 1995 pamphlet and since adopted by jurisdictions including Australia, the Netherlands and the UK.

There are three main reasons to support a twin peaks model.

First, Europe’s banks and insurers are often linked in financial conglomerates, which warrants integrated supervision of banking and insurance. Based on end-2015 disclosures, we calculate that bank-insurance conglomerates account for 49% of the aggregate assets of the EU’s 30 largest banks, and for 40% of the assets of its 30 largest insurers. In a crisis, problems may emerge in any part of a financial conglomerate, even though the nature and maturity of liabilities are structurally different between banking and insurance. Since the European Union does not appear to envisage a tighter regulatory separation between banking and insurance, it should move towards more integrated prudential supervision of both sectors. In the same spirit, the European Union should amend its capital requirements legislation to reverse the so-called Copenhagen compromise, which allows for double-counting of the same capital for banking and insurance regulation purposes and does not fully comply with the global standards set by the Basel Committee on Banking Supervision.

Second, the EU27 urgently needs to upgrade the supervision of its capital markets after Brexit. An empowered EU-level markets supervisor – in practice, a reformed ESMA with additional direct authority – is needed to adapt quickly to this new reality, as we argued in an earlier blog post. This would help to revive the EU’s capital markets union, whose rationale is sound but which so far has delivered only limited results. A twin peaks design enhances the importance of the markets supervisor by granting it authority over most aspects of the protection of investors’ and savers’ interests.

Third, prudential supervision and conduct-of-business supervision (including markets supervision) require different mindsets, skills and approaches. Prudential supervision requires staff trained in economics, finance and/or accountancy, while conduct-of-business supervision is more behavioural and legalistic. Conduct-of-business supervision involves policing the conduct of financial institutions in the markets (insider trading, market abuse, disclosure, etc) and towards clients (adequate information provision, duty of care, know your customer, etc). But on these issues, long and sometimes painful experience demonstrates that prudential supervisors often prioritise the interests of supervised entities over those of their customers.

Overlapping tasks between the prudential and markets authorities typically result in the failure to protect savers. This is one of the lessons of the debacle of securities misselling in Italy, with major negative consequences for individual households, for the reputation of banks, for that of public authorities, and for financial stability.

The recommendation for twin peaks is a long-term aspirational goal. Indeed, the treaty basis for ECB banking supervision expressly prevents its extension to insurance. Current national arrangements vary widely. For example, Cyprus, Greece, Italy, Luxembourg, Portugal, Slovenia and Spain have separate insurance supervisors. Moreover, in many member states, conduct-of-business supervision of banks and insurers is at least partly located in the prudential authorities. Nevertheless, defining a long-term goal is important for making the right decisions on short-term issues.

The most urgent priority is the relocation of EBA. Uncertainty about this will have damaging consequences for EBA staff morale and makes recruitment of qualified experts near-impossible. To remedy this, we recommend that the European Union announce a decision on the new location as soon as the late spring or summer of 2017.

We simultaneously caution against recently broached suggestions to merge EBA with either EIOPA or ESMA, which we view as counterproductive. An EBA-EIOPA merger would not achieve twin peaks, since neither agency is actually a supervisor. Instead, it would generate unwieldy governance complexities given the absence of a counterpart to banking union in the insurance space. An EBA-ESMA merger would be even worse, going squarely against the twin-peaks vision and creating damaging conflicts of interest between the conduct-of-business and prudential mandates of the resulting entity. It is also worth recalling that EBA is needed for technical rule-making and supervisory convergence, as long as the banking union framework does not cover all EU member states. EBA is the right venue to balance the interests between the “ins” and “outs” of banking union: as long as there are “outs,” its competencies cannot be directly assumed by the ECB.

Given all these considerations and the operational imperative to come to a decision quickly, we suggest that the 2017 decision on EBA should be only about relocation, and not about any further reform at this stage. Even though the choice of a new location can be expected to be a political one, rather than policy-driven, it is worth noting that having EBA in Frankfurt, even without a merger with EIOPA, would facilitate joint work with both EIOPA and ECB banking supervisors. It would also ease an eventual merger in a hypothetical long-term scenario in which all EU countries would have joined the banking union. Alternatively, EU leaders may opt for locating EBA in a non-euro-area member state, as a signal that the post-Brexit dominance of euro-area banks (which represent about nine-tenth of the EU27’s total banking assets) will not result in the “outs” being ignored in the preparation of banking regulations.

While EBA reform can wait, the reform and further empowerment of ESMA should be an immediate priority for EU leaders. This would give an important sense of direction for EU financial markets policy at  a time when many financial firms need to determine their operational response to Brexit by end-2017 or early 2018. In essence, ESMA’s governance and funding should be reformed to make it more independent and accountable. Its direct authority should be extended to include registration of all EU-critical market infrastructure (in liaison with prudential authorities for CCPs which are systemically important for financial stability, including presumably a legislative empowerment of the ECB and Single Resolution Board in that area); accounting enforcement; audit firm supervision; wholesale market activities of investment banks (under the EU Markets in Financial Instruments legislation); and most conduct-of-business regulatory relations with market authorities outside the European Union.

In accordance with the subsidiarity principle, most other tasks currently lodged in national authorities, such as authorisations for initial public offerings, fund management registrations, and the conduct-of-business supervision of smaller investment and insurance intermediaries to protect retail investors and savers, should remain there for the foreseeable future. However, national authorities should operate under ESMA’s umbrella to ensure EU-wide consistency.

The pooling of conduct-of-business supervision under ESMA’s oversight also implies that an increasing number of financial firms (including banks, insurers and CCPs) will be subject to “double supervision” by both conduct-of-business and prudential authorities. Special interests will surely denounce this duality as unacceptable complexity. But given the different objectives of the two types of supervision, it should be viewed as not only unavoidable, but actually desirable.

The European Commission’s review of Capital Markets Union, scheduled for June 2017, provides an appropriate opportunity to trigger a decision-making process that could result in EU decisions of principle on ESMA reform and further empowerment later this year. Of course, the finalisation and implementation of the corresponding legislation would inevitably take longer.

As for insurance, the EU Solvency II legislation, in force since last year, allows insurers to use their internal models for capital purposes. Given the strong cross-border nature of the large European insurers, EIOPA should become responsible for the approval and monitoring of these internal models. EIOPA might thus get direct supervisory tasks vis-à-vis the large insurers in the European Union.

These decisions would support the long-term vision of a Twin Peaks regulatory framework for the European Union. The completion of that framework would require treaty change, to merge ECB banking supervision with a still-to-be-created EU level of insurance supervision; and an extension of banking union to all EU member states, to allow the duplication between ECB Banking Supervision to be eliminated. None of these two conditions can be expected to be fulfilled any time soon. In the meantime, the swift relocation of EBA, elevation of ESMA into a vigorous conduct-of-business supervisor at the EU level, and gradual build-up of EIOPA direct authority, would together represent a consistent and effective European approach.

 

[1] Disclosure: one of the authors (Nicolas Véron) is an independent board member for a trade repository supervised by ESMA. More details are available here.

To Make the Best of Brexit, the European Union Needs to Beef Up ESMA

This post co-authored with Dirk Schoenmaker was published last week by the Peterson Institute and Bruegel. It emphasizes the first policy recommendation of our recent Policy Brief. 

Given London’s current central role in the European financial system, Brexit will generate significant risks and opportunities for the financial system of the remaining members of the European Union (EU-27). With Britain’s departure from the EU single market nearly certain to occur before mid-2019, the EU-27 should not wait to adapt its financial regulatory structure to successfully manage the resulting shifts. The main risks relate to the supervision of wholesale activities of financial firms and capital markets. To address these risks, European leaders should reinforce the European Securities and Markets Authority (ESMA) with significant additional resources and an expanded responsibilities.

Market disruption is not the main risk for the EU-27’s single market: Most market participants have enough time to prepare for the worst-case scenario of a lack of agreement on “B-day” in early 2019. Rather, the main risk is the market fragmentation along national lines that would occur with the loss of the London hub . Fragmentation could result in less effective market supervision than is currently achieved by the UK authorities, a higher likelihood of misconduct and systemic disturbances, and a more onerous cost of funding for EU-27 corporates and households.

Fortunately, and thanks to wide-ranging reforms introduced during the past years of crisis, the EU-27 is much better equipped to face these challenges than it would have been a decade ago. All euro area banks are now supervised on the prudential side by the European Central Bank (ECB), directly for the larger ones and indirectly for the smaller ones, which minimizes the possibilities of regulatory arbitrage and of a concentration of systemic risk in a given country. However, on market activity and regulation—including securities firms (also known as broker-dealers), asset managers and financial infrastructure, e.g., central counterparties (CCPs, also known as clearing houses)—and the conduct-of-business oversight of banks themselves, the ECB has no jurisdiction. Many wholesale market activities will need to be relocated from the United Kingdom to the EU-27 so that financial firms can keep serving local customers within the single market.

ESMA was created in 2011 to help foster “supervisory convergence” and mitigate the vast existing differences of approaches, experience, and effectiveness between individual member states’ national authorities, such as BaFin in Germany, AMF in France, and Consob in Italy. ESMA also has some direct supervisory authority, but only over comparatively tiny market segments, namely credit rating agencies and trade repositories. ESMA has accumulated a decent track record, but its current mandate is not sufficient to integrate EU-27 capital markets and ensure high standards of compliance with EU regulations.

The obvious solution is to enhance ESMA's responsibilities, especially over those wholesale market segments that are currently concentrated in London and that require uniform, high quality supervision. Recommended expanded responsibilities include the authorization of significant investment intermediaries (e.g., banks and securities firms) under the EU Markets in Financial Instruments Directive and Regulation (MiFID/MiFIR); the registration, supervision, and resolution of CCPs, at least those that serve international clients and have a potentially systemic importance from an EU perspective; and also the supervision of audit firms and the enforcement of International Financial Reporting Standards.

In parallel, the governance and funding of ESMA should be overhauled to better suit an enhanced scope of authority. Its current supervisory board, in which only representatives from national authorities have a vote, should be reformed to include an executive board of, say, five or six full-time members vetted by the European Parliament, as is the case with the ECB and the recently created Brussels-based Single Resolution Board. And in line with international best practices, ESMA’s funding should rely on a small levy on capital markets activity under scrutiny from the European Parliament, instead of the current political bargaining through the general EU budget.

Moreover, ESMA should be the single EU-27 point of contact for all interaction with third-country (non-EU) authorities. It should represent the EU-27 securities regulatory community in international supervisory colleges wherever relevant, and in international standard-setting bodies such as the International Organization of Securities Commissions and the Financial Stability Board. It should also, importantly, be given oversight authority over non-EU financial infrastructure that is systemically important for the European Union, similar to what already exists in the United States. This would allow flexibility in handling the financial stability challenges linked to the location of derivatives transactions, especially those denominated in euros, without having to force a costly relocation of their clearing in the euro area in the short term.

These reforms are significant but can all be achieved within the current treaty framework and without having to wait for the actual UK exit, since they would all take the form of Internal Market legislation approved by a qualified majority vote. In fact, the United Kingdom can be expected to favor them all, for the same reasons it supported the inception of banking union in 2012–14: It is in the interest of the United Kingdom to have a well-regulated, well-supervised EU-27 financial system as its neighbor, for economic growth and financial stability reasons.

There is no compelling counterargument against financial market policy integration, especially now that the early achievements of banking union, including a broadly strong and effective European banking supervision led by the ECB, have provided a “proof of concept.” Significantly, the influential German Council of Economic Advisors (Sachverständigenrat) indicated in its latest annual report that “organizing the supervision of banks, insurance companies and financial markets at [the] European level is the right approach.” The European Commission will review its signature policy of capital markets union in June: This should mark the opportunity to announce the reinforcement of ESMA along the lines suggested above.

Other initiatives are also needed to make the best of Brexit for the EU-27 financial system. In particular, banking union is still an unfinished project that will need strengthening in order to better share the risks and benefits of the forthcoming relocation of financial activity from London. The distracting project of a European Financial Transaction Tax should be either reframed as a stamp duty on securities transactions or abandoned altogether. Most importantly, leaders should make it clear that the inevitable competition among European financial centers to attract business from London should not be based on financial regulatory competition, but on other, nonregulatory factors such as infrastructure, skills, quality of life, as well as labor and tax legislation within the boundaries set by EU law. A swift move towards a stronger, more authoritative ESMA would be the best way to cement this vision.

Not So Low: A Review of Paul Blustein’s Book on the IMF and the Euro Area Crisis

This post was published by the Peterson Institute and by Bruegel on their respective blogs.

The International Monetary Fund’s involvement in the euro area crisis has raised a lot of controversy. According to a widespread conventional view, the “Troika” of creditor institutions—the International Monetary Fund (IMF), the European Commission, and the European Central Bank (ECB)—demanded excessive fiscal austerity of Greece and other errant countries in return for their assistance, and this stance not only failed to restore Greek public credit but also prolonged economic weakness in other countries, including Portugal and Italy. Instead of calling for austerity, according to this view, the IMF should have forced a reduction of Greece’s debt (in other words, engineered an orderly default) from the start of its involvement in the spring of 2010. The IMF is also blamed for ignominiously forcing Ireland to bail out senior bondholders of its failed banks in November 2010 under orders from a dogmatic ECB, itself captured by European financiers.

An educated and comparatively nuanced version of this storyline was masterfully told by Peter Spiegel, then the Brussels bureau chief of the Financial Times, in a 3-part reporting series that was later published as an ebook titled How the Euro Was Saved. A less well-informed version of the same critique is voiced by Nobel Prize laureate Joseph Stiglitz in his recent book The Euro: How a Common Currency Threatens the Future of Europe, variations of which inform opinions on the euro area among (too) many observers in Europe and globally.

Paul Blustein’s useful new book, Laid Low: Inside the Crisis that Overwhelmed Europe and the IMF, at the same time propagates and debunks the conventional wisdom. This ambiguous contribution reflects how far we still are from a settled reference narrative of the euro area crisis. Blustein, a former Washington Post and Wall Street Journal economics reporter, is one of the world’s most seasoned journalistic observers of the IMF and now works for the Centre for International Governance Innovation (CIGI), which is also the book’s publisher. The book’s unique perspective is to observe the euro area crisis through the lens of the IMF, an important though ultimately peripheral protagonist. This leads Blustein to analyse two separate but interconnected issues, the crisis itself and the IMF’s performance in addressing it.

In several ways, Laid Low follows the standard, formulaic, Greece-centered account of the crisis. More than half the book’s chapters are entirely or mostly about Greece. Some major non-Greek episodes involving the IMF, such as the assistance program for Portugal, are near-entirely omitted. The introductory second chapter (chapter 1 being a digression on Strauss-Kahn’s sexual issues) and the concluding chapter 20, as well as the book’s title, embrace a narrative of the Fund “laid low” by abusive political interference from Europe that prevents it from fulfilling its technocratic mandate with philosopher-kingly integrity. Here Blustein refers to an IMF “bruised and enfeebled,” its “credibility sapped” by yielding to Europe’s masters. “One word aptly describes the IMF’s role as junior partner in the Troika: travesty,” he writes in his conclusion.

But in the 17 descriptive chapters between introduction and conclusion, Blustein’s chronicle is too honest to support this indictment. His storytelling is highly engaging, and his reporting is superb. Not only does he bring together an astonishing variety of sources (journalistic, policy, academic), he also adds a number of scoops of his own. For example, he reveals how Strauss-Kahn attempted in April 2011 to walk away from the assistance program for Portugal, which was then being negotiated, unless it included conditions on euro area policy in addition to those on Portugal. (Wolfgang Schäuble, Germany’s finance minister, called Strauss-Kahn’s bluff.) Such new information is significant, since one of the more compelling criticisms made of the IMF is that it never insisted on euro area–level conditionality, an option that is not set out in the IMF’s formal tools but conceivable in the negotiation of individual programs. In the same vein, Blustein reveals that in the fall of 2012, IMF staff had wanted to include direct recapitalization of Cypriot banks by the European Stability Mechanism, a newly-created euro area fund, in the forthcoming assistance program for Cyprus, but that the IMF did not insist on it when EU leaders expressed their reluctance in late 2012.

Against the conventional critique, Blustein demonstrates that, while Strauss-Kahn did envisage a restructuring of Greek sovereign debt in the spring of 2010 (an option known in IMF lore as “plan B”), it was never a genuine option, not least because of the opposition of the Greek government itself. IMF staff was divided on the principle of restructuring, with some departments (e.g. Research and Strategy) maintaining that it would be eventually inevitable and others (most notably Europe and Fiscal Affairs) arguing it might be avoided altogether. Similarly, Blustein refutes the view that the November 2010 decision on Irish banks was the result of a unilateral diktat of the ECB, and correctly emphasizes the role of then US Treasury Secretary Tim Geithner in rejecting a stance of “burning the bondholders” that might have created additional instability in European finance. On a broader level, Laid Low goes some way towards puncturing the fiscal-and-sovereign-debt-only narrative of the euro area crisis, most prominently in chapter 15, which aptly describes the bank-sovereign vicious circle and the inception of Europe’s banking union. From these chapters, the picture that emerges of the IMF is actually that of a strong institution, more able than most large organizations to learn from its mistakes, and generally effective in its engagement with Europe with a constant willingness to challenge the area’s occasionally incompetent leaders. While participating in the Troika, the IMF never compromised its decision-making independence as regards the use of its resources. It was not always right, as Blustein illustrates with the examples of Latvia in 2009 in chapter 4, or of Cyprus in 2013 in chapter 16. But it was often successful and almost always constructive.

To be sure, the IMF was constrained by European politics. But this was the flipside of the fact that in the euro area crisis, for the first time in more than three decades, the IMF has been intervening close to the core of the global financial system rather than in its less systemic periphery. An internal IMF document of January 2012, quoted by Blustein at the start of chapter 14, makes it refreshingly clear: “No economy—whether advanced, emerging or low income—is immune to an escalation of the [euro area] crisis. … Whereas country shocks in the 50 years prior could largely be considered idiosyncratic in that they did not destabilize the entire system, shocks in the advanced economy core … are now effectively systemic.” There can be little doubt that, should it be called to help with a crisis in China or the United States (God forbid), the IMF would not have a fully free hand either—even though China and the United States, unlike Europe, are not overrepresented on the IMF’s executive board. But the mere fact that the Fund intervened in “core” Europe demonstrates its relevance and its strength rather than any weakness. And the constraints on IMF staff and management decisions from the Fund’s shareholders are not a problem but rather the mark of a functioning governance framework. This framework can be improved—for example, by reducing Europe’s unjustifiable executive board overrepresentation as Blustein recommends—but the book does not make it appear fundamentally unsound.

This framing of the IMF’s role in the euro area crisis also provides greater clarity regarding its analytical blunders. If anything, Blustein is often too forgiving of these, perhaps inevitably given his reliance on interviews with current or former IMF staff. The main error on Greece was not to impose excessive austerity, or even to delay the inevitable restructuring. Miranda Xafa, a knowledgeable analyst and former IMF official, calculated that, had this happened in May 2010 instead of March 2012, the additional reduction in public debt would have been around 16 percent of GDP—a significant but hardly decisive difference. The IMF’s bigger mistake was an overestimation of Greece's institutional strength and capacity to reform, a so-called advanced economy, and, as a founding member of the Organization for Economic Cooperation and Development, presumed to be functionally governed. Similarly, the IMF erred in trusting the assessments of the local banks’ soundness by the Portuguese authorities, which it should have second-guessed instead. One lesson here is that the IMF’s traditional distinction between “emerging” and “advanced” economies is increasingly counterproductive, as other recent developments also illustrate. The IMF would be well-inspired to abandon this distinction altogether.

Overall, and despite the misleading nature of its title and of some of its framing, Laid Low is an important addition to the burgeoning literature on the euro area crisis. Its main contribution is to assemble essential factual material for further analysis, complementing other books such as Carlo Bastasin’s Saving Europe or Neil Irwin’s The Alchemists, as well as the in-depth study published last July by the IMF’s own Independent Evaluation Office (IEO). These and other forthcoming volumes will hopefully allow a gradual shift in the public’s understanding of the euro area crisis, from a cartoonish Hellenic-centered morality tale to a more complex but also more accurate story of financial fragility, multilevel governance, and multiple reverberations between banking, fiscal, and monetary imbalances.

Note: The author was a member of the IEO team that prepared the evaluation report mentioned in this post’s last paragraph. The content of this post is not based on the author’s work for the IEO, nor does it in any way represent a view of the IEO itself.

 

Evaluation of the Financial-Sector Aspects of the IMF's Role in the Euro Area Crisis

Bruegel and the Peterson Institute just published lightly edited versions of a background paper which I contributed to the evaluation of the role of the International Monetary Fund in Greece, Ireland and Portugal by the IMF's own Independent Evaluation Office.

The blog piece below was published today by Bruegel and the Peterson Institute to introduce and summarize my report, which focuses on the financial sector aspects of the IMF's role. 

Bruegel just published “The IMF’s Role in the Euro Area Crisis: Financial Sector Aspects” in its Policy Contributions series, and the Peterson Institute posted a near-identical text on its website. Both are lightly edited versions of a background paper on financial-sector aspects which formed part of a broader evaluation of “the IMF and the crises in Greece, Ireland and Portugal,” published in late July by the Independent Evaluation Office of the International Monetary Fund. The IEO report, which was accompanied by eleven background papers (including mine), received wide coverage in international media, and prompted a welcome debate on the weaknesses and shortcomings it highlighted at the Fund.

My work evaluated the financial-sector aspects of the IMF’s performance on two levels. For the euro area as a whole, I give the Fund high marks for its ground-breaking analysis of the vulnerabilities of the currency union’s banking policy framework, starting years before the crisis and developed near-continuously during the crisis itself. The IMF was the first public institution, and among the first observers more generally, to identify the vicious circle between banks and sovereign states, which then became increasingly widely acknowledged as the central driver of the euro area crisis, and which euro area leaders memorably pledged to break when first announcing the reform now known as banking union in late June 2012. As early as May 2009, an IMF working paper by Ashoka Mody is the earliest public description I found of that vicious circle, presumably inspired by his experience of Ireland at that time. It was shortly followed by a euro-area-wide analysis by Silvia Sgherri and Edda Zoli emphasizing the links between sovereign risk and financial-sector fragility.

In terms of euro-area-level policy recommendations, the IMF was an early advocate of what we now call banking union, including through a series of publications in 2007 and a detailed proposal in 2010, which can be seen as the precursor of the euro area’s single resolution mechanism that came into force earlier this year. (My own first contribution to the banking union debate in 2007 was largely inspired by joint work with two IMF economists, Jörg Decressin and Wim Fonteyne.) The Fund was an equally forceful champion of banking union in the immediate run-up to euro area’s decision to initiate it, with a landmark blueprint provided in a January 2012 speech by the IMF’s managing director, Christine Lagarde. The IMF’s advocacy of European banking policy was not entirely continuous and was occasionally weakened by internal disagreements, but deserves significant credit for its contribution for the major steps the euro area has taken since 2012 towards banking union, arguably the most important structural reform adopted by the euro area in response to the crisis.

At the level of individual countries, my assessment highlights the contrasts between different programs, as does the IEO’s main report. On financial-sector aspects, the first Greek program (2010-12) successfully prevented short-term financial instability but couldn’t avert the sharp deterioration of Greek banks’ balance sheets in the run-up to the sovereign debt restructuring of March 2012. The Irish program (2010-13) was as close as it gets to a textbook example of effective banking sector restructuring. By contrast, the Portuguese program (2011-14) missed the opportunity to bring Portugal’s banking sector back to soundness, a collective failure for which Portugal is now paying a significant price. The Spanish program of 2012-14, to which the IMF contributed in major ways even though not under the “troika” arrangement, was, like Ireland, a remarkable success. The second Greek program (2012-16) and Cypriot program (2013-16) are not covered by the IEO evaluation because they were still ongoing when most of the evaluation work was being done. The paper attempts to explain how these diverse outcomes resulted from different country contexts but also from internal circumstances within the Fund.

The paper’s title and context clarify what it is and isn’t. First, it was written as part of an evaluation of the IMF. While a number of facts and assessments are provided on other actors such as national governments and EU institutions, these are only intended to help pass judgment on the performance of the IMF itself. In other words, the paper does not seek to evaluate the actions of any of these governments and institutions, even though it provides material that may be used for such evaluations. Second, the paper focuses on financial-sector aspects, and to be more specific, on banking-sector issues, since banks represent the overwhelming majority of financial intermediation in the euro area. Fiscal and structural policy challenges, in particular, are covered in other parts of the IEO evaluation but are not assessed in this text. Third, as highlighted in a disclaimer on the background paper published by the IEO, the views expressed in the paper are mine and not those of the IEO. As the IEO puts it, background papers “are published to elicit comments and to further debates.” Only the main report represents views of the IEO itself.

My evaluation supports the view that the euro area crisis is best understood as a set of complex interactions between fiscal and financial-sector developments, even though mainstream narratives tend to focus single-handedly on the fiscal aspects (and, correspondingly, on Greece). It also highlights the IMF’s contribution as a highly valuable partner for the euro area throughout the crisis, despite flaws on which the IEO project has shed an unforgiving light. The IMF has acted as a welcome check against European tendencies for insular and inward-looking thinking, and has provided important insights into the European policy process based on the Fund’s experience elsewhere in the world, even though European policymakers haven’t always heeded the IMF’s advice as they should. The Fund should try to build on its successes and learn from its mistakes to keep bringing essential value to European policy decision-making in the years ahead.

Finally, I wish to express my personal gratitude to the IEO, particularly to Shinji Takagi who led this evaluation project and to the Office’s Director Moises Schwartz, for having allowed me to participate in their collective effort. The IEO, which started in 2001, is a unique institution. It has once again demonstrated its capacity for ruthless truth-telling to the IMF, which in turn supports the Fund’s capacity for ruthless truth-telling to its member countries. The ability of the IEO to prepare and publish independent assessments, and to enable background papers authors to express independent judgments of their own, is truly impressive. For me, contributing to the IEO’s work over the last eighteen months has been a great honour and privilege.

Italy's Banking Problem Is Serious But Can Be Fixed

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

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

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

The Banking Problem

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

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

Trade-Offs of Burden Sharing

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

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

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

Finding the Right Balance

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

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

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

A Comprehensive Approach Beyond the MPS Case

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

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

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

The UK / EU Separation: How Fast Does It Happen?

This post was published yesterday by the Peterson Institute, and this morning by Bruegel.

Up until the British rebuff on Thursday, the European Union had always been in expansion mode, also known in EU parlance as enlargement. The UK vote to leave the EU marks the first-ever case of this process being reversed.

In the past, there have been a number of situations where a country could be outside the union legally, but inside politically. It was common practice in the early 2000s to invite ex-Communist candidate countries to attend votes in the Council of the EU in anticipation of their formal accession in early 2004. Yet in this case, a country, the United Kingdom, is inside the EU legally, but now firmly outside of it politically. From now on, the EU will routinely hold substantial intergovernmental discussions without the UK being represented, even though the formalities of membership will be maintained in parallel.

An additional layer of complexity derives from the fact that two component parts of the UK, Northern Ireland and Scotland, seek to remain politically inside the EU even though, for the moment, they remain legally tied with England and Wales. Nicola Sturgeon, Scottish First Minister, declared immediately after the Brexit vote, that “Scotland voted overwhelmingly to remain in the EU” and that “Scotland faces the prospect of being taken out of the EU against our will. I regard that as democratically unacceptable. (…) Starting this afternoon, [Scottish] ministers will be engaged in discussions with key stakeholders – particularly in the business community – to emphasise that as of now we are still firmly in the EU. (…) Scotland has voted to stay in the EU – and (…) I intend to discuss all options for doing so.”

In a strictly legal sense the referendum of June 23 is binding neither on the UK nor on the EU. In the UK, Parliament has supreme authority, but it is highly unlikely to reverse the mandate delivered by the voters. In the EU, the procedure for separation is set out in some detail in Article 50 of the Treaty on the European Union (TUE), and places the responsibility for initiating the process in the hands of the relevant member state’s government: ”A Member State which decides to withdraw shall notify the European Council of its intention.”

Article 50 TUE further implies that the government’s notification to the EU sets a clock ticking, which incentivizes the parties to find an agreement on the terms of separation within the following two years. If no such agreement is found after those two years, and in the absence of unanimity of all EU member states to extend the negotiation period, the EU membership of the member states is terminated automatically, which would be so disruptive for the country concerned that any sane government is expected to work hard to find mutually acceptable terms.

A key question for the UK, therefore, is this: when does its government notify its decision to withdraw under Article 50 following the vote on June 23? Prime Minister David Cameron explained in February at the House of Commons that “the British people would rightly expect that to start straight away” after a vote to leave. In his resignation speech, however, Mr Cameron made it clear that he would leave that notification on the to-do-list for his successor, probably not before the end of summer. “In my view we should aim to have a new prime minister in place by the start of the Conservative Party conference in October,” he declared. “A negotiation with the European Union will need to begin under a new prime minister and I think it's right that this new prime minister takes the decision about when to trigger Article 50 and start the formal and legal process of leaving the EU.”

By contrast, a joint statement of the heads of all relevant EU institutions on June 24 asked for the negotiation to start quickly: “We now expect the United Kingdom government to give effect to this decision of the British people as soon as possible, however painful that process may be. Any delay would unnecessarily prolong uncertainty. We have rules to deal with this in an orderly way. Article 50 of the Treaty on European Union sets out the procedure to be followed if a Member State decides to leave the European Union. We stand ready to launch negotiations swiftly with the United Kingdom regarding the terms and conditions of its withdrawal from the European Union.”

Among other concerns, the EU institutions’ leaders want the consequences of leaving to be clear and unambiguous to all. They understandably fear that a membership referendum may be pressed in other member states on the questionable premise that exit can be almost painless, as the UK Leave campaign has argued. They thus desire to establish the actual precedent as quickly as possible. It is too early to prejudge the outcome of such negotiation, of course. One may expect the EU stance to be not punitive, but unforgiving.

In practice, there is little the EU can do now to force an acceleration of the notification process. Article 50, as quoted above, leaves no room for interpretation as to how the process will be triggered. So the EU will have to wait until the domestic political consequences of the vote are sorted out in the UK before the actual business of negotiation can actually start. Just as during the referendum campaign, the EU institutions and all other member states must for the moment remain the spectators of a dramatic development in which they have a huge amount at stake.

European Banking Supervision: The First 18 Months

Bruegel yesterday published this report, which I co-edited with Dirk Schoenmaker, in its Blueprint series. To our knowledge, it is the first in-depth study of how European Banking Supervision (also known as the Single Supervisory Mechanism, in place at the European Central Bank since early November 2014) works in practice. It includes a euro-area overview and overall assessment, and nine country-specific chapters by local experts that bring anecdotal color and a sense of the lingering diversity of experiences and perceptions across member states. 

Dirk and I summarized key findings of the report in a Bruegel blog post which was also republished by Vox. 

In case of a Brexit, London would lose business as a global financial center

This text was first published in a slightly abridged version by The International Economy in its Spring 2016 issue, and republished by the Peterson Institute and by Bruegel.

There are multiple sub-scenarios in the aftermath of a No vote on June 23. In almost all of them, however, London would lose business as a global financial center. Part of its unmatched position as a hub for international financial services is linked to its membership of the European Union and corresponding access to the EU internal market. Non-European banks, especially US ones, use London as a beachhead into the single market, and many euro-area banks centralize their EU wholesale markets activities there. The EU “passport” concept of mutual recognition among supervisory authorities works smoothly for investment banking activities. The EU framework provides strong legal protection against regulatory fiat, as was illustrated when the European Court of Justice in March 2015 rejected the European Central Bank’s “location policy,” intended to force clearing houses to move their euro-denominated operations from London to the euro area. The access and protections would disappear if the UK was to withdraw from the internal market.

Most non-UK-headquartered large financial institutions are actively working on post-referendum plans, and take the possibility of a No vote seriously. For understandable reasons they do not communicate about this planning work and its conclusions. But early indications suggest that their moves following a No vote could be quick and significant, given the likelihood that the United Kingdom would enter a prolonged period of high uncertainty. An order of magnitude of one-third of activity potentially relocated outside of the United Kingdom does not appear far-fetched.

The next obvious question is about who would win the business that London would lose. Inside the European Union, some have expectations that, since Germany and France would be the largest remaining countries, Frankfurt and Paris would be best placed to gain. But this ignores the incentives for financial firms to go to the most finance-friendly places, and there are a number of them in Europe. A rule of thumb of finance-friendliness is provided by the European Commission’s ill-starred proposal of a Financial Transaction Tax, whose adoption only a minority of EU member states are considering. FTT doubters such as Denmark, Ireland, Luxembourg, the Netherlands, and Sweden are more likely to attract business from London than FTT supporters including France, Germany, or, for that matter, Belgium.

But even bigger transfers could happen outside the European Union, and specifically to the United States. On almost any measure, London and New York are by far the world’s two largest financial centers. U.S. authorities have acknowledged London as a preferred entry point into the European Union for American financial firms, and have built strong working relationships with UK financial regulators over the years. But once the bilateral link with London is no longer part of the larger relationship between the United States and the European Union, one can expect a more competitive stance to favor New York as the best place to do international financial business.

Even more difficult to assess, but arguably also even more substantial, is the opportunity cost of a Brexit. London would have a lot to gain from the continuation of EU financial integration. Banking Union, even in its current halfway form, will lead to the opening of more financial business to cross-border competition across the European Union, and so will any concrete moves in the direction of the European Commission’s vision of a Capital Markets Union. But if the United Kingdom is no longer in the European Union, it will not be able to reap as much advantage from these future developments as it has in the past steps of EU integration.

The European Union Continues to Lag on Banking Supervisory Transparency

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

Bank supervisors in the European Union have shown no improvement in publishing data on the institutions they supervise. In fact, supervisory transparency has deteriorated since our 2013 survey of bank data disclosures (Gandrud and Hallerberg 2014).

At the European level, the inception of the euro area banking union is a major change of policy regime since our previous survey, but it has not yet made enough of a difference in supervisory transparency. Also at the European level but predating banking union, the European Banking Authority (EBA) has continued to make important improvements in supervisory transparency. But its efforts are insufficiently institutionalized and do not cover the full spectrum of banks in the European Union.

This lack of transparency is worrying because further successful integration of the EU financial sector requires financial market participants and the public to be able to access information on banks’ activities and health across borders. Some jurisdictions provide much more detailed, regular, and frequent information. In the United States, for example, roughly 8,200 banks are required to make quarterly “call reports” that have data on the respective bank’s earnings, balance sheet, asset quality, liquidity and capital. A federal agency, the Federal Financial Institutions Examinations Council (FFIEC), makes this information available online, generally the day after it receives it.

Supervisory authorities, including the European Central Bank (ECB) in its new capacity as euro-area financial supervisor, should dramatically step up their efforts to provide the public with more information about Europe’s massive banking sector.

Transparency at the National Level

In our 2013 survey we found that only 11 of the European Union’s 28 member states, and only 5 of 19 banking union countries, made any such information easily available on the internet (Gandrud and Hallerberg 2014). These data were generally fairly simple balance sheet information, such as total assets and capital. Even in Spain, the country with the most comprehensive data, the level of detail was low. It did not include information on nonperforming loans, a crucial metric for determining a bank’s health.

In early 2016, we find the picture has actually worsened. Now only nine of the 28 EU member states, and four of the 19 banking union countries, make any individual bank data easily available online. In four of the five countries where we found any changes to data transparency, the situation worsened. In France and Luxembourg, data reported was not only unavailable but also now confidential. This classification could make it even harder for the public and potentially other supervisors to access bank data. In Estonia, the data found in the 2013 survey are still available but have not been updated, suggesting that basic transparency measures were not institutionalized. The Czech Republic has had the largest shift towards opacity: Data that were once available are now no longer so. The only limited improvement we found is in Ireland, where the data, while still unavailable, are no longer classified as confidential. Table 1 presents the full results of the updated survey, highlighting the changes since our previous survey.

Transparency at the EU Level

Financial supervisory data transparency at the EU level has moved in a more positive direction but does not offset the shortcomings at the national level. EU institutions have conducted ad hoc transparency exercises and bank balance sheet reviews and published many of the results. However, transparency measures have not been institutionalized, and so could be easily discontinued, and they cover only a subset of Europe’s banks.

ECB Banking Supervision has regularly updated its list of supervised entities and occasionally released data from exercises such as the 2014 and 2015 Comprehensive Assessments, but it does not regularly publish quantitative data about euro area banks beyond a highly imprecise indication of balance sheet size. The 2014 Comprehensive Assessment covered 130 banks; the 2015 one was of 9 additional banks; and another assessment is planned for 2016. The ECB also publishes biannual consolidated banking data for all EU banks broken down by country, domestic vs. foreign ownership, and bank size, but this information is not available at the bank level and is only presented as national aggregates.

The EBA, which covers all 28 member states, published results of a transparency exercise in December 2013, EU-wide stress tests in October 2014, and a follow-up transparency exercise in November 2015. These covered, respectively, only 64, 123, and 105 banks (of which one was from Norway and the rest headquartered in the European Union). The vast majority of Europe’s more than 3,500 banks, representing perhaps a quarter of total assets, have been left out. The transparency exercise is valuable but should be further institutionalized, and its frequency should increase so that at least some of the data would be released annually or even quarterly.

Supervisory Transparency Matters

Legitimate questions have been raised about the extent to which supervisors should release the information that they collect about individual banks. There are concerns that too much transparency may reveal trade secrets or that markets may punish banks that turn out to have weaker books than expected so much that bank failures become more likely, thus increasing financial instability.

Yet, even with these concerns in mind, there are compelling reasons why supervisory transparency for individual banks should lead to more financial stability, not less. Bankers will want to prevent adverse market reactions if they know that more data about them will be made public. Better transparency may facilitate contestability and mergers, especially cross-border mergers, where information asymmetries are high. Data transparency allows parliaments and the public to better judge supervisors' performance, which means that supervisors expect more scrutiny and so should act more responsibly. These benefits of transparency are well established in the relevant literature. For example, Nier (2005) finds that more transparent banks are less likely to experience a crisis, while Tadesse (2006) reports that countries with more extensive bank disclosure requirements are less likely to experience a systemic banking crisis.

References

Gandrud, Christopher, and Mark Hallerberg. 2014. Supervisory Transparency in the European Banking Union. Bruegel Policy Contribution 2014/01. Brussels: Bruegel.

Nier, Erlend. 2005. Bank Stability and Transparency. Journal of Financial Stability 1, no. 3: 342–54.

Tadesse, Solomon. 2006. The Economic Value of Regulated Disclosure: Evidence from the Banking Sector. Journal of Accounting and Public Policy 25: 32–70.

Christopher Gandrud is a Lecturer in International Political Economy at City University London anda Postdoctoral Fellow at the Hertie School of Governance. Mark Hallerberg is Professor of Public Management and Political Economy at the Hertie School. Nicolas Véron is Senior Fellow at Bruegel and a Visiting Fellow at the Peterson Institute for International Economics. The authors are grateful to Marina Pavlova for excellent research assistance.

Table 1 Updated EU Member State Financial Supervisory Data Transparency

Country	Individual bank data availability, early 2016	Change since previous survey (Gandrud and Hallerberg 2014)
Austria	Confidential	No change
Belgium	Confidential	No change
Bulgaria	Available	No change
Croatia	Available	No change
Cyprus	Confidential	No change
Czech Republic	Unavailable	Change: Data available previously
Denmark	Regularly updated	No change
Estonia	Same format, not updated since 2007	Data not updated since previous survey
Finland	Regularly updated	No change
France	Confidential	Change: Data unavailable previously
Germany	Confidential	No change
Hungary	Available	No change
Ireland	Unavailable	Change: Data confidential previously
Italy	Unavailable	No response to follow-up survey. No indication of change.
Latvia	Available	No change
Lithuania	Available	No change
Luxembourg	Confidential	Change: Data unavailable previously
Malta	Unavailable	No change
Netherlands	Unavailable	No change
Poland	Unavailable	No change
Portugal	Available	No change
Romania	Confidential	No change
Slovakia	Unavailable	No response to followup survey. No indication of change.
Slovenia	Unavailable	No change
Spain	Available	No change
Sweden	Unavailable	No change
United Kingdom	Confidential	No change

 

PIIE Reality Check for the Global Economy

The Peterson Institute just published Reality Check for the Global Economy in its Briefings series. As the title suggests, this collection of short essays edited by Olivier Blanchard and Adam Posen aims to give some facts-based perspective following the wild market gyrations observed in February, which arguably included some excessive pessimism in parts of the investor community.

My contribution to the project focuses on European banks and current uncertainties about them, including the use of Contingent Convertible (CoCo) debt, the unfinished clean-up of the euro area banking system (especially in Italy), and broader open questions about the future European approach to bank crisis resolution. I argue that all three issues are important but not new, and that the fact that investors are now acknowledging them more realistically is a welcome development. 

Click here to download the entire PIIE briefing in PDF format. My piece was also republished today (with minor updates) on the Bruegel Blog. 

In Defense of European Deposit Insurance

This text was published by Bruegel and, in a slightly abridged version, by the Peterson Institute. 

Last November, the European Commission published a proposal for a European Deposit Insurance Scheme (EDIS), which is currently being negotiated among EU member states.

Yesterday, this elicited a response from Ludger Schuknecht, the German Federal Finance Ministry’s respected chief economist. While his objections to EDIS are not new, they have rarely been articulated with such clarity, at least in the English-speaking debate, and deserve careful consideration.

As it happens, none of his arguments of policy substance is compelling. By contrast, the obstacles he highlights in terms of Germany’s politics and political economy are real enough, and will ultimately play a big part in determining the EDIS negotiation’s outcome.

There are two major oversights in Dr Schuknecht’s anti-EDIS outburst, respectively about deposit insurance and about banking union. Correcting these would radically shift the balance of his arguments, and reverse his conclusions.

First, deposit insurance. While it carries the same name, this policy does not raise the same moral hazard issues as, say, fire insurance or theft insurance. Trust in deposits is a fundamental layer of confidence that underpins economic activities in developed countries. When it is compromised, so is social cohesion more broadly.

The EDIS would only guarantee deposits up to the European limit of EUR 100,000. No government would want to voluntarily trigger bank failures, including losses on uninsured deposits, and thus precipitate its own demise. Indeed, an EDIS would better align governments’ incentives with the financial stability objective than the current framework does.

As Dr Schuknecht himself concedes, EDIS would mean that “central banks would not have to jump in with emergency liquidity assistance quite as quickly” as they have in the recent past, thus imposing more discipline on bank creditors and policymakers.

Neither Mr Tsipras nor Mr Varoufakis advocated haircuts on uninsured Greek deposits last year. The idea that rogue politicians would annihilate financial activity in their jurisdiction for the sake of making the Germans pay is a case of worrying more about imaginary than real risk scenarios.

Indeed, Germans should be more sensitive than most to the counter-arguments. The last bank run in Germany was in 1931, triggered by the collapse of Creditanstalt in nearby Austria, and played a role in the tragic developments of the following years. Postwar Germany has built an elaborate system of private and public institutional protections to ensure this doesn’t happen again, at the risk of creating a lot of moral hazard among the banks’ creditors.

Since the onset of the financial crisis in 2007, numerous banks have failed in Germany, but not a single bank creditor, no matter how junior, has lost money on their claims – in contrast to most other euro area countries such as Austria, Cyprus, Greece, Ireland, Italy, the Netherlands, Portugal, Slovenia, and Spain.

Savings banks protect each other, so do cooperative banks, and savings banks are often additionally cushioned by their public-sector stakeholders. Even private institutions benefit from mutual protection: a year ago, tiny Düsseldorfer Hypothekenbank was expensively bailed out by a national guarantee fund of the commercial banks, “in order not to damage the reputation of Germany as a place to do banking business.” Few countries are as committed as Germany to prioritizing financial-sector safety nets over theoretical moral hazard arguments.

Second, banking union. Dr Schuknecht’s article curiously ignores both the rationale for it and its new realities on the ground, as if the author wished to hark back to a pre-2014 era when banking systems were essentially national.

The motivation for banking union, including the creation of the Single Supervisory Mechanism (SSM), was the objective to break the vicious circle between banks and sovereigns, under which the euro area was at a serious risk of break-up at the time (mid-2012).

The SSM was reportedly first proposed by no other than German Finance Minister Wolfgang Schäuble. When Dr Schuknecht implies that the SSM will be unable to enforce sound capital discipline because “national supervisors will always remain important,” he underplays his Minister’s achievement in fostering a broadly robust and credible SSM that is now the licensing authority for all banks in the euro area, not only the larger ones.

The German government also endorsed the Single Resolution Mechanism (SRM), a construct that is arguably less robust than the SSM but entails a significant degree of risk-sharing, including a late-2013 common “Statement of Eurogroup and ECOFIN Ministers on the SRM Backstop” (available here). In the latter, Dr Schuknecht’s Ministry committed to a common fiscal backstop to support the SRM in future extreme crisis situations, even though the backstop’s practical features remain undecided.

If anything, this creates more moral hazard and awkward incentives than the implementation of EDIS would, including in the unlikely but still possible case that the common fund would run empty, because of the inherently less narrow and more discretionary nature of resolution financing as compared with deposit insurance.

A resilient banking union needs an EDIS, as countless economists but also the International Monetary Fund and European Central Bank have insisted, together with the European Commission.

Without an EDIS, national budgets remain the backstop for national deposit insurance schemes that rely principally on the quality of European-level supervision – a potentially more damaging misalignment of incentives than the ones Dr Schuknecht denounces. Most basically, the continuation of national deposit insurance perpetuates the highly destabilizing bank-sovereign vicious circle in the euro area, as last year’s developments in Greece illustrated once again.

When Dr Schuknecht affirms that “the risk of bank runs is today far lower than it was before the crisis,” he strangely ignores this stark reality. Last September, a controversial non-paper from the German government started with the reaffirmation of the “key objective (…) to decouple banking sector risks from public sector risks and thereby breaking the vicious link between sovereign risks and bank risks.”

By omitting to even mention the existence of the bank-sovereign vicious circle, Dr Schuknecht lags well behind his employer, let alone the broader European policymaking community.While not all points in the German non-paper were convincing, it was right to push for a balance between the “risk sharing” device that is EDIS and other measures that should improve the banks’ risk allocation and management, now widely though somewhat misleadingly referred to as “risk reduction” (we don’t know enough about the future to assess risk that objectively).

This should entail, in particular, vigorous action to dismantle the currently massive concentration of home-country sovereign risk in many euro-area banks’ bond portfolios. It should also include measures to improve the banks’ accounting, auditing and disclosure frameworks to enhance market discipline; more regulatory harmonization, as the SSM has started to promote with its action on so-called options and national discretions; an end to harmful ring-fencing of capital and liquidity across national borders within the euro area, which prevents geographical diversification; a single bank insolvency regime enforced by a European bank insolvency court, mirroring the SRM; and even further on the horizon, some harmonization of the taxation of banks and banking activities in the euro area.

Not all of these can be achieved immediately, but the German idea to frame EDIS as part of a broader policy package is apt. By implying that any deal that includes EDIS is worse than the status quo, Dr Schuknecht ignores this promising dynamic.

In sum, Dr Schuknecht’s points of policy substance are less than compelling, and he himself sounds strangely unconvinced by them: his article starts with a reminder of many of the advantages of the EDIS proposal, which he portrays as “in themselves strong arguments.”

The nub of the matter lays elsewhere – in current German domestic politics and political economy. The EDIS proposal would create challenges for Germany’s idiosyncratic pillar-based systems of deposit insurance, namely those for politically influential savings banks and cooperative banks which Dr Schuknecht refers to obliquely as “the existing guarantee systems in certain countries” – actually such autonomous sub-national systems are now a unique German feature.

The broader political challenge is the willingness of the German public to accept further risk-sharing with euro-area neighbours. It is not a legal issue. Dr Schuknecht’s insistence that the EDIS proposals are legally unsound or would require “the approval of all countries [instead of qualified majority] and changes to the European treaties” contradicts Germany’s past approval of the SRM Regulation of 2014, which is based on the same legal framework of the Internal Market as the EDIS would be.

Rather, the problem is, as Dr Schuknecht writes, “the political risks arising from the mutualisation of liability.” But in truth, this mutualisation is inherent in the German Chancellor’s oft-repeated insistence that the integrity of the euro area must absolutely be defended.

The real debate is not abstract, about mutualisation or no mutualisation in a single currency area, but practical, about how to minimize perverse incentives, moral hazard, and risks to financial stability. From that perspective, and even with awareness of the undeniable reticence of German local banks and of significant parts of the German public, the adoption of EDIS would be an important step forward.

Europe's Capital Markets Union and the New Single Market Challenge

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

The European Union has started a conversation on reforming its capital markets which raises difficult questions about market integration in regulated services sectors, of which finance is one. Powerful political constraints, currently centered on (but not limited to) the United Kingdom, prevent the European Union from creating pan-European agencies for regulatory enforcement. But decentralized enforcement in such sectors tends to defeat the aim of cross-border integration. As regulated services are increasingly important in the continent’s economy, Europeans will eventually need to make a choice between building a single market and maintaining sovereignty over regulatory enforcement.

European Commissioner Jonathan Hill announced an action plan on September 30 to transform European Commission President Jean-Claude Juncker's vision of a European “Capital Markets Union” into reality. As Mr Juncker explained it back in July 2014, “[t]o improve the financing of our economy, we should further develop and integrate capital markets. This would cut the cost of raising capital, notably for SMEs, and help reduce our very high dependence on bank funding.” There is much to be commended in the Commission’s new document. It strikes a sound rhetorical balance between the need to develop financial services vital for the European economy and the imperative to ensure proper financial sector regulation. The diagnosis that EU capital markets are underdeveloped, and that less dominance of banks in the system would benefit growth and stability, is important and well-taken. Many of the specific initiatives appear reasonable.

Nevertheless, the incremental nature of the action plan contrasts greatly with the ambitious language of the Capital Markets Union – with its echoes of Banking Union, a separate and genuinely radical policy development. It mostly boils down to pruning existing rules and correcting some of the European Union’s own recent regulatory overreach. This is the normal business of the Commission’s arm that deals with financial regulation, recently renamed from DG MARKT to DG FISMA. But while such fine-tuning work is important, it is not likely to bring much change to the overall structure of Europe’s financial system. Potentially the plan’s most significant initiative is new EU legislation to harmonize insolvency law, to be published by the Commission in late 2016, but this is left undefined and could end up being unimportant. Major obstacles to capital markets integration remain untouched, including divergent accounting enforcement regimes, fragmented market infrastructure, or incompatible frameworks for the taxation of financial investments.

Why this apparent lack of ambition? Special interests that have much to lose from capital markets union may play a part. Some segments of the EU banking industry, and protected financial “national champion” market infrastructure firms in some member states, have made it clear that they do not view the capital markets union as a good idea. But the European Commission has a decent track record on overcoming such resistances. Ideological obstacles, especially in countries where anti-capitalist and anti-market rhetoric has broad public appeal such as France or Italy, may create roadblocks. But this explanation is also insufficient. In fact, the Commission has been appropriately unapologetic about its market-based vision. Its announcements have spurred healthy national debates that may lead to a better understanding of the economic case for capital markets. Even if this happens, however, it won’t be enough to trumpet mission accomplished: ultimately, the European Commission’s mission is about public policymaking, not just public advocacy.

A more convincing explanation for the plan’s underwhelming content is the Commission’s self-imposed restraint on any change in the institutional architecture. Commissioner Hill and DG FISMA officials insist that any discussion of institutional reform would be an unwelcome and ultimately pointless distraction from the policy substance at stake. On this, Commissioner Hill's view diverges from Commission President Juncker's, as expressed in the so-called Five Presidents’ Report last June, which argued that the capital markets union “should lead ultimately to a single European capital markets supervisor.” More importantly, the refusal to consider institution reform is highly debatable on grounds of substance. As practitioners know, having to deal with different regulators in different countries creates duplication, inconsistencies, and ultimately barriers to seamlessly integrated cross-border business.

The Commission may be wary about disputing the turf of Europe’s myriad national financial authorities. (There are no fewer than 51 of them, only looking at membership of the three European Supervisory Authorities and not including non-EU participating members of the European Economic Area.) But the European Union has been able in the recent past to create central agencies with bite when needed: for example, the Banking Union’s supervisory arm hosted by the European Central Bank, known as the Single Supervisory Mechanism (SSM), and the Single Resolution Board (SRB), a new agency in Brussels; or Frontex, the Warsaw-based agency that coordinates border guards for countries including all those in Europe’s Schengen area for the free movement of individuals. These examples, however, also illustrate the limits of European institution-building. The SSM was created under extreme duress, when it was (aptly) seen as the only way to prevent a breakup of the euro area in mid-2012. The SRB and Frontex coexist awkwardly with national agencies that retain much autonomy.

Last but not least, these cases hint at the specific position of the United Kingdom, which is a participant in neither the Banking Union nor Schengen. Commissioner Hill insists that its capital markets union should include the United Kingdom, and he is correct on this: London is the undisputable hub of Europe’s capital markets. An integration project excluding Britain would entail the much more serious risk of creating a harmful fault line inside the European Union than is the case with banking. But British sensitivity about any executive centralization, currently exacerbated by the upcoming UK referendum on EU membership in 2016 or 2017, results in a refusal to consider any joint enforcement or supervision, even in ostensibly nonpolitical areas such as accounting enforcement or audit oversight.

In the short term, there is a solid case for the European Commission not to go against this effective UK veto over any meaningful change in European financial regulatory institutions. The referendum creates the risk that the United Kingdom might leave the European Union, which could be severely detrimental for both. Any initiative that may fan the flames of anti-EU passion across the Channel must be toned down or outright shelved. But therein also lies a great irony. While all member states would gain from a genuine capital markets union, Britain would gain disproportionately. In most other member states, nonfinancial enterprises would unambiguously benefit through better access to finance, but the impact on the domestic financial sector could be neutral or even negative given the additional competitive pressure. By contrast, the City of London and other parts of the UK financial services industry are almost sure to gain from more development and integration of Europe’s capital markets, given their entrenched comparative advantage in financial intermediation—assuming that the United Kingdom remains in the European Union.

This observation can be extended beyond the debate about capital markets and financial services regulation. The traditional view of Europe’s single market project was all about harmonizing product standards, a view that is perhaps best embodied in the Single European Act of February 1986. In markets for goods and unregulated services, harmonization is sufficient to eliminate cross-border barriers, because enforcing standards is sufficiently straightforward to be left to a decentralized network of public authorities and courts. However, in regulated service sectors such as finance, enforcement functions (which include licensing, authorizations, and supervision) involve considerable judgment and discretion. In such sectors, leaving these functions exclusively or mainly to the national level results in cross-border fragmentation, while pooling them at the European level is a necessary (though not always sufficient) condition for cross-border integration. National authorities typically don’t trust each other, defend their territorial prerogatives, and are often motivated to defend or promote their respective national champions. For that reason, “passporting” or mutual-recognition frameworks are often not complied with, as authorities find ways to add national requirements or oversight to participants that have been authorized in third countries. In short, for such sectors, a single market worthy of its name will remain elusive as long as regulatory enforcement remains primarily at the national level.

As it happens, regulated services are also increasingly important for Europe’s growth and its economic and social resilience. Witness Juncker’s flagship structural reform projects—including an “Energy Union” and a “Digital Single Market” along with the capital markets union—that are also focused on regulated services sectors and raise similar trade-offs about European versus national administrative authority. While the “old” single market in goods and unregulated services was satisfactorily addressed through standards harmonization, the new single market challenge is all about regulatory enforcement institutions. Denial of this stark reality is widespread in Europe, not least in the United Kingdom itself. Such denial may be politically expedient but is analytically unhelpful, and stands ultimately at odds with the proclaimed commitment to a European single market. A clear-sighted public debate about this challenge may be delayed until after the UK referendum, but not indefinitely.

 

Celebrating Bruegel's 10th Anniversary

Last Monday and Tuesday, Bruegel held its customary Annual Meeting in Brussels with a special flavor, as it also celebrated its ten years of operations since publishing its first paper in September 2005. On this occasion it published a series of short texts on Bruegel's early development, by Mario Monti, Leszek Balcerowicz, Jean-Claude Trichet, Jean Pisani-Ferry, Guntram Wolff, and me. The one by Pisani-Ferry, in particular, gives the most detailed account yet of the improbable circumstances of Bruegel's creation in 2002-05. 

The Many Births of Bruegel

This post was published by Bruegel on April 20, as start of a series on How Bruegel Was Born to be continued later this summer. 

Ten years ago, on 20 April 2005, Bruegel’s fledgling team moved into what would become its permanent address, on the third floor of 33 rue de la charité / liefdadigheidstraat 33 in Brussels. The works to adapt our premises to their use as a think-tank venue was still far from finished. A few days later, Bruegel’s Board held its second meeting in what was still a makeshift boardroom in a vast open space. Most internal walls came only later.

At that time, Jean Pisani-Ferry, who had been appointed Bruegel’s first Director in January, Yvonne Hilario, Jozefien Van Damme and I were still entirely focused on the early operational and organizational build-up, also relying on Soizick Bévan as the project’s generously pro bono consultant. The research team would take initial shape only later in the spring, with the arrival of André Sapir as Bruegel’s first Senior Fellow, followed by three Research Fellows who have since moved on to expanded horizons: Alan Ahearne as a senior Irish financial and monetary policymaker, Juan Delgado as chief economist of the Spanish Competition Authority, and Jakob von Weizsäcker as Member of the European Parliament from the German SPD party.

That year 2005 was effectively when Bruegel started. There were many milestones, all of them important. On 17 January, the Board had its first meeting, at Brussels’s timeworn University Foundation near the Royal Palace. Under Chairman Mario Monti’s leadership, it adopted the name Bruegel – which Monti had himself suggested, playing on the idea of a “Brussels European and global economic laboratory” – and marked the start of Bruegel actual operations. The day after, Monti and Pisani-Ferry held a press briefing in which the new child was announced to the world, and received promising initial coverage.

Die Zeit emphasized the project’s Gemütlichkeit, calling it “Bruegels Denkstube”; Libération noted approvingly that it might help Europe find a voice to match les influents think tanks américains; the Italian press understandably focused on what the Bruegel chairmanship suggested about Monti’s future moves; and the Financial Times wrote “Monti recalled that Bruegel (the Elder, of course) was also known for his depiction of the Tower of Babel, which the think-tank would not resemble in the slightest.” A few days later, columnist Brian Groom noted in the same newspaper that “Initial fears at the European Commission that [Bruegel] would be another French-German manoeuvre to seize back the political initiative has turned out wide of the mark.”

After the move to the new offices, Bruegel held its first workshop there, on 13 May, on “Europe’s productivity drift and how to reverse it”. On 27-28 June it held its first high-level conference on the challenge to trade multilateralism from regional deals, a theme that also resonates these days, in the historic Erasmus House in Anderlecht. On 9 September, Bruegel’s first paper, written by André Sapir, was distributed and discussed at an informal ECOFIN meeting in Manchester. That same paper, “Globalization and the Reform of European Social Models”, was published as Bruegel’s first Policy Brief on 24 October, on a visual charter designed by Jean-Yves Verdu, who had also created the Bruegel logo. It firmly established Bruegel as a source of influential policy ideas from the very outset.

Even though the events of 2005 felt like a series of beginnings, they were also the culmination of a process of gestation that had started three years earlier. Both Jean Pisani-Ferry and I had been thinking about the possibility of a new European think tank, first on separate tracks and then jointly after a lunchtime conversation in Paris on 18 October 2002. The project was launched on 22 January 2003, by Jacques Chirac and Gerhard Schröder as part of the joint French-German declaration on the 40th anniversary of the de Gaulle-Adenauer Elysée Treaty. After some delays, it was then further elaborated by a French-German working group that brought it to discussion within the European Economic and Financial Committee, initially introduced by Jean-Pierre Jouyet and Caio Koch-Weser on behalf of their respective finance ministries. On 9 March 2004, 11 EU member states (Belgium, Denmark, France, Germany, Hungary, Ireland, Italy, the Netherlands, Poland, Spain, and – last but never least – the UK) announced their initial agreement to support Bruegel’s launch, conditional to successful fundraising from the private sector that was secured later in 2004. Pisani-Ferry was appointed project manager on 1 April 2004, and the legal entity that is Bruegel was formally created on 10 August 2004. This paved the way for the formation of Bruegel’s first Board, which Monti accepted to chair shortly after leaving the European Commission in late October 2004.

All these dates were, each in its own way, birthdates of Bruegel. Since then, our think tank has rapidly gained recognition and reputation, indeed more quickly than its founders initially thought possible. As for real estate, we expanded further in 2008, and will do so again later this year with a larger room for workshops and conferences and new facilities for our visitors and staff.

Bruegel is typically focused on the present and future, more than on the past. Nevertheless, the tenth anniversary of its start provides an appropriate occasion to recall how it all started. As one who was present at the creation, I will tell that story in further blog posts in the course of this year of celebration – while at the same time wishing Bruegel many more decades of success, expansion, and hard work. 

The European Union Lags on Basel III

This post was published this week by Bruegel and the Peterson Institute. 

The European Union, which often claims leadership on championing global financial standards, has been found to be the global laggard on a key aspect of banking regulation, as documented by the latest report (Dec. 5) of the Basel Committee on Banking Supervision. As was to be expected, the Basel Committee—in examining adherence to its international banking regulatory framework, known as the Basel III accord—found the EU “materially non-compliant,” and the US “largely compliant.” Other jurisdictions reviewed earlier had all been found “compliant.”  But complying with the Basel framework remains in the EU long-term interest. The EU can get closer to this goal, short-term by actions of the European Central Bank (ECB), and longer term through new legislation.

The two Basel Committee reports on the European Union and the United States are part of the Basel Committee’s multiyear Regulatory Consistency Assessment Program (RCAP). In October 2012, preliminary assessments of the EU and the US, were based on draft rules at the time. A separate assessment found Japan compliant. The Committee has also published RCAP reports on Singapore (March 2013), Switzerland (June 2013), China (September 2013), Brazil (December 2013), Australia (March 2014), and Canada (June 2014), all of which were also found compliant with Basel III. Under the Committee’s current work schedule, assessments of Hong Kong, Mexico, India, South Africa, Saudi Arabia, and Russia will follow in 2015, and Argentina, Turkey, Korea, and Indonesia in 2016.

The jurisdictions already assessed cover a dominant share of the global banking system, including all 30 groups (14 in the European Union, 8 in the United States, 3 in China, 3 in Japan, and 2 in Switzerland) classified as global systemically important banks by the Financial Stability Board. Thus, even if future reports find other jurisdictions materially non-compliant or even “non-compliant” (the worst grade), the EU and US will remain the laggards among the most important banking jurisdictions.

As cynics may note, compliance status for a country or region does not imply that all corresponding banks are safe and sound. The RCAP process does not look at how rigorously and reliably the rules are implemented and enforced, only at whether the rules conform to the global accord. Gaps in governance and implementation may exist in some emerging markets and developed economies. Acknowledging these gaps, the Basel Committee has initiated separate assessments of outcomes, starting with risk-weighting calculations, which are the target of many of the Basel framework’s most biting critiques. (The Basel Committee also monitors whether jurisdictions have adopted Basel III rules at all, irrespective of their compliance status.)

The RCAP process appears rigorous, balanced, and thorough. An ad hoc assessment team is formed for each report, composed of delegates from the supervisory authorities of jurisdictions other than the one being assessed, and supported by members of the Basel Committee’s permanent secretariat staff. A review team and a RCAP peer review board examine its work. Relevant identities are disclosed in each report. For example, Mark Zelmer, Canada’s deputy superintendent of financial institutions, led the team assessing the European Union. Mark Branson, chief executive of the Swiss Financial Market Supervisory Authority (FINMA), did so for the United States. Of seven other team members for the US report, five were from the European Commission or from individual authorities of EU member states, and the other two from China and Japan. Additional checks and balances have also been introduced since the first reports in 2012.

The assessment itself is comprehensive and authoritative, citing local context, impact on selected banks (which are identified), amendment processes under way, and responses from public authorities. The EU report thus includes a joint response from the European Commission, the European Banking Authority (EBA), and the ECB. The US report includes a joint response from “the US agencies,” including the Federal Reserve Board, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency. The EU and US responses commend the work of the RCAP assessment team, even while contesting some conclusions. To be sure, financial policy is not an exact science, and individual judgment by the assessment team members plays a role.

The reports examine 14 specific “components” in each jurisdiction. For the EU, two weaknesses are highlighted. The EU Capital Requirements Regulation (CRR) of 2013 allows more leeway than the Basel framework to apply a zero risk-weight to banks’ claims on sovereign and other public-sector debtors, as well as reduced risk weights to claims on small- and medium-sized enterprises (SMEs). As a result, the report grades the “credit risk: internal ratings-based approach” component as materially non-compliant. Another weakness is that the CRR exempts certain derivatives transactions of banks with public-sector entities and nonfinancial corporate entities from a capital charge for counterparty risks known as credit value adjustment (CVA), with material impact on actual capital ratio calculations. As a result, the EU report grades the “counterparty credit risk framework” component as non-compliant. In both these cases, the rules have been adjusted during the EU legislative process to favor the bank financing of governments, other public entities, and companies—steps that may be described as mild financial repression with European characteristics.

As for the United States, the components “credit risk: securitization framework” and “market risk: standardized measurement method” are graded materially non-compliant, in both cases because the Dodd-Frank Act of 2010 prevents banking regulations from explicitly referring to the ratings produced by credit ratings agencies. For both the European Union and the United States, four additional components are graded largely compliant. All remaining components are deemed compliant, except one that has not been implemented in the United States and is thus assessed as not applicable.

The Basel Committee’s assessment is actually milder on one component regarding the European Union than could have been expected. That component, “definition of capital and calculation of minimum capital requirements,” is graded largely compliant (as it is also for the United States). The report notes a number of departures from Basel III under this chapter. Among them is the treatment of insurance subsidiaries (which are important for large French banking groups), the capital of cooperative banks (important in Germany and other member states), and temporary accounting quirks on the booking of losses on sovereign debt portfolios. These departures from Basel III were included early in the elaboration of the capital requirements regulation under what has been labelled the “Danish compromise” because it was negotiated during the Danish Presidency of the Council of the European Union in 2012. The compromise led the first RCAP report of October that year to grade the draft CRR as materially non-compliant on the definition of capital criterion. Since then, EU negotiators have apparently convinced the assessment team that the corresponding impact is less significant than initially feared.

The European Union has departed from the Basel standard more than other advanced economies in part because of the preference—at least until the inception of banking union in mid-2012—for hiding banks’ problems as long as they could still satisfy their short-term obligations. This lenient approach, politely referred to as supervisory forbearance, has affected the position of several EU member states in the Basel Committee during the negotiation of Basel III in 2008–10. It has also shaped the legislative process that led to the CRR and its complement, the fourth EU Capital Requirements Directive (CRD4), which was finally adopted in June 2013. The absence of a sustainable fiscal framework at the euro area level largely explains (and arguably justifies) the risk-weighting of euro area sovereign exposures at zero. The aim to favour the direction of credit to struggling member states and companies led to the amendments on SME risk-weighting and CVA risk exemption in the later phases of the CRR/CRD4 legislative process. The European Union could have restricted the contentious provisions to small- and mid-sized banks, avoiding any problem of Basel III compliance because the Basel accords are only intended for large internationally active banks. But the EU, perhaps influenced by larger banks, has long preferred to apply the same prudential rules to all banks irrespective of size.

Even so, the EU departure from Basel III has downsides:

• It results in more lax supervisory standards. Banks’ regulatory capital ratios are higher than they would be if Basel III had been consistently applied. (The size of the difference depends on each bank’s specific risk profile.) The looser standards undermine trust in the European banking sector as a whole. Investors are left in the dark as to how much lower the ratios would be under “full” Basel III. For example, the recent comprehensive assessment of the euro area’s 130 largest banks resulted in the publication by the EBA of a measure of capital ratios that was widely referred to by the media and analysts as “fully-loaded Basel III.” But that assessment was actually (as the EBA correctly described it) a CRR/CRD4 ratio based on the rules to become applicable in 2016, after the expiration of transitional provisions. Though progress from previous practice on supervisory transparency was achieved, these disclosures fall short of informing investors about each bank’s capital strength according to Basel III.
• The departure from the global framework undermines the European Union’s influence in the Basel Committee, and more generally in global financial standard-setting bodies. In such bodies, as a senior policymaker once put it, “compliance is influence:” all things equal, the more a jurisdiction can credibly claim that it applies the agreed standards faithfully, the more impact it can have on future revisions or new standards. The European Union had such moral authority following its swift adoption of the previous Basel II accord of 2004, and has not refrained from blaming the United States about its own delayed process of Basel II adoption. But this advantage eroded when the crisis revealed major flaws in the Basel II framework, and is now impaired as the European Union lags in adopting the more rigorous Basel III.
• The European Union has long championed the emergence and strengthening of global financial standards as a general proposition. Its long-term interest remains aligned with successful global financial regulatory initiatives. But by not complying with Basel III, the EU weakens the global authority of the Basel Committee itself. Other jurisdictions may now introduce their own deviations from the global standards, under debatable assertions of local or regional specificities, and invoke the EU precedent.

For these reasons, the European Union should readjust its supervisory practice and prudential legislation, to comply with Basel III as it did with Basel I and Basel II. Annex 16 of the RCAP report helpfully lists 11 “issues that the European Union should consider to evaluate progress in aligning the EU capital regulations with the Basel framework.” The Basel Committee prefers this diplomatic phrase to simpler “recommendations,” because it does not want to be seen as being heavy-handed in seeking removal of the “materially non-compliant” mark.

Prospects for such convergence are mildly encouraging. The European Commissions’ statement in response to the RCAP report’s publication is more open and constructive than in October 2012, when the Basel Committee’s first assessment was denounced by Michel Barnier, then European commissioner. This time the shrill response has come from the European Parliament’s main political groups via a scathing joint statement assailing the Basel Committee as “a body that is working without legitimacy and without any transparency.” The lawmakers’ assertion that the Basel Committee “cannot modify the decisions taken democratically by the European institutions” is beyond dispute. But the irony, not missed by some observers, is that their arguments mirror those used by Eurosceptics who paint the European Union itself as unaccountable, opaque, and illegitimate and reserve the democratic label exclusively for national institutions. In fact, the Basel III accord received ringing endorsements from political principals of the world’s main economies, including the European Union and its largest member states, in successive summits of the G-20 since 2010. In spite of the posturing, however, future revisions of the EU CRR/CRD4 legislation, and of the Basel III accord itself, could gradually eliminate at least some of the most egregious non-compliance provisions.

On a shorter time horizon, the ECB has an important role to play (since November 4) as the supervisor of all euro area banks—directly for the 120 largest ones and indirectly, through a common policy framework, for the others. It can use its supervisory discretion (what the Basel jargon calls Pillar II measures) to impose stricter capital requirements than the minimum ones set by the CRR, and may align these with a more consistent application of the Basel III accord. It may also disclose how much a “fully-loaded” application of Basel III would reduce each bank’s capital ratio, something that it has the authority to enforce under the EU’s banking union legislation. In October 2014, both the ECB and the Single Supervisory Mechanism that it hosts have become full members of the Basel Committee, in which the ECB had only observer status before. The compliance-is-influence principle also applies to it. To maximize its impact in setting the future global standards on bank capital and prudential regulation, the ECB should use its new authority over banks to impose practices that better comply with Basel III than the imperfect minimum set in the EU CRR/CRD4 legislation. 

Europe's Banking Union Starts on an Encouraging Note

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

Sunday, October 26 was D-Day for Europe’s banks: At noon in Frankfurt, the European Central Bank (ECB) announced the results of its “comprehensive assessment” of the euro area’s 130 largest banks, including an Asset Quality Review (AQR) and stress tests. Simultaneously in London, the European Banking Authority (EBA) announced the results of these stress tests for a larger sample of banks, including the largest banks headquartered in the European Union but outside the euro area.

This was meant as a cathartic watershed that would allow the ECB to take over its new role as the licensing authority of all the euro area’s banks and direct supervisor of the largest ones, a transfer of authority from national supervisors that will occur on Tuesday next week, November 4. The comprehensive assessment is intended to draw a line under years of unsatisfactory oversight by national watchdogs and to allow the ECB to start from a high level of trust.

On the face of it, these objectives appear to have been met, even though a definitive assessment will only be possible several months from now. The ECB identified 25 banks as having been undercapitalized as of end-2013; of these, 12 have raised enough capital this year to be technically compliant with capital requirements, but the other 13 need to submit recapitalization plans to the ECB within two weeks. Four of these are in Italy: Monte dei Paschi di Siena (MPS) (which may have to lose its independence), Carige in Genoa, Banca Popolare di Milano, and Banca Popolare di Vicenza: This puts a cloud above the Bank of Italy’s reputation as a supervisor, especially as several other Italian banks also appear fragile. Farther west in Lisbon, Banco Comercial Portugues (BCP) is among the other institutions asked to strengthen their balance sheet, or else. In total, the assessment identified slightly more “problem banks” than expected but did not uncover problems so massive that they may trigger systemic instability.

Perhaps more importantly, the ECB (and EBA) flooded the market with a deluge of data, the full analysis of which will take several more days. One not-so-hidden nugget of information is how the banks would have fared if a more rigorous yardstick of capital, known as fully-loaded Basel III, had been used instead of the current “phased-in” measure that Basel III will replace in the European Union in a few years. In that case, a few significant German banks would have failed the test as well. They include HSH Nordbank, a northern German Landesbank that provides wholesale services to local savings banks (Sparkassen), in spite of the guarantees it has received for up to €10 billion from the local governments that are also its main shareholders. This group also includes DZ Bank and WGZ Bank, the two wholesale institutions that serve Germany’s system of local cooperative banks (Volksbanken and Raiffeisenbanken)—possibly the biggest surprise of Sunday’s entire disclosure package. The fact that Germany and Italy, two of the euro area’s biggest countries, are not immune to the ECB’s inquisitiveness suggests that the assessment has been kept reasonably independent from political pressure. In the two other largest countries, France and Spain, most banks passed the test successfully.

Crucially, this exercise must be seen as the beginning of a sequence of policy actions by the ECB—even as, to the thousands of professionals who participated in the process, it may feel like the end point of a long hard slog. To start with, investors and the public will need to be persuaded that there are no more skeletons hiding in the banks’ cupboards. This is likely to take a few months: The credibility of the EBA-led stress tests whose results were announced in mid-July 2011 was later ruined by the problems of Dexia in October 2011, then of Bankia in May 2012. Moreover, some of the AQR’s consequences will only be felt in the banks’ financial statements as of end-2014: For example, more of the €136 billion of additional nonperforming loan exposures identified in the AQR may be written down at that time. Overall, the definitive assessment on the robustness and credibility of the comprehensive assessment, and specifically of the AQR, will probably have to wait until the first quarter of 2015.

Furthermore, the ECB has a lot of followup work on its plate on a number of issues it has signalled it will address gradually after its assumption of direct supervisory authority on November 4. It should gradually tighten the definition of capital to make it fully compliant with the Basel III framework, including on the contentious question of insurance subsidiaries of diversified banking groups (a point on which even today’s “fully-loaded” disclosures are based on a laxer standard than the international accord, and which is particularly sensitive for several large French banks). It should put an end to the widespread practices of geographical ring-fencing of capital and liquidity by national supervisors within the banking union area, an aim that may eventually require legislative changes in Germany and elsewhere. It should vigorously encourage those banks that keep a high home-country bias in their sovereign debt portfolios to reduce it, something that ECB top supervisor Danièle Nouy has already announced. It should encourage cross-border bank acquisitions, and investment in banks by international private equity funds, to decrease the sector’s current fragmentation along national lines. Finally, it should gradually bring smaller banks (mostly German, Austrian, and Italian) into its supervisory fold, as Ms. Nouy’s deputy Sabine Lautenschläger has indicated.

The full economic impact of the comprehensive assessment will depend on these developments still to come. If all goes according to plan, it may unlock some of Europe’s repressed growth, by allowing most banks to lend more freely now that their creditworthiness has been duly checked—even though this will not resolve a number of other problems in Europe’s anaemic economy that contribute to depressed credit demand. Overall, this debut of Europe’s banking union comes five years too late, but better late than never. It is an encouraging start for the most transformative policy initiative that has emerged from Europe’s crisis so far.

Free Flash Cards for Commissioner-designate Jonathan Hill

This was posted today by Bruegel and the Peterson Institute (in two parts: I and II). 

The President-designate of the European Commission, Jean-Claude Juncker, has nominated Jonathan Hill, previously a UK government minister, as Commissioner-designate for Financial Stability, Financial Services and Capital Markets Union. The European Parliament has a veto on the eventual confirmation of the whole Commission, and has used this right in the past to request and obtain the replacement of individual candidates it deemed unfit. As part of the confirmation process, the Parliament’s Economic & Monetary Affairs Committee has quizzed Mr Hill on October 1, and decided to conduct a second hearing session next week. In preparation thereof, President of the European Parliament Martin Schulz has sent a list of questions to Mr Hill on October 2. The 23 questions in that list are copied below.

To enable Mr Hill’s overworked staff to enjoy a rare sunny weekend in Brussels, ready-made answers are suggested here. With due regard to the European Commission’s ever-stretched finances and to avoid any possible perception of conflict of interest, they are provided free of charge.[1]

1. What is your vision of a well-regulated and integrated Capital Markets Union? How do you define the concept, what are its features and what are in your opinion the three most important elements to achieve a Capital Markets Union?

Well these are meaty questions, so I will make a bit of a longish answer. The concept of the Capital Markets Union is the fulfilment of the Treaty’s promise of a single market for financial capital in the EU. The single biggest obstacle to this vision was the fragmentation of the banking supervisory framework, a crucial one given that banking intermediation represents most of the EU’s financial system. Now that this obstacle is being lifted thanks to banking union, we need to go further in creating a single market for capital. Because London is the hub of the EU’s capital markets, this needs to encompass all EU member states in a way that was not as critical for banking union, as Commission President-designate Jean-Claude Juncker helpfully reminded me in my mission letter.

As with banking union, the features of the Capital Markets Union are about regulation, supervision, and crisis management. In regulation, I will seek to fulfil the Larosière Report’s vision of a single rulebook, taking into account the principles of subsidiarity and proportionality with regard to existing national rules that affect capital markets. In supervision, I will review which non-bank financial firms need to be supervised, and for those that need to, whether the national or European level is most appropriate. For example, credit rating agencies and trade repositories are – appropriately, in my view – supervised at the European level by the European Securities and Markets Authority (ESMA). I believe it is appropriate that small audit firms be supervised by national audit regulators, even though I am less sure about firms that belong to the larger international audit networks. Financial consultancies and the like are not supervised at all. I will also review crisis management and guarantee frameworks for those non-bank financial firms that may require a special resolution regime or any other form of intervention process other than court-ordered insolvency in case of failure. I am thinking particularly of financial market infrastructures here, and specifically about central counterparties (CCPs) for which I have promised a recovery and resolution framework in the answers I sent you a few days ago.

As I wrote in these answers, the Capital Markets Union will have to be initiated quickly. But some of its components will take time to elaborate, decide and implement. I will duly consult and listen before entering into detailed proposals. That said, I can already tell you that I see the three most important elements as being:

(1)    An overhaul of the policy framework for capital markets infrastructure in the EU. I said during my hearing on Wednesday that I needed to get the plumbing right, so here we go. All market practitioners know that national barriers to sharing infrastructure, aided and abetted by economic nationalism (the promotion and protection of national champions), are a major factor of unnecessary cost and market fragmentation in Europe. I want Europe to have as efficient, cost-effective and innovative market infrastructure companies as the United States.

(2)    A quantum leap for consumer and investor protection. For example, it is common knowledge that while the EU has adopted common accounting standards by endorsing International Financial Reporting Standards (IFRS), these standards’ implementation and enforcement are not fully consistent across the EU because of separate national audit firms, audit regulators and enforcement authorities. I want us to do better than that.

(3)    An unprecedented EU effort on national insolvency frameworks. These need to be reformed and partly harmonized to allow for better financing of fast-growth companies and securitization of Small- and Medium-sized Enterprises (SME) loans. I know this is a political minefield but I will not shy away from the endeavour. Also, to complete the banking union, I will seek the creation of a single insolvency regime for large banks, perhaps as an alternative option to existing national regimes. I believe this can be achieved without Treaty change.

There are other elements of course, such as new rules on securitization, money market funds and other financial products; a review of possible obstacles to SME and infrastructure financing that may come from our prudential rules (especially Solvency II); and perhaps some work on the taxation of savings, even though I am aware of how difficult it will be to reach any form of harmonization in this latter area.

2. What are the main barriers to creating a Capital Markets Union? What specifically needs to be done for these barriers to be removed? Which ones will you be giving priority and why?

There are all sorts of barriers inherited from the past, and maintained by the pervasive economic nationalism that remains a key driver of our policy framework, in spite of all the lip-service given by member states to their obligations under EU treaties. To remove such barriers, I need to ceaselessly analyse and expose the costs of market fragmentation and the economic benefits of capital markets development, which require a degree of market integration. Let me stress that the objective is not integration or centralization for the sake of it, but to develop our capital markets for the benefit of all EU citizens.

3. If securitisation is to be revived, please outline your view of how it can be made safe and how it will lead to growth and jobs.

Financial activities are based on a trade-off between risk and reward and can thus never be made perfectly safe – otherwise it is the safety of the graveyard, as they say. I believe the recent joint paper of the Bank of England and European Central Bank can be a good starting point for our reflection. I expect to be able to make more specific proposals before the end of 2014.

4. What legislation can be adapted or introduced to support he further development and diversification of capital markets? How would this lead to SME's gaining better access to long-term funding via capital markets?

One instrument is to legislate on specific products or market segments to make sure they are properly monitored and stay within reasonable prudential limits, such as the Commission’s proposal on European Long-term Investment Funds. I will develop more proposals of this kind. However, I believe the framework conditions for capital markets development are even more important, in good Ordnungspolitik fashion as I may say in the language of Master Eckhart. (Or was it Erhard?) Thus my three priority elements as outlined under Question 1.

5. What recommendations would you suggest with regards to digital currencies like bitcoin?

I need more in-depth analytical work on this, and more generally on how technology is rapidly changing the shape of our financial system and the very categories through which we think about finance and regulate it. It is frustrating that people make more mobile payments in Kenya than in most EU countries. I want to be much more ambitious in adapting our financial regulatory framework so that it allows EU citizens to benefit from great new technologies, while providing adequate protection for consumers and against systemic and other risks.

6. What is your opinion on high frequency trading in general and its compatibility with the need to stimulate long term financing?

High-frequency trading is one form of technology-enabled financial innovation. I will consider it in a dispassionate way, and will also look with interest at what the US authorities are envisaging in this regard. There are both investor-protection and financial-stability concerns about HFT, which I take seriously but on which I have not drawn conclusions yet. Having said that, our financial system is vast, and it includes many different segments. I don’t see why the simultaneous existence of HFT and long-term financing should pose a problem per se.

7. The Chair of the European Banking Authority indicated that certain banks might not pass the on-going stress tests. Should this happen, what action would you take?

We are building up the Single Resolution Board and it will be ready for the deadlines set by the Single Resolution Mechanism Regulation. That said, in the next few months the responsibility for addressing the consequences of the European Central Bank (ECB)’s Comprehensive Assessment in terms of bank restructuring and resolution remains at the national level. Of course, I will monitor such developments closely and participate actively in those discussions that have a euro-area or EU dimension in this respect.

8. Could you provide details on how you see the distribution of responsibilities between yourself and Commissioners-designate Moscovici and Katainen in respect of issues in ECON’s field of competence, as well as the distribution of responsibilities between yourself, Commissioners-designate Moscovici and Dombrovskis, particularly with regard to the external representation of matters concerning the euro area?

I will work with Vice President Katainen under the terms set by my mission letter. Commissioner-designate Moscovici will take the lead on the Financial Transaction Tax and other issues of taxation, but I look forward to working together with him on assessing and addressing any possible impact in terms of market integration and financial stability. The teams that are transferred under my responsibility from the European Commission’s DG ECFIN will continue to play their important part in the financial sector assessment work of the so-called Troika. The external representation of matters uniquely linked to the euro area will be a task for Vice President Dombrovskis, assisted by Commissioner-designate Moscovici. Any external representation of matters concerning the banking union are for VP Katainen or (more probably) for me directly, as far as the Commission is concerned. And I will do external representation on EU financial regulation, for example in the Financial Stability Board, IFRS Foundation Monitoring Board, etc., the way my predecessor Michel Barnier did.

9. Taking into account he previous commitments of the Commission, are you in favour of a Single EU Deposit Guarantee Scheme? Will you make a legislative proposal to that effect, and if so when?

Well, as I am sure you well know, there can be no effective deposit guarantee without a potentially unlimited backstop from a credible fiscal capacity. This capacity currently exists at the national level but not at the European level, and is clearly not in my area of responsibility to create one. As soon as such a capacity exists, I will make proposals for a federal – oops, single – deposit guarantee scheme that will be backed by it. In the meantime, there is little more I can do than help implementing and enforcing the existing DGS Directive.

10. Can you make a clear commitment that when legislating for the EU28 you will guarantee the integrity of the single market and neither propose nor support or introduce double majority voting applicable to euro area and non-euro area Member States such as in EBA?

I do commit to the integrity of the single market. Now, as you know, I inherit some tricky issues as the Single Supervisory Mechanism (SSM) regulation and SRM regulation do not treat all member states equally. This was a necessary consequence of the political conditions under which they were adopted, not least the sometimes irrational unwillingness of my country of citizenship to participate in common-interest EU initiatives. (May I quote from the February 2014 report of the UK House of Lords here, paragraph 187: “It would be wise not to close the door on the possibility of some level of [UK] participation in Banking Union in the future, in particular as a means of further promoting and shaping the Single Market in Financial Services and the UK’s position within it”.)

As for double majority voting, it was found appropriate for the EBA last year. But in his mission letter, President Juncker asked me to “review the governance and the financing” of the European Supervisory Authorities, including the European Banking Authority. I will do this with an open mind and you will of course be closely associated with such review.

11. How do you intend to deal with discrepancies between EU and other important jurisdictions, notably USA? Which approach do you intend to take on third-country equivalence decisions? How do you plan to involve the European Parliament in third-country related matters?

This is a very complex area, and I cannot have a one-size-fits-all approach. The current discussion on financial services in the Transatlantic Trade and Investment Partnership does not look promising. I will need to give a serious second look at our objectives and proposals in this respect. The European Parliament will of course be involved in policy decisions that correspond to a legislative level, but not in individual supervisory decisions, as is common practice in finance.

12. Will you keep the European Parliament fully informed about the work being done in international bodies such as the FSB, Basel Committee, the IASB, and guarantee that unnecessary and unadapted rules for the EU financial sector are being avoided?

I will inform the European Parliament in these areas in line with what I will identify as best practices in other advanced democratic jurisdictions that are members of these bodies. These organizations being global, I cannot commit on their decisions. That said, I will do my best to favour decisions that are aligned with the European interest, and can be implemented in Europe in a fully compliant manner. I will also take a second look at areas in which the EU is currently not fully compliant with the global standard, such as the IAS 39 accounting standard and some aspects of Basel III.

13. What do you think of the proposals on Eurobonds made by the Commission in the Green Paper on the feasibility of introducing Stability Bonds?

I now have a particularly informed view on the subject. I believe that Eurobonds are part of a broader debate about what could be a sustainable fiscal framework for the euro area. I also believe that the sustainability of the current euro area fiscal framework is open to question, even though this will not be in my area of primary responsibility as a Commissioner. Frankly, we know that more debate and evolution of the national consensus is needed in Germany before this issue can move significantly, so I’ll stop there and let Chancellor Angela Merkel take the lead.

14. What do you think about payment regulation and the fact that payments in the Member States to suppliers should be done within 60 or 90 days at most?

I like the idea, but need to check whether this falls within my responsibility or is on a colleague’s turf.

15. You agreed that the problem of “to-big-to-fail” banks is important and persists. Can you outline how you intend to address it through legislation currently on the table and, potentially, new initiatives? Can you outline what a healthy European banking system looks like?

As for the January proposal of the European Commission on banking structural reform, I will consult extensively before taking a stance. I am sure you will also soon undertake hearings of your own. I have two clear objectives for this legislation. First, it should be a genuine single rulebook, at least inside the banking union area and I believe also for the EU as a whole: some recently adopted national legislation may need to be modified as a consequence. Second, it should facilitate not impede the resolvability of banks, even though I know full well this is easier said than done. Having some convergence with the so-called Volcker Rule in the US would be nice as well, though not a must-have. For the rest, I have an open mind.

Beyond this text, I am following with particular attention the FSB work on bank resolution and still believe a globally consistent framework can be agreed upon there, in which case I will work at its compliant adoption in the EU. A healthy European banking system should be diverse, well-capitalized, well-managed and well-supervised.

16. The IMF is warning about an uncontrolled rise of shadow banking activities. You stated a need to be vigilant of the risks such activities entail but also to distinguish economically useful activities of this kind from others. Can you outline how you propose to detect these activities, assess their utility and ensure the application of the principle of “same risks, same rules”? In this regard, what is your opinion about the key provisions regarding the Commission legislative proposal on Money Market Funds?

There is no such thing as a typical shadow banking activity. The generally accepted (though arguably incorrect) use of the term refers to all non-bank finance. This encompasses myriads of market segments, defined by what they are not (namely, banks) not by what they are. We need to be humble as regards assessing what you call their economic usefulness: economists have not yet come up with a working macroeconomic model of the financial sector, and are unlikely to do so for a while yet. That said, I will do my best. Money Market Funds are one of these segments, and I believe the Commission proposal’s key provisions are reasonable.

17. You made several references in your written and oral answers to ECON about the possibility that we “may have got it wrong” in certain aspects of financial markets regulation and their interactions to the detriment of the real economy. Can you provide some examples of areas where this could be the case? Can you outline how you propose to detect such cases?

I believe the third regulation of credit rating agencies (CRA III) is a good example of politically motivated regulatory overkill. Some aspects of the European Market Infrastructure Regulation (EMIR) also appear to require review in light of the experience of their early implementation so far.[2]

I will ask an independent task force of highly respected luminaries to do an in-depth review of overlaps, underlaps, inconsistencies, unintended consequences, and mere bad drafting of currently applicable legislation and rules, with the aim of having a comprehensive report by early 2016. Without wanting to boast about UK experiences, I believe the Independent Commission on Banking (also known as Vickers Commission) provides a good benchmark in methodological terms. It had a temporary secretariat for a period of up to a year, formed of very capable technocrats seconded by various public authorities, and gave an extensive look at the academic and other analytical literature not just at the legal or political context. Such features could inspire me for the review task force.

18. You mentioned in your written responses that one of the key features of this parliamentary term will be the renegotiation of the relationship between the UK and EU. As a senior member of the UK government, you will be fully aware of any contentious areas in the financial services portfolio. Could you outline what they are and what strategy you would suggest to deal with potential conflicts between UK and EU objectives?

Put simply, the City of London serves the entire EU (and to an extent as well, the global economy) but is primarily supervised, and largely regulated, by the UK government and its agencies. There is a tension there. The EU interest, the UK interest and indeed the interest of the City (though I won’t pay any attention to the latter) are aligned on many topics, but not all. Systemic risk management is a good example of misalignment, as sadly illustrated by the ongoing lawsuit by the UK against the ECB on its so-called location policy for CCPs. My strategy is simple. I will work entirely for the EU interest, within the framework of EU institutions that give a significant voice to the UK government and citizens. I believe that a strong, internationally competitive and properly supervised City of London is absolutely in the EU interest.

19. You committed yourself to the principle of proportionality. Can you outline measures and proposals you want to put forward in order to ensure that small and low complexity financial actors will not be pushed out of the market because of regulatory burden?

This is a case-by-case question. For example, the Alternative Investment Fund Managers Directive has size thresholds under which some provisions do not apply. If I decide to propose a revision of AIFMD, I will certainly keep the principle of such thresholds.

20. Could you provide the committee with a complete list of the financial services clients you personally, or the companies in which you held directorships or shares, worked for?

See Appendix A. [Appendix A still to be drafted.]

21. Do you agree that financing of the three European Supervisory Authorities wholly by the sectors they supervise, as indicated in the mission letter by President-elect Juncker, is simply taxation through the back door?

Well, financing them out of the EU budget is also taxation through the back door, or maybe the front door depending on your perspective. These are public institutions, and their funding cannot be based on voluntary donations. My understanding of my mission letter is that the funding should be changed to make it more predictable, more sustainable and less prone to frequent political negotiation. Such change would be appropriate and indeed needed for independent supervisory authorities. As I said before, their governance needs to change as well, supporting their independence and mandate to serve the European public interest.

22. Could you provide us with a specific figure/estimate on the size of the implicit funding subsidy for Too Big to Fail Banks by taxpayers in the EU and how you envisage removing that subsidy by means of banking regulation?

Economic studies suggest this implicit subsidy is evolving over time and generally decreasing of late. I do not have a more specific quantitative snapshot at this point, but will work at reducing it further. See also Question 15.

23. In relation to the Commission proposal on Benchmarks, there is significant pressure to extend or increase the number of definitions of benchmarks. Do you take the view that it is appropriate to have different supervisory rules for different benchmarks, depending on their importance, which could give rise to regulatory arbitrage, or do you think it is better to have a simple supervisory rule that applies to all benchmarks?

I am instinctively wary of one-size-fits-all solutions to complex challenges, but your point on the risk of regulatory arbitrage strikes me as well-taken as well. I will also look at having a framework on benchmarks which is compatible with evolving requirements and practices outside the EU.

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[1] It should be noted that unlike Mr Hill, the author has no political affiliations or commitments. Therefore, these prepared answers for Mr Hill do not necessarily reflect the personal opinions of the author.

[2] N.B. The author is an independent board member of the global trade repository arm of DTCC. More disclosures are on www.bruegel.org. 

Mapping Europe's (Mostly German) Small Banks

This blog entry was posted today by Bruegel and the Peterson Institute. 

A well-known limitation of Europe’s banking union is the fact that most banks in the euro area will escape direct supervision by the European Central Bank (ECB) and the Single Resolution Board that will address insolvent banks from next year. Indeed, the ECB’s recently published mapping identifies 3,652 banks in the euro area, of which only 120 groups are subject to its direct supervisory authority, though these 120 larger banking groups represent at least 80 percent of total euro-area banking assets.

A closer look at the ECB’s list shows that the smaller banks are concentrated in a limited number of countries, much more so than larger ones. Germany, Austria and Italy together are home to almost four-fifths of all smaller banks, and Germany carries the lion’s share. (1,697 out of the 3,532 smaller banks which the ECB calls “less significant supervised entities” are in Germany.)

 

This imbalance is linked to the structure of the banking market in Germany, where many savings banks (Sparkassen) and cooperative banks (generally called Volksbanken or Raiffeisenbanken) serve local customers. Austria is also home to hundreds of often tiny cooperative Raiffeisenbanken and Raiffeisenkassen. In Italy, small local banks take different forms, including many cooperative credit banks (banche di credito cooperativo), rural savings banks (casse rurale), and cooperative casse Raiffeisen in former territories of the Austrian Empire.

By contrast, in many other countries, local banks are consolidated into groups that are large enough to be subject to the ECB’s direct supervisory authority. This is the case of most Spanish savings banks following recent consolidation (cajas de ahorros and cajas rurales); of Finnish Osuuspankki cooperatives within the OP-Pohjola Group; of French savings and cooperative banks (Crédit Mutuel, Caisses régionales du Crédit Agricole, and Banques populaires and Caisses d’épargne et de prévoyance within BPCE Group); and of Dutch rural Raiffeisen-Boerenleenbank cooperatives within Rabobank. It is also the case of Austrian savings banks (Sparkassen), consolidated within Erste Group, and Volksbanken under Österreichische Volksbanken AG.

The ECB’s criteria for distinguishing between groups it considers integrated (such as Rabobank or Erste) and those scattered across independent local entities (such as the German Sparkassen or Austrian Raiffeisen cooperatives) are based on legal form and ownership. Whether this distinction is meaningful for prudential purposes is not a trivial question, however. German savings banks rely on an elaborate system of mutual oversight and contingent guarantees, which suggests that they might be consolidated as one single entity for the purpose of systemic risk analysis. In other terms, the ECB’s separation of euro area banks into “significant” and “less significant” relies on objective criteria, but these criteria’s economic relevance may be tested over time.

One additional twist is that, in several countries and systems, local banks pool functions such as asset management and wholesale market activity into separate entities that are typically large enough to be caught in the ECB’s direct supervisory net. Specifically, Germany’s Sparkassen rely on regional Landesbanken, which are all directly supervised by the ECB (except the tiny one in Saarland), and on DekaBank for asset management. German Volksbanken and Raiffeisenbanken similarly rely on DZ Bank and WGZ Bank, and so do Austrian Raiffeisenbanken on Raiffeisen Zentralbank. While the nature of these links does not lead to accounting consolidation, the corresponding financial interdependencies could be significant in at least some crisis scenarios – especially as the European Commission’s recently strengthened assertiveness on state aid control could limit the availability of alternative support by municipalities or other territorial entities, as has often been observed in the past.

In contrast to small banks, the 120 larger banking groups subject to the ECB’s direct supervisory authority are much more equally spread across all euro area member states:

The much longer “tail” (the grey quadrant) in this chart is due to the legal minimum of three “significant” banks per member state, which leads to comparative overrepresentation of the smaller countries. Otherwise, and unlike the above chart about smaller banks, member states are represented broadly according to their economic weight – with a slight overrepresentation of Luxembourg, as a significant financial center, and of Spain, where recent consolidation of Cajas has led to a large number of medium-sized banks. France is slightly underrepresented in this count, because its banking sector is uniquely concentrated.

These observations have policy implications. The exemption of small banks from the ECB’s direct supervisory authority was not in the European Commission’s initial proposal for the Single Supervisory Mechanism Regulation (September 2012). This exemption was introduced during the negotiation within the Council, reportedly at Germany’s vocal insistence. Its consequences on the structure of Europe’s banking union are asymmetrical: the exempted banks (for which the ECB will be the ultimate license-granting authority, but will delegate supervisory tasks to the relevant national authority) form a minor part of most participating countries’ financial systems, but loom large in Germany, and to an extent also in Austria and Italy. It remains to be seen how this asymmetry may, or may not, lead to future political tension and/or regulatory arbitrage across European nations.