Nicolas Véron

Banking Regulation in the Euro Area: Germany Is Different

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

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

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

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

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

 

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

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

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

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

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

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

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

 

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

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

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

 

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

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

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

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

 

Conclusion

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

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

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

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

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

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

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

Is the United States Reneging on International Financial Standards?

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

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

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

The new Fed rule breaches the Basel III Accord

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

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

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

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

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

The motivations for these changes are unconvincing

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

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

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

The United States would lose from abandoning global financial standards

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

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

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

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

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

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

Expected Loss vs Incurred Loss Provisioning

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

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

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

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

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

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

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

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

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

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

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

The Basel III Experience

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

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

A European AML Supervisor: From Vision to Legislation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

A Major Step Toward Combating Money Laundering in Europe

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Brexit and Finance: Brace for No Impact

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

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

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

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

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

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

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

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

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

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

Questions on financial services policy for Valdis Dombrovskis

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

References

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

 

How the EU May Respond to US Trade Aggression

This blog post co-authored with Anabel Gonzalez was just published by PIIE. It is based on our recent study for the Greens/EFA Group of the European Parliament.

Update (September 19): the same post was published on the Bruegel Blog. 

The incoming European Commission led by Ursula von der Leyen faces a dilemma on the transatlantic trade relationship because of the unpredictable policies of the Trump administration. Should the Commission negotiate with the United States to de-escalate sanctions and defuse myriad issues and work through the World Trade Organization (WTO)? Or should the Europeans simply wait the administration out, knowing that making a significant deal is nearly impossible and hoping that President Donald Trump will no longer be in the White House after 2020?

Whether or not Trump follows through on his threats of more tariffs on Europe, the European Union cannot afford to just wait and see. It should test whether the administration can agree to some specific timely deals to minimize the risk of car tariffs; the conditions are not there, however, for a broader agreement. It should also try to settle the long-standing dispute over subsidies pitting Boeing against Airbus. Most important, Europe should bring together China and like-minded countries to uphold and reform the WTO. A united EU internal front is critical to deliver on these goals.

The Trump administration has repeatedly expressed unhappiness with Europe. In August 2019,  President Trump reiterated that “the European Union is worse than China, just smaller. It treats us horribly.” The July 2018 visit of European Commission President Jean-Claude Juncker to the White House brought the European Union some respite, but points of contention have only increased since.

The European Union is the world’s largest and most open trading bloc. In dealing with the United States, it is affected by Washington’s approach toward China and its attack on the WTO. But Europe is itself also a target of the disruptive US trade policy stance, and its bilateral trade deficit with the United States has not shrunk (see figure). The threat of national security tariffs on automobiles and automobile parts from the European Union hangs in the air, along with the possibility of more tit-for-tat tariffs over the long-running Airbus-Boeing dispute and French plans for a digital tax on technology companies.

In recent months, Washington has made rapid progress on a limited deal with Tokyo, granting concessions on auto tariffs in return for Japan allowing market access for some US agricultural products (similar to what it has agreed to in the Comprehensive and Progressive Agreement for Trans-Pacific Partnership). A similar “agriculture for cars” deal with Europe would be hard to attain, since the United States and Europe are at odds on negotiating objectives. The new European Commission could revise the European stance. But French farmers are unlikely to cede on agriculture to save German carmakers, even if German car production draws heavily on imports of auto parts from all over Europe. Moreover, the European Union has stated it will not accept quotas or any form of managed trade in automobiles, making a “zone of possible agreement” uncertain at best.

The alternative to no agreement, however, is not good either. The European Union could face higher tariffs in its most important market for car exports, which could add up to $11,000 to the price of each EU car. Also, in addition to filing a WTO case against the United States, Brussels would likely retaliate with tariffs on imports of US products. The new European Commission announced it will strengthen its toolbox to use sanctions when other countries adopt illegal measures and simultaneously block the WTO dispute settlement process. While necessary from the perspective of power politics, “tariff rebalancing” would harm EU producers and consumers.

But some creative options to avert an escalation are not impossible. For example, a recent low-profile deal to improve US access to the EU beef market has created some goodwill. At the G-7 meeting in August 2019 in Biarritz, France offered a compromise on digital taxes in which it would repatriate revenue from the tax if there is a global deal on taxing technology companies.

Meanwhile, the 15-year-old dispute between Airbus and Boeing is coming to a head. The WTO has found both sides at fault for subsidizing their companies and authorized them to retaliate. Washington estimates damages caused to Boeing from EU subsidies at $11 billion while Brussels’ assessment of damages is $12 billion. Both sides have already produced lists of items to be potentially hit by tariff increases. Conditions are, therefore, ripe for a stand-down. Both the United States and the European Union have broken the rules, but a negotiated settlement to bring them into compliance with multilateral rules and a long overdue new framework to govern export financing in this sector would be the wiser course of action.

US and EU views diverge on multiple other topics, including the use of Huawei equipment in 5G networks, the impact of China’s Belt and Road Initiative, sanctions on Iran, and the strengthened extraterritorial application of US law on Cuba. Some escalation on these and other tensions may be unavoidable, but cooler heads should at least try to find alternative ways of managing differences in the next year.

The European Union has a special role in sustaining the multilateral trading system and preventing its potential demise. While the US approach has been less than constructive, the European Union is well placed to exercise leadership of middle-sized powers and developing countries to build a large coalition in support of the system. It may even be able to bring China around to play a constructive role in effective WTO reform. The immediate concern is focused on the Appellate Body crisis, which most likely cannot be sorted out without a greater commitment by emerging-market countries to the system and negotiation of new rules on subsidies, forced technology transfer, notifications, and others. Temporary solutions may be necessary, but ultimately, engagement with the United States is indispensable.

The European Union draws credibility from its long-standing principled commitment to the rules-based order, from established policy instruments such as its competition policy, and from its economic might. But it must further rally its citizens around the compatibility of an open trade policy and the fight against climate change and oppose economic-nationalistic agendas of some political leaders. The greater the divides between member states and with the EU institutions, the lesser the chances of the European Union forging effective policies toward the United States and China.

 

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.