Nicolas Véron

Banking Union & Capital Markets Union: Prospects for 2015

This opinion piece was published last week by Caixin, in Chinese and in English, under the title "The Reshaping of Europe's Financial System," and reposted by the Peterson Institute. 

Financial crises always challenge conventional assumptions about financial systems. Europe is no exception. Before 2007, most Europeans thought that their system, which was dominated by banks supervised by national authorities, provided them the safe and efficient financial services they needed. But the crisis has revealed unsuspected fragilities in Europe's banks, and the consequences are still unfolding. The year 2015 will see new steps in the resulting transformation of European finance.

The most important policy initiative so far has been the inception of a banking union in 2012. This refers to the decision to endow the European Central Bank (ECB) with central authority over banking supervision in the euro area, and to create a new European agency to handle future cross-border banking crises. The ECB duly took on its supervisory responsibility in November, and the bank resolution agency will be operational in a year's time. In July, the new president of the European Commission in Brussels, Jean-Claude Juncker, announced another financial reform effort, which he called a capital markets union. He presented it as a push to develop non-bank financing of the European economy. A debate has started on the capital markets union's exact ambition, timing and content.

The economic reasoning behind all this is sound. Contrary to pre-crisis consensus, Europe's overdependence on banks has meant fragility not strength. When banks need to repair and reduce their balance sheets following financial turmoil, as is now the case, there is no "spare tire" to keep providing credit to the economy. This stands in contrast with the more diverse U.S. financial system, where bank restructuring in 2009-10 did not have contractionary impact because alternative channels of financing were available. It thus makes sense for Europe to develop larger, more integrated capital markets. The European commissioner in charge of financial services legislation, Jonathan Hill, can safely move his teams' attention from banks to capital markets, while his predecessor, Michel Barnier, had to concentrate most of his focus on banking laws that are now enacted.

However, EU policymakers should have no illusion about the pace of change in the structures of the financial system. Strong, vibrant capital markets will take many years to develop. In the meantime, banks will remain the mainstay of European finance, and banking policy will still have much more economic impact than new capital markets legislation.

Thus, in the short-to-medium term, the central role in addressing Europe's financial challenges will be played by the ECB, not the European Commission. The ECB has a heavy agenda in its new role as Europe's banking supervisor. First, it should enforce a more harmonized and rigorous definition of capital. Second, it should put an end to the constraints imposed by national regulators, which prevent pan-European banks from shifting capital and liquidity across borders within the euro area, and thus lead to harmful financial fragmentation. Third, it should force banks that hold excessive amounts of sovereign debt issued by their home country to rebalance their debt portfolios and reduce their home-country sovereign exposure to at least below one-quarter of regulatory capital. Fourth, it should adopt a consistent policy framework for groups of small banks that support each other, such as Germany's savings banks, to ensure they do not result in hidden systemic risk. Fifth, the ECB should dramatically enhance the transparency of supervisory and risk information that it provides about banks, and that banks provide about themselves. This would build on the numerous disclosures made last October at the close of the ECB's initial assessment of the euro area's 130 largest banks, but making these disclosures regular time series rather than a one-off observation.

Most importantly, the ECB must finish the job that has been started with that comprehensive assessment. The massive exercise of asset quality review and stress testing was a significant step in the right direction, but has not yet restored confidence in Europe's battered banking sector. The ECB must reassure the doubters. It should ask all banks it supervises, including those whose shares are not publicly listed, to disclose their capital ratio under a definition truly compliant with the global Basel III standard. All the discrepancies between that standard and the EU's Capital Requirements Regulation, as listed in a recent report from the Basel Committee, should be corrected in such calculations, except possibly the zero-risk-weighting of EU sovereign debt, as long as the euro area does not have a sustainable fiscal framework. The ECB should mercilessly wield its supervisory authority to impose higher capital requirements on all banks it considers unviable and trigger a resolution process if those requirements are not met. In other words, kill the zombies and heal the wounded. This thankless work should be essentially completed by the end of 2015. Waiting beyond that date would make it much more difficult, as the ECB will be held responsible for its own supervisory shortcomings in the meantime.

By contrast, the capital markets union agenda is entirely about the long term. Trying to boost its short-term impact, with public subsidies or regulatory shortcuts, will only result in harmful distortions that will defeat the initiative's purpose. The level of ambition should be correspondingly high. Rather than tinkering at the edges of securities regulation, the European Commission should aim at substantially harmonized frameworks for insolvency law and the taxation of savings; an integrated supervisory and resolution system for key markets infrastructure firms; fully consistent financial disclosures, accounting and auditing practices across EU countries; and an asset management industry that better serves the interests of European investors and savers.

The EU has many problems. Its growth is anaemic, and unemployment too high. Some of its member states are still living beyond their means. Its citizens are increasingly resentful of political elites and institutions. But in financial services policy, it may belatedly be moving in the right direction. The ECB's banking policy actions in the short term, and the European Commission's capital markets legislation in the long term, have the potential to make Europe's financial system more stable, more diverse and more efficient, to better serve the needs of European households and companies. This opportunity must not be missed.

Banking Union in Nine Questions: Interparliamentary Conference Testimony

On Tuesday 30 September, I participated in an Interparliamentary Conference bringing together representatives from parliaments of (almost) all EU member states as well as the European Parliament, hosted by the Italian Chamber of Deputies at Palazzo Montecitorio in Rome. My written statement takes stock on banking union, its past, present and future. It was also posted by Bruegel and the Peterson Institute. 

My Hearing at the UK House of Lords

Together with corporate lawyer Simon Gleeson, I was a witness last week (September 9) before the Sub-Committee on Economic and Financial Affairs of the EU Select Committee of the UK House of Lords, as part of their review of the EU financial regulatory framework. This was an in-depth conversation on the EU's responses to the crisis since 2007-08, its successes and mistakes, the EU policymaking process and its differences with the US, and the UK interest. 

Both the audio podcast and the PDF transcript of the hearing are available on the House of Lords' website. The transcript was also republished by Bruegel and PIIE and is separately available here. 

Europe's Half A Banking Union

This piece was co-authored with Adam Posen as the cover story of the June 2014 issue of Europe's World (reposted with permission - © Europe's World)

This spring, the EU institutions agreed a series of legislative texts that suggest bank closure decisions will be taken at the European level, not nationally. A Single Resolution Board will be established in Brussels as a new EU agency, and backed by a Single Bank Resolution Fund to be set up by separate treaty. These measures complement last year's legislation for pooling the supervision of most of the European Union's banking sector by the European Central Bank (ECB) in Frankfurt.

The link between European countries' creditworthiness and that of banks headquartered in them still exists for a number of reasons: the limitations imposed on the Resolution Fund, the absence of common deposit insurance, and the insistence by some countries that so-called "legacy" bad debts cannot be paid for by common financial resources. In any event, it's inevitable that some European taxpayers will again be finding themselves the unwilling victims of more banking failures, perhaps as soon as this autumn.

Skepticism about Europe's banking reforms should, however, end there. Decisions made so far on Europe's banking union are significant, substantial, and likely to become entrenched. As we argued in June 2009 in a paper published by the Peterson Institute and Bruegel, a system-wide process of bank triage, forced recapitalization where it was needed, and restructuring was the tried-and-tested way to resolve Europe's systemic banking crisis, and to succeed it had to be done at the European rather than national level.

If adequately executed, the ECB's asset quality review (AQR) of the euro area's largest banks will provide a credible, though sadly belated, triage of the kind we proposed back then, if accompanied by the requisite resulting capital injections and restructurings. The early credibility of the AQR can be seen in banks' widespread and substantial cutbacks in loan books, and the far fewer but still extant capital raising exercises, over the last few months to get their balance sheets ready.

The starting point of Europe's banking union was the euro area summit statement of mid-2012, when EU leaders committed to:

• "break the vicious circle between banks and sovereigns,"
• centralize banking supervision at the ECB,
• and use the recently-created European Stability Mechanism (ESM) for direct recapitalization of individual banks, including those that were then in the process of being restructured in Spain under EU oversight.

Until that statement, EU member states had defended their local control over banking policy as an unnegotiable attribute of national sovereignty. What can be described as "banking nationalism"—a continued reliance on national policy instruments to defend and promote national banking champions in an increasingly integrated European financial market—can be identified as a key reason why the financial crisis of 2007–08 had such a severe impact on Europe, despite having started in the United States. It also explains why, unlike in the United States, European policymakers were unwilling to resolve it and were unable to rapidly reestablish trust in their banking system.

Before the crisis, national authorities had encouraged "their" banks to grow so that they could become predators rather than prey in what most anticipated would be a wave of cross-border banking consolidation across Europe. This ambition came at the expense of prudence about systemic risk; between 2003 and 2008, the aggregate assets of Europe's banks grew by the equivalent of almost the entire European GDP. The act symbolizing this era was the takeover of the Dutch bank ABN Amro by a consortium of the UK-based Royal Bank of Scotland, the Belgium-based Fortis, and (after a follow-up transaction) Italy's Monte dei Paschi di Siena. All three took on too much risk and debt for their own good in the process. They should have been discouraged from doing so by their respective home-country supervisors, but were not. All three acquiring banks then became costly failures, requiring fiscal bailouts and disrupting of credit flows.

After the crisis erupted in the summer of 2007, banking nationalism again stood in the way of swift crisis management and resolution. It was a classic collective-action failure. Many national authorities knew there were weaknesses in "their" banks, but were unwilling to address them before neighboring countries did likewise, as this could put their own local champions at a competitive disadvantage and maybe lead to their takeover by outsiders. This compounded the usual harmful incentives for bank supervisors to engage in forbearance, i.e. holding off on closing or forcibly merging regulated banks in the hope that an economic recovery (or the end of the supervisor's term) would spare them from the need to do so.

For each national authority, the incentive was thus to pretend that the extent of problem loans was not only exaggerated (while actually allowing them to increase), but also that the worst problems were outside of their own territorial remit (while going soft on supervision at home). This became all too apparent in the inadequate stress tests whose results were announced in September 2009, July 2010, and July 2011. Banks like Dexia were given a clean bill of health, only to collapse a few months later. Self-defeating supervisory behavior is hardly unique to euro area bank supervisors, but the escalation of such reality denial in the face of market panic and bank-sovereign doom loops in 2010–11 was the result of banking nationalism.

Seen in this light, the banking union is a direct solution to the Maastricht treaty's incompleteness in the banking area. The 1992 EU treaty combined a commitment to a single financial market and a single currency with a nationalistically-motivated refusal to integrate bank supervision and resolution at the European level. It took Europe's leaders five years of deepening credit collapse and financial crisis and a dramatic rise in Spanish and Italian sovereign spreads, plus the brief denial of access to dollar funding experienced by French banks in the summer of 2011, to realize that this combination was proving terminal. In late June 2012, with the single currency's survival at stake and running out of options to prevent a break-up, they took the extraordinary but necessary step of effectively bidding farewell to banking nationalism.

Perhaps inevitably, a combination of policy successes and setbacks marked initial implementation of the banking union commitment. An early disappointment came in mid-September 2012, when the finance ministers of Finland, Germany, and the Netherlands issued a joint statement opposing any direct bank recapitalization by the new European Stability Mechanism to bridge "legacy" capital gaps, i.e. losses on investments made by banks before the banking union. The statement reversed the prior agreement by those same countries' at the European Union's June 2012 summit that the ESM would directly recapitalize Spanish banks, if only retroactively. That reversal understandably raised doubts about the northern euro members' commitment to the entire banking union project. However, thanks to the announcement by the ECB of its Outright Monetary Transaction (OMT) commitment, as well as the justified belief that although legacy losses were finite, banking union would be forever, investor sentiment shifted to a new equilibrium that discounted the likelihood of a euro area collapse.

The establishment of the Single Supervisory Mechanism (SSM), however, was pursued with speed and determination. By December 2012, all member states agreed on draft legislation that empowered the ECB as the bank licensing authority for the whole "banking union area", including the euro area but also including any non-euro EU country that might join the banking union voluntarily. In a concession to the uniquely powerful German local bank lobby, most smaller banks with balance sheets under €30 billion were exempted from direct supervision by the ECB. But that low threshold still leaves the vast majority of the banking union's banking assets, including almost all German Landesbanks and other mid-sized institutions, under the ECB's immediate authority. Furthermore, the ECB has room to expand its remit and retains ultimate licensing authority over all credit institutions. The ECB also gained enforceable access to information from supervised banks, and the legislation makes it practically impossible for individual national authorities to obstruct ECB supervisory processes. Despite the delays resulting from the subsequent negotiation with the European Parliament, and various procedural roadblocks by Berlin during Germany's pre-election period, the SSM Regulation of October 2013 stands out as a swift and comprehensive pooling of sovereignty with few equivalents in the whole history of the European Union.

More recently, the European Union adopted a Bank Recovery and Resolution Directive together with the Single Resolution Mechanism, in principle paving the way towards a future in which the resolution of insolvent institutions would be conducted at European level and would minimize recourse to public funding. Unlike the SSM, the Single Resolution Board will be single in name only, as the legislation that sets it up foresees a significant degree of lingering autonomy for national resolution authorities.

Other progress has been made towards a banking union, though not all changes were equally comprehensive. The adoption of the Capital Requirements Regulation in June 2013 was a significant step towards having a "single rulebook" that the ECB could enforce uniformly across the banking union area, even though it regrettably deviated from the Basel III accord on several important points. Simultaneously, countries including France and Germany adopted idiosyncratic national laws on the separation of activities within banking groups, which conflicted with their stated commitment to the banking union. The most worrying gap remaining is that the unification of deposit insurance within the euro or banking union area has not even been broached by political leaders. This is understandable in the absence of a fiscal union that could credibly back it, but its absence underscores the dangers of incompleteness, a good example having been the huge movements of savings across borders after Ireland's unilateral extension of deposit insurance in 2008.

With supervision now meaningfully integrated within the ECB, centralized resolution on the right path even though not yet there, and common deposit insurance sadly off-limits, it is fair to label the current legislative arrangements a "half a banking union." It is much more than a small step on the journey towards eliminating the vicious circle between banks and sovereigns, but it's still incomplete. As always in European institutional development, the question is whether a half-measure of integration is helpful or is too slow and even dangerously unstable. Our view is that in the case of half a banking union, this is sufficient progress to be meaningful and of a stabilizing nature. As we argued in 2009, to end the European banking crisis required the strict testing of bank solvency by a European-level authority using a unified and transparent standard. The half a banking union meets these criteria.

Crucially, the key transition step was put into motion by Article 33(4) of the SSM Regulation, which mandates the ECB "to carry out a comprehensive assessment, including a balance-sheet assessment, of the credit institutions" that it would start directly supervising in November 2014. The importance of this process, now widely referred to as the asset quality review (AQR), has become ever more obvious during the course of 2013. It amounts to a massive front-loading of the ECB's supervisory effort by a near-term deadline that is now approaching. This requirement creates large operational as well as political challenges, but to its credit the ECB is taking them on. One can hardly imagine the ECB granting or confirming a banking license to a bank that it wouldn't consider insolvent—and the many past failures of national supervisors imply that the ECB could not base its initial supervisory assessment only on their respective opinions. Most importantly of all, the AQR holds the promise of putting an end to the systemic banking fragility that has affected Europe since mid-2007.

It is now possible to be confident that the AQR will be more robust and credible than the previous European stress tests. The ECB will have direct access to bank information that was unavailable to the Committee of European Banking Supervisors (CEBS) in 2009 and 2010, and to its successor the European Banking Authority (EBA) in 2011. As the future supervisor, it will be able to demand much more cooperation from both banks and national authorities, and it has the legal means to enforce its information requests. It has a much larger staff than the CEBS or EBA had, and in addition can rely on armies of consultants and auditors. But given that the previous European stress tests ended in policy failure, just this comparative statement of capabilities may not be enough to guarantee that the AQR will be certain of success.

Nor can the success or failure of the AQR be demonstrated simply by either zero forced recapitalizations, which is likely to mean too soft an approach, or by some pre-set target number of banks being compelled to fail, which would be likely to indicate arbitrary political decisions rather than by supervisory assessment. In essence, the AQR should be deemed successful if three criteria are met:

• On the micro-prudential level, it will succeed if there is no equivalent case to Dexia in 2011—meaning that insolvent cross-border banks get identified and resolved rather than having their problems put aside and allowed to accumulate;
• On the systemic stability level, it will succeed if credit growth to normal nonfinancial borrowers turns positive again after the AQR results and any recapitalizations;
• On the market level, it will succeed if there is greater differentiation of prices among bank equity and debt within any given national economy, and banks deemed sound are not excessively punished for their country of headquarters—i.e., a narrowing of spreads.

Not all of this will be revealed immediately at the time of announcement of the AQR results, expected in October, but we expect there will be many indications within a short period of time thereafter.

The ECB's approach appears, reasonably, to be to incentivize banks to act ahead of this deadline, to write down any dubious assets, and to recapitalize proactively to the extent needed, as Italy's UniCredit and Intesa Sanpaolo and Germany's Deutsche Bank have announced. But pre-emptive capital-raising is unlikely to be feasible for the weaker banks, which may fail to convince investors to buy newly issued capital instruments, and may also be unable to sell distressed assets at prices high enough to bridge their capital gap. Problem banks of this sort will need restructuring or resolution by national public authorities, as ESM direct recapitalization is unavailable for "legacy" situations, and the Single Resolution Board won't yet exist when the AQR results are announced.

For the AQR to succeed, the ECB must not flinch at naming problem banks, and the relevant member states must address them in a manner consistent with their policy commitments, including the new state aid rules issued last year by the European Commission that restrict the potential for overt or covert bank bailouts. The fact that lending has been falling even as the euro's growth prospects have been improving and government interest rates have declined is evidence that the banks subject to the AQR have been taking this threat as credible and are raising their ratio of capital to loans. And the self-separation of those banks that can raise sufficient capital from those that cannot is further evidence, as well as progress on our third criterion.

Against this yardstick, our expectation is that the AQR will be broadly, if perhaps not entirely, successful. There could still be a failure of nerve by the ECB to see this through, or an unwillingness of a national resolution authority to do its job, but we believe this is unlikely to be on a large enough scale to compromise the whole exercise. Such a failure would have major negative consequences for the ECB, the euro area and the European Union as a whole, which would become apparent in markets almost immediately. The point of public pre-commitment is to make the costs of reneging so high that carrying out an obviously unpleasant duty nevertheless becomes a matter of self-interest. Government talk is often cheap (witness the previous failed European bank stress tests), but our assessment is that European policymakers, including the ECB, have now made a credible commitment. They have burnt their bridges and cannot retreat.

Assuming a successful AQR, the European half a banking union will become a reality, offering a reasonably clean and well-capitalized starting point for the vast majority of the banking union area's bank assets and all of its large credit institutions. Barring large external shocks to European financial stability, we expect this to have a more transformative impact on Europe's financial and economic structures than many observers seem to realize. This impact should become evident along a number of dimensions:

• Credit crunch resolution: A successful and complete AQR would trigger the return of trust in Europe's banks and an end to balance sheet contraction in those banks. This will improve retail credit conditions, particularly in the European periphery, thus reducing a major drag on economic growth and employment. A reliable signal of a return to normality would be growth in bank lending to small and medium-sized enterprises, with reduced spreads between lenders from different member states. On the policy side, this would allow an exit from the Eurosystem's extraordinary liquidity provision program to banks, known as fixed-rate full allotment, which has been in place since October 2008.
• Stricter supervision: Unhampered by banking nationalism, the ECB is likely to be a more demanding and less forbearing supervisor than the national authorities it will supersede. This will apply to supervisory practice, but we expect it will also improve regulation. Compared with national authorities from the euro area in the recent past, the ECB will not resist as much the strengthening of regulatory standards at the Basel Committee and in EU rulemaking processes, even though it may still champion advantages for European banks in international discussions.
• Fewer taxpayer-funded bailouts: As banking nationalism was a major driver of the EU preference for public bailouts during the first five years of financial crisis, the shift of supervisory authority to the ECB lends credibility to the proclaimed objective of relying more on "bail-in" and financial burden-sharing by creditors in future bank restructurings—even though systemic stability considerations would still justify a recourse to public financing in severe crisis scenarios. This in turn would further weaken the vicious circle between banks and sovereigns, a significant part of which is the anticipation of nationally-funded bank rescues.
• More cross-border financial integration within the banking union area: The ECB will have no incentive to discourage cross-border entry and acquisitions, as national authorities have done time and again in spite of formal commitments to the EU single market. In turn, the gradual emergence of truly pan-European banking groups will create a powerful interest in favour of the gradual elimination of countless cross-border competitive distortions and onerous national "gold-plating" of the EU single rulebook. In this new political economy, Europe's banking market may become more open to entry by non-European-headquartered banks, including into retail market segments, or at least more open to pressure on this front.
• The reduced dominance of banking in European finance: So far, banks have remained uniquely dominant in Europe's financial system when compared to other developed economies. One reason is the protection they have enjoyed from public authorities against potential competition from alternative credit channels, again motivated consciously or not by banking nationalism. The ECB has indicated it would take a much more sanguine view of the growth of market-based finance and nonbank financial intermediaries. Together with the previous point, this might contribute to a more diverse European financial ecosystem that could prove both more supportive of growth and employment, and more resilient in the face of systemic risk.
• A lower home bias in sovereign debt portfolios: The large holdings of home-country sovereign debt by a number of banks, particularly in periphery countries, have powerfully contributed to the euro area's bank-sovereign vicious circle. A large part of these holdings result from so-called moral suasion, or nonpublic arm-twisting, by national authorities on the banks they supervise to help finance "their" national government. The ECB is unlikely to have any interest in exerting this.
• A new balance in external representation: The ECB and other European-level agencies such as European Securities and Markets Authority and the Single Resolution Board can be expected to gradually gain prominence, in comparison to national authorities in banking union area countries, in international bodies such as the Financial Stability Board, the Basel Committee and the International Organization of Securities Commissions.

Many things could still go wrong for European financial stability. The ECB could become too prescriptive on the corporate governance and business models of supervised banks, leading to a damaging erosion of diversity in banking structures within the banking union area. Political confrontation between European and national authorities over resolution of a given bank could prove damaging to the sustainability of the whole framework, at least in the early stages. Conflicts of jurisdiction may appear. The divide between the banking union area and the rest of the European Union could prove damaging to the single market, and if (as is likely) some noneuro countries join the banking union, competitive distortions between these and the euro area could arise. The exclusion of smaller banks and nonbanks from direct supervision at European level could lead to harmful regulatory arbitrage. The reduced ability of member states to exert moral suasion over local banks will create political resistance to what reduces credit availability in dependent regions and sectors. But even with all these risks in mind, we are convinced that in terms of financial stability and beyond, the half a banking union that has been undertaken will be transformative and positive for the European Union.

Testimony on Banking Union to the Portuguese Parliament

On February 26, I gave a testimony to a joint session of the Committee on European Affairs, the Committee on Budget, Finance and Public Administration, and the Committee on Economics and Public Works of the Portuguese Parliament (Assembleia da Republica) in Lisbon. The text of my testimony was just published by the Peterson Institute, available here (and also here if the previous link does not work). 

The testimony is both backward-looking and forward-looking. It established the key importance of banking dysfunction and banking union in the broader sequence of the European financial crisis since 2007; describes the long-term policy challenges of completing Europe's banking union; and formulates specific short-term recommendations on the crucial comprehensive assessment and repair process of European banks in 2014, led by the European Central Bank and otherwise known as Asset Quality Review. 

Tectonic Shifts: a status report on European Banking Union in Finance & Development

Finance & Development, the International Monetary Fund's quarterly magazine, just published the following article. It is also available in PDF format from the F&D website. 

Tectonic Shifts

Banking union is a long-term process that will dramatically reshape Europe’s financial system

 On June 29, 2012, the leaders of euro area countries set in motion what is now universally known as European banking union, or the transfer of banking policy from the national to the European level. The first step, the empowerment of the European Central Bank as the new supervisor of most of Europe’s banking system, has a fair prospect of meeting—by late 2014 or early 2015—its stated aim of addressing the long-standing fragility of Europe’s banking system. But banking union will not stop there, and its structural implications will unfold well beyond the transition to centralized supervision.

Europe’s banking problem

Banking union was initiated to resolve a pressing problem. The euro area crisis highlighted the damaging vicious cycle of either weak government balance sheets, which undermined banks’ soundness, as in Greece, or banks’ weaknesses, which damaged government credit, as in Ireland. This linkage became a threat to the entire euro area and its financial system in mid-2011 and forced policy action in 2012. But the underlying problem of European banking system fragility long predates the outbreak of the euro area sovereign debt crisis in 2009-10.

This problem was generally denied throughout the first five years of the crisis. Many policymakers first claimed that banking weaknesses could be blamed on the U.S. subprime mortgage market, and then argued that fiscal mismanagement in countries such as Greece was to blame. This narrative was the conventional wisdom until 2012, especially in Germany and France, where policymakers used it to excuse home-grown sources of financial weakness.

However, the roots of Europe’s banking problem went much deeper. The core of the problem was a misalignment of incentives of Europe’s banking supervisors. EU countries and institutions, in the wake of monetary union in the 1990s, set themselves ambitious aims to remove cross-border barriers to entry in European finance. In reaction, national authorities tended to champion the protection and promotion of their countries’ banks to give them an advantage in an increasingly competitive environment, even when this entailed additional risk-taking.

This form of “banking nationalism” effectively downgraded prudential concerns about risk accumulation. A striking example was officials’ assent to the ill-fated takeover and breakup of the Dutch bank ABN AMRO in 2007, which contributed  to the subsequent difficulties of other banks, including Fortis, Royal Bank of Scotland, and Banca Monte dei Paschi di Siena. More generally, banking nationalism goes a long way toward explaining the massive buildup of leverage and risk in many European banks’ balance sheets in the decade preceding the global financial crisis.

The mismatch between the national scope of supervision and the European dimension of the financial system also explains the failure to address the fragile banking system from the outbreak of the crisis through 2012.

This failure was not for lack of adequate warnings, including from the IMF. Instead, it was a quintessential collective-action problem. Most countries were deeply reluctant to identify weak banks for fear of putting their banking sector at a disadvantage compared with those of neighboring countries, particularly in the euro area. The absence of a strong central authority resulted in paralysis or inadequate action. Successive Europe-wide bank stress tests in September 2009, July 2010, and July 2011 failed to restore confidence when their results quickly proved unreliable.

Watershed developments

Europe’s unresolved banking problem then became a factor in the euro area’s unfolding sovereign debt crisis.

The exposure of euro area banks, particularly in France and Germany, to Greek risk was a key reason why Greece’s government debt was not swiftly restructured in early 2010. Later in the same year, similar factors led to Ireland’s being barred from imposing losses on its failed banks’ senior creditors, which compounded its fiscal deterioration. By mid-2011, contagion in the market for government bonds had reached two of the four largest euro area economies, Italy and Spain. In August 2011, even French banks were briefly denied normal market access to dollar-denominated liquidity.

An increasing array of investors and policymakers started to factor the possibility of a euro area breakup into their calculations, raising the possibility of a disastrous self-fulfilling prophecy. The pressure generated by this environment led to a number of major policy changes in key member states and in the European Union as a whole, all between mid-2011 and mid-2012.

In the United Kingdom, the flow of bad news from the euro area cemented the conviction that the country should isolate itself from the continent and not participate in additional institutional buildup. This shift was summarized by Chancellor of the Exchequer George Osborne’s comment in July 2011 about the “remorseless logic” of political integration in the euro area, in which Britain would decline to take part. This marked a radical departure from decades of British participation in EU initiatives, even while attempting to moderate them—most recently the formation in 2010 of the London-based European Banking Authority.

In France, the banks’ funding difficulties in August 2011 undermined the self-confidence of the financial community and its belief in an independent national banking policy. This psychological turning point helps explain France’s strong promotion of banking union in 2012, even though it was a key opponent of supranational banking supervision during earlier negotiation of EU treaties, including Maastricht in 1992 and Nice in 2001.

In Germany, the euro area turmoil compelled the European Central Bank to take unprecedented policy initiatives that broke the policy orthodoxy of the Bundesbank, and triggered the two institutions’ parting of the ways. The European Central Bank had long been perceived as under a form of Bundesbank tutelage. However, after its crisis response led to the successive resignations of German central bankers Axel Weber and Jürgen Stark but was nevertheless endorsed by German Chancellor Angela Merkel despite Bundesbank dissent, it gained stature as an independent institution with a distinctive policy identity. This transformation arguably underpins the acceptance by all EU countries of the extension of its authority to banking supervision.

Throughout the European Union, the previous doctrine that banks should never be allowed to fail, an explicit pledge by European leaders in mid-October 2008, was abruptly reversed. Until early 2012, even junior creditors of failed banks were protected by government action from any losses in almost all EU member states, no matter how small the bank. But by then it was increasingly evident that the protection of all creditors threatened government balance sheets and was politically unsustainable. In early June 2012, the European Commission proposed EU legislation based on the principle that creditors should take losses before taxpayer-funded bailouts can be considered. Meanwhile, the Commission’s competition policy arm started imposing losses on junior creditors as a necessary condition for state aid to banks, in Spain in 2012 and as a generally applicable rule in August 2013.

In light of these developments, the initiation of European banking union in late June 2012 did not happen in a vacuum. It is best described as the most visible of a series of tectonic shifts generated by the unresolved European banking problem and subsequent euro area deterioration. It was itself described as a condition for the European Central Bank’s later announcement of its Outright Monetary Transactions program to buy government bonds. Together, these shifts resulted in considerable reduction of the perceived risk of a euro area breakup since summer 2012.

Prospects for resolution in 2014

Even so, as of early 2014, Europe’s banking problem is not resolved—but this could change in the months ahead. The EU legislation to establish an integrated bank supervisory framework, now in force, foresees the November 2014 handover to the European Central Bank of supervisory authority over most of the euro area’s banking system. It mandates in the meantime a comprehensive assessment of these banks by the European Central Bank, a process started in 2013 that is widely referred to as Asset Quality Review. In addition to the balance sheet assessment, this process includes a supervisory risk assessment and EU-wide stress test coordinated by the European Banking Authority.

The Asset Quality Review was initially seen by many as a relatively minor technical requirement; it is mandated only in a subarticle of the legislation’s final section on transitional arrangements. But  its practical effect is to front-load a politically challenging process of bank triage, recapitalization, and restructuring. The experience of past banking crises suggests that this process is essential for successful crisis resolution. Its consequences may include the revelation of more past failures by national bank supervisors; shareholders, taxpayers, and creditors taking a hit; and an end to “pretend and extend” lending to dubious borrowers, which may in turn trigger extensive restructuring of nonfinancial companies. So the review has rapidly moved up the European policy agenda and is likely to generate headlines throughout 2014.

The review process is as ambitious and risky as it is unprecedented. The European Central Bank had little prior experience supervising banks, but has devoted considerable resources to this task. It is fully aware that its credibility is on the line, as a future supervisor and more generally as an authoritative institution. But while the assessment process is in the hands of the European Central Bank, its consequences will also involve governments that must restructure banks deemed weak by the review. Restructuring may be disruptive, financially and politically, for individual countries, especially since there will be no financial risk pooling at the European level, at least as long as market conditions do not deteriorate dramatically. At this early stage of the assessment process, it is too soon to say which banks and countries are most at risk.

This suggests that the interaction of governments, national authorities that have overseen banks until now, and the European Central Bank will become increasingly tense as the review gets closer to completion. National governments will be influenced by banking nationalism and by innumerable links that tie them to their respective banking systems. In July 2011, these factors resulted in the failure of the bank stress test process, which severely undermined the credibility of the European Banking Authority. But the balance of interests is different this time. All euro area countries have a stake in the credibility of the European Central Bank as the central pillar of the euro’s sustainability.

Uncertainty, and quite possibly market volatility, will mark the review until it is completed, probably in late 2014. The coordination of the bank restructuring process will be a key aspect, including the possibility of setting up a European joint asset management vehicle, or “bad bank,” even if financial risks remain allocated to individual member states. All things considered, it appears more likely than not that the review will broadly fulfill policymakers’ objective of restoring confidence in the European banking sector and thus resolving Europe’s short-term banking problem.

Longer-term outlook

A successful review and subsequent restructuring of banks identified as too weak would probably start a gradual healing of Europe’s banking system. If so, bank funding conditions could return to normal in the course of 2015, allowing the European Central Bank to gradually withdraw its extraordinary intervention tools applied since 2008. The review may also lead eventually to a wave of bank mergers and acquisitions, many of them on a cross-border basis, which would reshape the European banking landscape.

The review would mark neither the full separation of banks’ and governments’ balance sheets nor the completion of banking union. These require broader steps, including further integration of EU frameworks for fiscal policy and political accountability, often referred to as fiscal and political union. Such union would pave the way for a genuinely integrated system to resolve bank crises and a pan-European deposit insurance system that would ultimately sever the financial link between banks and governments. The timing of such steps, if they occur at all, is impossible to forecast.

Nevertheless, the single banking supervisor could trigger a number of structural transformations over the next decade, depending on future European Central Bank policy decisions. Many banks’ governance models, which are currently shaped by national or subnational political and legal contexts, may be affected. Non-European banks may enter the European retail and commercial banking market. Europe’s financial system may become more diverse and less dependent, as it now is, on banking intermediation. The geography of wholesale market activity and financial centers in Europe may change. And governments, no longer able to fund themselves by harnessing domestic banks, may have to become more disciplined.

As this tentative list illustrates, Europe has just started a long journey of discovery. Banking union amounts to a regime change for European finance. Even as prospects for the first step are reasonably encouraging, it will be a long time before the implications for Europe’s financial stability and economic prospects can be comprehensively assessed.

Nicolas Véron is a Senior Fellow at Brussels-based think tank Bruegel and a Visiting Fellow at the Peterson Institute for International Economics in Washington, D.C. 

European Banking Union Tentative Assessment (Le Monde, in French)

This article was published on January 16 by Le Monde (link) as the first of a special section that also included contributions by Martin Schulz, Laurence Scialom, Thierry Philipponnat and Marie-Anne Barbat-Layani. 

Un grand pas pour l'Europe, mais le déficit démocratique demeure

Le 18 décembre, les ministres des finances européens ont annoncé un accord sur la mise en place d'un mécanisme de résolution unique (MRU) pour le traitement des crises bancaires. Certaines réactions présentent cet accord comme l'achèvement de l'union bancaire, d'autres comme un compromis impraticable. Cette apparente contradiction est révélatrice de la nature du projet d'union bancaire : radical et de long terme. Le MRU n'en est pas le point d'aboutissement, mais il illustre le chemin parcouru depuis son engagement en juin 2012.

Qu'est-ce que l'union bancaire ? Dans sa définition la plus simple, l'expression désigne le transfert au niveau européen des instruments de politique publique relatifs au secteur bancaire, en particulier la supervision, la résolution des crises et la garantie des dépôts.

La motivation est de rompre le cercle vicieux entre finances publiques et systèmes bancaires nationaux, identifié en 2011-2012 comme un facteur-clé de la crise de la zone euro. Sur le premier point, un mécanisme de supervision unique (MSU) a déjà été décidé et prévoit un transfert d'autorité, cette année, du niveau national vers la Banque centrale européenne (BCE).

La relation entre banques et Etats est au coeur du développement historique des économies européennes. Son transfert au niveau supranational est un changement structurel de grande ampleur et soulève la question du pouvoir politique, fiscal et budgétaire au niveau européen. Le président du Conseil européen, Herman Van Rompuy, a raison de suggérer une « union quadruple », bancaire, budgétaire, économique et politique, pour résoudre la crise.

UNE UNION FSICALE PARTIELLE ET DÉGUISÉE

Mais le débat sur l'union budgétaire et politique est gelé par la frilosité de nos gouvernants, le manque de confiance entre Etats membres et la difficulté de modifier les traités européens. Tant qu'il en est ainsi, l'union bancaire ne peut être qu'une construction incomplète. Toutefois, même inachevée, cette construction est un progrès majeur. L'union monétaire est rendue bien plus solide par une union bancaire même partielle.

Le MSU est à lui seul un gigantesque pas en avant pour la stabilité financière européenne. En comparaison, le MRU, dont les attributions se situent en aval du MSU, apparaît nettement moins convaincant, avec ses procédures hybrides entre Etats membres et Union européenne (UE), sa complexité byzantine, et sa mise en application conditionnelle et étagée entre 2015 et 2025. Le discours politique s'est focalisé sur la résolution des crises bancaires « à coût budgétaire nul », en faisant payer les créanciers et les banques elles-mêmes.

En réalité, une contribution imposée aux banques, comme l'impôt sur les sociétés, est une taxe, même si elle n'est pas directement prélevée sur les ménages. Elle revient à créer une union fiscale et budgétaire partielle et déguisée, d'où la méfiance compréhensible de certains gouvernements. Quant à faire participer les créanciers, l'intention est bienvenue, mais sa mise en oeuvre sera difficile.

Depuis le début de la crise, les gouvernements européens ont été beaucoup trop généreux avec les créanciers des banques, qui ont bénéficié d'un attachement excessif au maintien des champions bancaires nationaux. Mais, dans certains scénarios de crise aiguë, l'intervention publique est justifiée pour arrêter la panique. Le but est donc de trouver un meilleur équilibre en imposant une discipline fondée sur des incitations plus saines ; mais cet équilibre sera défini par la pratique des années à venir, autant, sinon plus, que par la législation en cours de discussion.

L'ACCORD EST UNE ÉTAPE

Les Etats-Unis ont une meilleure discipline de marché sur ce point et ont pu fermer des centaines de banques depuis 2007 en imposant des pertes importantes à leurs créanciers. Mais leur système est lui-même loin d'être parfait, et il a fallu des décennies pour en arriver là. Le retard européen sur ce point ne sera pas comblé en une seule étape. A court terme, l'essentiel est ailleurs.

La mise en oeuvre du MSU requiert une revue des bilans des banques qui passent sous l'autorité de la BCE. Certaines de celles qui seront identifiées comme sous-capitalisées devront être restructurées par les autorités publiques nationales, bien avant la mise en place opérationnelle du MRU. C'est là que se joue le sort de l'union bancaire.

Si la revue des bilans manque son objectif de rétablissement de la confiance, il n'y aura rien à attendre du MRU, et la zone euro rechutera sans doute dans la crise. Mais si l'exercice s'achève avec succès fin 2014, l'héritage des échecs passés ne pèsera plus sur les négociations européennes comme aujourd'hui. Dans ce nouveau contexte politique, il n'est pas impossible d'imaginer que les questions de fond sur la responsabilité et la représentation, en d'autres termes l'union politique, puissent être abordées de manière renouvelée.

L'accord du 18 décembre n'est donc qu'une étape, et pas la plus importante, sur la longue route vers l'union bancaire en Europe. La question centrale, comme l'indiquent les intentions de vote aux élections européennes de mai, reste celle du déficit démocratique de l'Union. Sans mandat démocratique, les institutions européennes, Conseil inclus, resteront grippées par leur déficit de capacité exécutive. Et sans cette capacité, l'union bancaire est condamnée à rester inachevée.

 

Outlook for 2014 (Caixin)

This article was published in China 2014, a special issue of Caixin Magazine (Chinese version here). It was also republished by Bruegel and the Peterson Institute. 

2013 has been a remarkably calm year in Europe, arguably the calmest since the onset of the financial crisis in 2007.

The year started with two significant events that under different circumstances could have shaken financial markets. First, in, Italy, the euro area's third-largest country, an election in February elevated an almost unknown political force, the Five Star Movement led by comedian Beppe Grillo, to the top of the political landscape on a platform rejecting the country's mainstream parties and European commitments. Second, in Cyprus in March, a combination of inadequate risk management in local banks and a bungled European policy process led to the imposition of capital controls despite the fact that such controls contradict the ground rules of the euro area monetary union.

But global investors were largely unperturbed by these two shocks. They were reassured by promises from European policymakers in 2012 to do "whatever it takes" to defend the integrity of the euro area, including through the creation of a European Banking Union and the possibility of massive purchases of sovereign debt (known as Outright Monetary Transactions, or OMT) by the European Central Bank (ECB). Later in 2013, investors shifted their focus to the exit from quantitative easing and paralyzing fiscal battles in the United States. The turmoil in emerging markets during the summer was also a distraction from Europe, which suddenly appeared less troubled than other parts of the global economy. Several European politicians declared that the worst of the European crisis was over.

Several reasons suggest that 2014 will be a bumpier year for Europe, however.

First, the implementation of the first phase of banking union, with the transfer of supervisory authority over most of Europe's banking system from national authorities to the ECB, involves an assessment of the banks' financial soundness, known as asset quality review (AQR). This review will probably expose previously unrecognized weaknesses in some banks, possibly requiring public intervention and restructuring, accompanied by political tensions.

Second, the banking union will remain incomplete. Member states are unlikely to agree on a workable design for its two other necessary components, a European authority empowered to resolve crises over troubled banks and a European deposit insurance system. The realization that banking union is essentially limited to supervisory integration at the ECB may reawaken investors' worries about the vicious circle between banks and sovereign credit that destabilized the euro area in 2011 and early 2012.

Third, the combination of the delay in restoring the banking system back to soundness, fiscal austerity, and the ECB's continued reluctance to engage in unconventional monetary policies, suggests that the European economy will remain anaemic. Growth performance could be dampened by the failure of Italy, France, and other countries to undertake structural reform.

Fourth, the European Parliament election in May 2014 is expected to crystallize citizens' dissatisfaction with their current governance in most countries outside of Germany, sending shockwaves throughout Europe's political establishment. For example, the xenophobic and anti-establishment National Front is predicted by many to become France's leading party in that election. Comparable trends are observable in the United Kingdom, the Netherlands, and other EU member states.

How Europe's politicians and policymakers will react to such developments could range from further paralysis of decision-making to the jolts provoking more boldness to reform.

A renewed debate on Europe's institutional mismatches is likely over what European jargon refers to as "political union" as a necessary complement to banking union, fiscal union, and economic union.

EU institutions, as currently defined by the European treaties, are too weak to deal with these problems. The European Commission has shrunk in stature during the crisis, lacking the policy leadership that had been assumed to be its defining ability, except in specific areas such as competition policy, and hobbled by a (not entirely undeserved) reputation as an overpaid and inefficient bureaucracy. The European Parliament has less control over the power of the purse than most national legislatures. Too many of its members lack dedication or gravitas. It is insufficiently representative of the European electorate: In particular, the number of parliamentary seats is not proportional to member states' voting populations, and electoral processes vary widely across countries. The European Council of national heads of state and government is unaccountable as a collective body, even though each member is democratically accountable to national constituents. There is no mechanism to endow it with a political mandate to channel the preferences of the majority of European citizens. This lack of legitimacy has repeatedly paralyzed it when decisive action was needed.

In summary, the core EU institutions—the Commission, Parliament, and Council—are affected by a combination of democratic deficit, or the lack of proper representation and accountability to the European citizenry, and executive deficit, or the inability to make and implement policy decisions at the right moment. These twin deficits perversely feed each other, sapping the European Union's popularity in many countries.

The ECB stands in contrast to the other institutions' ineffectiveness. In several instances, it has filled the European Union's executive vacuum and saved Europe's day by making bold policy commitments while generally maintaining its credibility. As a consequence its authority has increased through the crisis, not least because of its new supervisory tasks as a first step towards banking union. But its independence also means that it cannot rely on a democratic mandate based on the public's consent. Trusting it with too much policy power and no corresponding accountability may not be sustainable. The ECB is acutely aware of this risk and limitation.

Simultaneously, the crisis has exacerbated centrifugal forces kept in check in previous decades. For example, the United Kingdom has entered uncharted territory by openly contemplating its own exit from the Union. The United Kingdom also faces a forthcoming referendum on Scottish independence, as does Spain with the exacerbation of tensions between Catalonia and the central government in Madrid.

To be sure, countervailing forces of cohesion should not be underestimated. The euro area has preserved its integrity so far, against widespread predictions in early 2012 that Greece would leave the monetary union during that year. Even so, a British exit would transform the nature of European integration and may disrupt Europe's future.

Germany's dominance of intergovernmental decisions raises particular concerns. German preferences are often enlightened, but they also occasionally reflect German prejudices or parochial special interests. Citizens of other countries feel increasingly disempowered, with some justification, even if Germany is restrained in the use of its outsized influence. The French-German "couple" used to bring a degree of balance. But it can no longer work as in the past and is at best a minor corrective.

A debate on how to address these multiple mismatches has started in Germany but needs to become more vibrant on a European scale. The overwhelming majority of Europeans are committed to democracy and the rule of law and can find common ground in how to embed these principles in a reform of Europe's institutional arrangements, both within the current treaties and through their eventual revision. What Europe needs is institutional innovation and experimentation, as it found in banking policy.

The ambition that underpins European integration should not be underestimated. For most EU member states, including the four largest euro area countries, European integration has become a core component of national identity. The crisis has revealed major vulnerabilities in the EU construct, but has also highlighted some of its strengths. Jean Monnet, a founding father of the European Union, noted that Europe is shaped by its response to successive crises. The inception of European banking union was triggered by market volatility in 2011–12. Similarly, further steps towards fiscal, economic, and political union could well result from other episodes of turbulence.

Institutional challenges are not the exclusive preserve of the European Union, as was illustrated this year by the dysfunctional treatment of fiscal policy by the US Congress. Less democratic regimes face similar challenges as well. Europeans have a lot to learn from the experiences of other countries all around the world.

Europe's institutional mismatches will not all be successfully resolved in 2014. But one can expect, and perhaps hope, that they will become clearer and start being debated more openly and broadly. A proper diagnosis is the first step towards healing.

ECB's Big Moment

This article was published in the December issue of Financial World, and reposted by the Peterson Institute and Bruegel.

Europe’s banking union project has had many doubters since it started to be widely discussed in the spring of 2012. What is not in doubt, however, is its transformative nature. In June 2012, EU leaders chose – in a galloping hurry, as usual – to move towards the centralization of bank supervision across eurozone countries, with this authority entrusted to the ECB. The consequences have only gradually become apparent to most and they represent both an opportunity and a risk.

The opportunity is to re-establish trust in European banks, reboot the pan-European interbank market, end dysfunctional credit allocation and start reversing the vicious circle between bank and sovereign credit. In an optimistic scenario, the ECB’s 12-month process of “comprehensive assessment,” including an asset quality review (AQR) and stress tests of around 130 credit institutions covering 85 per cent of the eurozone’s banking assets, will trigger triage, recapitalization and restructuring that financial history suggests is a prerequisite for systemic crisis resolution.

The risk is that, if the assessment fails to be consistent and rigorous, the ECB may find its reputation so damaged that the credibility of its monetary policy – and the perception of Europe’s ability to get anything done – could be affected. After all, this exercise is unprecedented in scale and scope, which means the ECB has little prior experience. At the same time, the political fallout is potentially poisonous in most of the states concerned.

Thus, much is at stake in next year’s balance sheet review, and the scene is set for an escalating confrontation between the ECB and member states in the months ahead. The ECB has pointedly made clear that it will form an independent judgment on the capital strength of the banks examined, without necessarily following the views of national supervisors.

It has also noted that the AQR can be expected to reveal significant new information – which, after all, is the whole point of it. A number of banks that, until now, had been deemed sound by national watchdogs may be found by the ECB to be undercapitalized, or even insolvent. In such cases, restructuring will inevitably be painful for the corresponding national governments, both politically and financially, leading them to plead for forbearance. The tension can be expected to generate more market volatility in Europe in 2014 than was seen in 2013.

A successful AQR and establishment of the Single Supervisory Mechanism (SSM) – EU jargon for the handover of supervisory authority to the ECB – would have structural consequences. Europe’s national and local governments often use their leverage over the publicly-regulated banking industry for industrial policy purposes, or to facilitate their own financing, a dynamic known to economists as financial repression.

Furthermore, the combination of national banking policy frameworks with the EU’s integrated single market has created powerful incentives for banking nationalism. It has led to the protection or promotion of domestic banking champions on the pan-European competitive field, both against competing foreign banks and potential new entrants and non-banks. This has often been detrimental to financial stability. The shift of supervisory authority to the ECB can be expected to gradually weaken these links and to hamper the ability of eurozone member states to engage in financial repression and banking nationalism. In particular, the “moral suasion” wielded by national authorities to persuade local banks to buy domestic sovereign bonds and ringfence funding across borders may become considerably less effective under the new regime of ECB supervision.

More generally, and even without rapid completion of a European resolution and deposit insurance framework, one can expect the centralization of bank supervision to foster market integration, cross-border bank consolidation and the emergence of a more diverse financial sector with a greater variety of banking and non-bank intermediation business models. If the transition is successful, then non-euro countries such as Denmark, Poland and even Sweden can be expected to join the SSM over a three-year horizon. This will not make the UK’s relationship with the rest of the EU simpler.

All this, of course, rests on the assumption that a credible AQR and well-handled bank restructuring will allow the ECB to establish itself as a sound, single eurozone banking supervisor. This cannot be taken for granted but appears more likely than not. Numerous and powerful interests may work against it, but an even stronger interest will probably prompt the eurozone’s leaders, starting with those of Germany, to do whatever it takes to help the ECB pass its make-or-break test.

Nicolas Véron is senior fellow at Bruegel and visiting fellow at the Peterson Institute for International Economics

The European Crisis and Banking Nationalism

This speech was given in late June in Istanbul, at the 30th anniversary symposium of the European Private Equity and Venture Capital Association (EVCA). It has taken me some time putting it into written format. It has also been posted by the Peterson Institute and Bruegel. 

In the speech, I develop a narrative of the run-up to the European crisis and of its management since 2007, through the lens of what I see as an important and under-analyzed driver of financial sector policy. This driver is labelled here "banking nationalism" for lack of a better term, but is really about the mismatch between national banking policy frameworks and the integration of the European financial system through EU policies. The initiative to create a banking union may resolve this mismatch in a manner that preserves European integration, but whether it will actually do so is still too early to tell. 

Financial Times Comment: Europe Must Avoid Two Extreme Doctrines on Bank Restructuring

The Financial Times today published my analysis of what the bank restructuring in Cyprus and of Eurogroup President Jeroen Dijsselbloem’s much-commented interview earlier this week. I suggest that the EU must now find a more stable path between too extreme, harmful policy stances – excessive moral hazard (which I call the “Sanio Doctrine” based on the seminal decision to bail-out IKB in late July 2007), and denial of systemic risk (the “Mellon doctrine” with reference to ill-fated US policy before the inauguration of Franklin D. Roosevelt). This is an important debate for Europe and not least for future discussions on the banking union framework.

Briefing Paper for the European Parliament: Single Supervisory Mechanism

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

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

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

 

The Political Redefinition of Europe

On June 8, I was invited by Sweden's Financial Markets Committee (FMK) to give opening remarks at a conference they organized in Stockholm about the role of the European Parliament. I used this occasion to collect some personal thoughts on the political and historical dimensions of the Eurozone crisis.

The text is available here as published by FMK, here as published by PIIE, and here as republished on the Bruegel Blog - or alternatively here in PDF format. 

US Senate Testimony - The Future of the Eurozone

Click here to download the PDF version of the statement I delivered today at the US Senate, Committee on Foreign Relations, Subcommittee on European Affairs chaired by Senator Jeanne Shaheen. 

A video of the hearing is available on the Senate's website, as well as the statements of the other two witnesses, Frances Burwell and Simon Johnson. 

The statement was also published by the Peterson Institute and by Bruegel. 

The EU's Bank Recapitalization Plan

In this piece published by Emerging Markets, the magazine distributed in major international economic gatherings (in this case the Cannes summit of the G20), I take a critical look at the bank recapitalization plan announced by EU leaders last week and suggest that the Eurozone cannot be sustainable without an explicitly federal framework for banking policy. 

US Senate Testimony: the European Debt and Financial Crisis

On 22 September, I was a witness at a hearing of the Subcommittee on Security and International Trade and Finance of the US Senate Committee on Banking, Housing, and Urban Affairs. My written statement is accessible here, and a webcast of the entire hearing including my oral testimony and questions is here. 

Click here for the publication in Bruegel's Policy Contribution series. 

Click here for the publication on the Peterson Institute's website. 

The Dodd-Frank Act, One Year On: e-book

In July, Vox published this e-book based on a conference in which I participated in Washington DC, at the initiative of the Pew Charitable Trusts and NYU Stern School of Business. I contributed the (short) last chapter on financial reform outside of the US and global financial authorities, and how they connect with the reforms undertaken in the US. 

Click here to download the PDF version directly. 

Eurozone Crisis Resolution Requires a Single Banking Market

The Financial Times on 15 July published this column, in which I emphasize the importance of EU-wide integration of the banking system for both short-term crisis resolution and long-term sustainability of the Eurozone. 

It is also accessible on the websites of Bruegel and PIIE. 

The next Managing Director of the IMF

This post co-authored with Arvind Subramanian was published by the Peterson Institute for International Economics yesterday.

Update: on May 19th we published a follow-up post which is also pasted below.

A Quick Guide to the Upcoming Contest for the Next MD of the IMF

by Arvind Subramanian and Nicolas Véron | May 17th, 2011 | 04:24 pm

This note provides a quick guide—in the form of a table—to the likely candidates to succeed Dominique Strauss-Kahn as next Managing Director (MD) of the IMF, assuming that he resigns shortly. It also highlights some key points that must guide the process of selecting the next MD.

Need for urgent action. The IMF is at a critical juncture with lots of problems to solve, not least in Europe. A leadership vacuum and uncertainty must be avoided, which requires urgent initiatives by the larger players—the United States, Europe, China, Brazil, India, South Africa and others.

Europe can no longer claim the job of MD: Europe no longer has the divine right to this job, irrespective of the circumstances of the European incumbent’s (assumed) departure. The world has changed, and antiquated if unstated arrangements dating from 1945, in which a European heads the IMF and an American heads the World Bank, must keep pace with reality. The next MD must be selected on the basis of merit, which is not to be found only in Europe.

The thoughtful Wolfgang Münchau of the Financial Times made the case yesterday that the successor to Dominique Strauss-Kahn should be another European. "The eurozone’s contagious financial crisis constitutes the biggest threat to global financial stability today," he wrote. "The IMF is a partner in the multilateral loan programme for Greece, and a structural partner in the eurozone’s financial rescue mechanism. The size of these programmes dwarfs whatever else the IMF is doing at the moment."

We disagree. For a start, it elicits the obvious question: During the Asian financial crisis, would Mr. Munchau have extended his logic and asked for an Asian to be head of the IMF? And for most of the history of the IMF, given the identity of the borrowers, should the head have come from the developing world?

Dominique Strauss-Kahn has played a key role during the Euro crises, especially last year, in persuading eurozone leaders to partner with the IMF in addressing the Greek crisis. But the next challenges will be of a different nature. Last year, the IMF leadership’s sensitivity to European politics was key to ensuring acceptance in Europe of IMF-led conditionality for the countries receiving aid. Now, if and when Greece comes back for its second tranche of borrowing, the MD will have to play a different role: to convince Europe, in what promises to be a heated discussion, that Greece has a solvency problem and requires debt restructuring; or, if the IMF concludes that Greece merits international support and all other options are worse, to convince the rest of the world to extend further financial commitments. Either way, there is less need for a European and more for an objective outsider.

Key US role: The leadership of the IMF and World Bank are linked. So, a corollary to Europe forgoing its monopoly rights to the IMF leadership is that the US right to leadership of the World Bank (and for that matter, to the Number Two position at the IMF) is no longer a given either. Although the United States supported a weak G20 commitment in 2009 to a merit-based selection procedure for both institution, it has been more recently sitting on the fence on this issue. But its leadership is needed to avoid weakening the Bretton Woods institutions in a 21st-century world that arguably needs them more than ever. The United States has always argued that American leadership at the World Bank helps persuade Congress to put up the money for development assistance. But that argument has been rendered obsolete by the realities of modern global politics and economics. President Obama or Treasury Secretary Timothy Geithner should say clearly that Washington commits to the principle of fair, transparent, and merit-based selection for the leadership of both institutions.

Strong emerging market candidates: As the attached table shows, the list of potential contenders from emerging market countries is very strong. There is absolutely no excuse therefore for not casting the selection net wide to focus on these contenders. The attached table also shows what the possible doubts about some of these candidates might be. Given the importance of the process and the break from the past that it would represent, the search should not be confined to those who are well-known in IMF and World Bank circles. In other words, even among those on this list, there are "insiders" and "usual suspects" and the process should not be biased towards them.

On the other hand, since Asia is at present the location of the world’s strongest-growing economies, and the countries of Asia are clamoring for more of a role in all international institutions, the IMF would do well to look carefully at candidates from that continent. In that spirit, serious consideration should be given to the Finance Minister of Singapore, Tharman Shanmugaratnam, who ticks many of the key boxes: he is an Asian who might be acceptable to other Asians; he has the right senior policy experience, both as central banker and as finance minister; and most important, he is highly regarded intellectually and has a track record of strong and thoughtful leadership. As many commentators have already noted, Kemal Dervis of Turkey, a former director of the United Nations Development Program, is also strong in the list, as a highly respected emerging-market figure who is also culturally and politically very close to Europe. Trevor Manuel, the finance minister of South Africa, has no obvious disqualifications. Perhaps less predictably, we also suggest considering a senior IMF career staffer, Ajai Chopra, who has distinguished himself during the European crisis in his handling of the Irish IMF program, even if he lacks political heft and connections compared with others in the list.

This is certainly not to say that there is no matching talent in Europe, or the United States for that matter. Christine Lagarde, finance minister of France, is highly respected internationally, and a first-ever female MD would be welcome. But our point is that there are more credible candidates from emerging countries this time than arguably ever before.

Pitfalls to avoid: There are two major dangers. One is that jockeying between Europe and the United States will lead to protracted uncertainty, creating a rush to make a quick perpetuation of the status quo as a means out of the IMF’s leadership instability. This underscores the need for the United States to be clear about selection procedures for both Bretton Woods institutions. A similar possibility arises if emerging market countries squabble among themselves and cannot agree on a common candidate. Unlike EU member states, these countries do not have strong institutional mechanisms to coordinate their positions, but they too should resolve their differences and get their act together.

In short, after years of talk about change, the time is ripe for genuine reform in the governance of international institutions to reflect the changing economic realities. The list of emerging market candidates for the IMF job is very strong. The United States should not cast itself as a defender of an antiquated status quo; and the decision should be made quickly. Letting this key negotiation drift would threaten the legitimacy and effectiveness of what are vital structures of international cooperation.

	A Guide to the Potential Non-European, Non-American Successors to Dominique Strauss-Kahn
	Name	Current Position	Nationality	Qualifications	Questions
	Montek Singh Ahluwalia	Head, Planning Commission	India	Previous IMF experience; associated with successful Indian economic reforms	Will China agree to an Indian head of the IMF?
	Agustin Carstens	Governor, Central Bank	Mexico	Extensive IMF experience	Is Mexico seen as too close to the US?
	Ajai Chopra	Senior Staffer, IMF	India	Career IMF staffer; extensive Europe experience; handled recent Irish crisis	Is he viewed as having political heft?
	Kemal Dervis	Vice-President, Brookings Institution	Turkey	Close to US and European policy-making; implemented a successful adjustment program in Turkey as Finance Minister; has headed an international organization (UNDP)	Will he command the support of his own country?
	Mohamed El-Erian	Co-head PIMCO	Egypt	Combines IMF and private sector experience
	Arminio Fraga	Senior Position, Gavea/J.P. Morgan	Brazil	Successful stint as head of the Brazilian central bank	Are public sector credentials seen as strong compared to his private sector background?
	Trevor Manuel	Head, Planning Commission	South Africa	Successful national experience as Finance Minister during time of transition away from Apartheid; Led task force on reform of IMF governance
	Il Sakong	President, Korea International Trade Association	Korea	Varied experience, including as Korea chaired last year’s G-20 summit	Will some be concerned about close ties to the US? Can two Koreans head major international organizations (IMF and UN) at the same time?
	Tharman Shanmugarathnam	Minister of Finance	Singapore	Singapore seen as bridge within Asia	Is he as prominently known internationally as other candidates?
	Zhou Xiaochuan	Governor, Central bank	China	Would represent rising power	Will other Asians agree and will China accept this level of international responsibility?
	A Truly International Monetary Fund or a Continuing North-Atlantic Monetary Fund? by Arvind Subramanian and Nicolas Véron | May 19th, 2011 | 02:53 pm This post follows up on, updates, and responds to a number of comments we received on, our previous post on the succession to Dominique Strauss-Kahn as Managing Director of the IMF. Why not a meritorious European this time? Some have argued that the key principle to introduce is merit not nationality. And if that results in a European candidate—for example Christine Lagarde—that should be fine. We agree. But this time is special. The process must be, and must be believed to be, merit-based. If the process throws up a European candidate, doubts will linger: was the candidate truly meritorious or will the presumption be that the result was a stitch-up—once again—between the Europeans and Americans. Signaling a decisive change from the past requires an outcome that is different. This principle would apply also to the next change at the World Bank to which the United States must commit, difficult as it might be for the US administration to convince Congress that a non-American should head this institution. Once the process acquires legitimacy, one can move to a truly nationality-blind process that can then throw up Europeans to lead the IMF and Americans to head the World Bank. We think it highly desirable to have women as heads of international institutions. But at this stage, discrimination on the basis of nationality is an even bigger threat to the legitimacy of the Bretton Woods institutions than that based on gender, which of course must also be addressed. What are the most important selection criteria? Imagination and leadership, then experience and political heft. The world economy faces unprecedented challenges: the euro crisis of course, but also global imbalances and the US fiscal situation. Also, the risk of instability in emerging markets has not disappeared. These challenges call for a spirit of policy innovation, absence of doctrinal or cultural prejudices, and an ability to create consensus on new solutions. It is difficult to find this combination of talents, so it is crucial to enlarge the potential pool of candidates. Shouldn’t Europeans get the job just because the IMF has so much exposure in Europe? As our colleague Ted Truman has noted, the Fund has only about half its exposure in Europe at this point, and who knows what will happen in the emerging world over the next five years. In any case, why should the debtors be in charge of the bank? This is certainly not an argument we heard from Europe during the Asian Crisis in the late 1990s. From a European viewpoint, isn’t it in the European interest to have a European MD even if it is not in the global interest? Things are less clear-cut in practice. A year ago, the key challenge for the IMF was to convince the Europeans that the Fund’s involvement in the euro crisis was in their own interest. This is now done and accepted, not least thanks to Dominique Strauss-Kahn’s past leadership. The next challenges will be different: especially, if the Fund decides that further assistance is needed for Greece, the most difficult part will be to convince reluctant stakeholders in the rest of the world, especially Asians and the US Congress, to keep going along the Europeans on this path. All things equal, a European MD would find this task more difficult than a non-European. If this is the right way to look at it, then one could even argue that the special interest of Europe calls for a non-European MD. How can Europe be expected to voluntarily renounce a top position? Europeans head the World Trade Organization (Pascal Lamy), the Financial Stability Board (Mario Draghi), the Bank for International Settlements (Jaime Caruana), the Basel Committee on Banking Supervision (Nout Wellinck), the International Accounting Standards Board (Hans Hoogervorst), and many other international organizations with economic policy relevance. In a changing world, they simply cannot keep all these. Can a non-European understand and manage the intricacies of European politics? Certainly as much as a European could understand the intricacies of Asia in the late 1990s. There is a long track record of non-Europeans who have been very adept at managing the complexities of Europe. The European Department of the IMF itself is an example, with a string of officials, from Michael Deppler to today’s Ajai Chopra, who have commanded widespread respect in the Europe. Can the emerging countries defend a common candidate? This is probably the biggest reason why it remains likely that the next MD will be a European. For all their customary squabbling, the Europeans have a powerful coordination mechanism with the machinery of EU institutions and meetings. This does not exist in the emerging world, where the rhetoric can be common but common positions on substantial matters are not frequently achieved. If the BRICS were able to field a joint candidate, it would be a game-changer. But this remains less than likely.

The European Union should start a debate on too-big-to-fail

This column co-authored with Morris Goldstein was published online by Vox, and also in Dutch by NRC Handelsblad.

The existence of too-big-to-fail financial institutions represents a three-fold policy challenge.

• First, such institutions exacerbate systemic risk by blunting incentives to manage risks prudently and by creating a massive contingent liability for governments that, in extreme cases, can threaten the latter’s own debt sustainability; Iceland in 2008-2009 and Ireland in 2010-2011 serve as dramatic, recent cases in point.
• Second, too-big-to-fail financial institutions distort competition. The 50 largest banks in 2009 benefitted from an average three-notch advantage in their credit ratings (BIS 2010) -- an advantage presumably related in part to the higher likelihood of official support at times of crisis.
• And third, the favoured treatment of too-big-to-fail institutions – often summarised as “socialisation of losses and privatisation of gains” – lowers public trust in the fairness of the system (Johnson 2009).

It is no wonder then that the too-big-to-fail issue is at the forefront of the debate on financial regulatory reform --as least as seen from Washington DC, London, and Zurich. Federal Reserve Chairman Ben Bernanke testified in September 2010 that “if the crisis has a single lesson, it is that the too big to fail problem must be solved” (Bernanke 2010). US Treasury Secretary Tim Geithner underscored that “the final area of reform (…) is perhaps the most important, establishing new rules to constrain risk-taking by – and leverage in – the largest global financial institutions (Geithner 2010). The Dodd-Frank Act of 2010 contains a host of provisions targeted at the regulation and supervision of systemically-important financial institutions, including enhanced risk-based capital, leverage, and liquidity standards and the requirement to prepare and maintain extensive rapid and orderly dissolution plans. In the UK, Bank of England Governor Mervyn King emphasised in a recent interview that “the concept of being too important to fail should have no place in a market economy” (King 2011). And later this month, the Vickers Commission is slated to give its recommendations on the banking industry, including its verdict on the merits of separating functions within the largest banks. Meanwhile, in the strongest approach to date to deal with the too-big-to-fail problem, a committee of experts appointed by the Swiss Federal Council (and including a representative from the Swiss National Bank) recommended that the total capital requirement for Switzerland’s two largest banks (UBS and Credit Suisse) be set at 19% of their risk-weighted assets, and that at least 10% of those assets must be held in the form of common equity (Committee of Experts 2010). If adopted, these capital requirements would be substantially more rigorous than the minimums recently agreed under Basel III (Goldstein 2011).

It is all the more remarkable then that the too-big-to-fail problem is barely present in substantial financial policy debates and initiatives in most Continental European countries and at EU level, including the European Commission. These jurisdictions have tended to favour the application of uniform regulations to financial institutions irrespective of size and systemic importance, and have been generally reported as arguing against specific policies targeted at systemically-important financial institutions in international bodies such as the Basel Committee on Banking Supervision and the Financial Stability Board.

In a working paper that specifically analyses the transatlantic and intra-European variations of the too-big-to-fail debate (or absence thereof); we identify four broad reasons for this contrast (Goldstein and Véron 2011):

• First and foremost, the much higher degree of concentration of banking markets makes the too-big-to-fail problem more acute but also intrinsically more intractable in virtually all EU countries than it is in the US, which may explain a strong reluctance to consider financial reform through the too-big-to-fail prism in the first place; see Figure 1.

Figure 1. Aggregate assets to GDP of top three banks in selected countries (%)

Source: Bank for International Settlements

The higher assets-to-GDP ratios observed in Europe are mainly due to high banking sector concentration, significant international expansion of some major banks, and business models that lead banks to retain many assets on their balance sheet. Differences in accounting standards also play a role, but only to a much smaller extent.

Of course, a large part of this transatlantic difference would disappear if the systemic importance of Europe’s largest banks could be assessed against the size of the entire European economy, rather than national GDP. Indeed, the ratios of consolidated assets to European GDP for Europe’s largest banks are similar to the ones that can be observed in the US, or actually smaller when corrected for differences in accounting standards. Unfortunately, this is not the correct scale of analysis as long as no EU-wide policy framework exists for bank crisis management and resolution. Such a framework has been advocated and discussed by the IMF and others (see Cihak and Decressin 2007; Fonteyne and al 2010; Véron 2007; Wall et al. 2011) but has not achieved political consensus in the EU so far. Policy proposals are expected from the European Commission this year, but they are unlikely to result in more than incremental progress from this perspective (European Commission 2011).

• Second, most European countries have displayed a general reluctance to let banks fail irrespective of their size, so that the moral hazard problem is not confined to the largest institutions. An example of this (early in the recent crisis) was the German government’s rescue of IKB and of other small-to-medium-sized institutions at a significant cost to the taxpayer. By contrast, scores of US banks were allowed to fail since the start of the crisis, most of them (including the very large case of Washington Mutual) through the Federal Deposit Insurance Corporation’s receivership procedure that has no direct equivalent in many European countries. This difference can partly be traced back to long-term historical legacies and attitudes to risk and failure.
• Third, the interdependence between banking and political systems tends to be high in Continental Europe, though difficult to assess quantitatively in comparative perspective. Significant segments of Europe’s banking industry are constituted of non-commercial banks such as savings banks and mutual’s whose governance often directly involves elected officials, as in Spain or Germany, as well as directly state-controlled institutions such as Poland’s PKO BP or Germany’s Landesbanken. France’s tightly knit financial establishment, which brings together both senior regulators and senior bank executives, is another example of such interdependence. While the features vary markedly from one country, there is ample scope for capture of the policy debate and process by the industry’s dominant players.
• Fourth, nationalism continues to play a significant role in shaping Europe’s financial policy choices which tend to differentially protect and favour domestic “banking champions”, in spite of the non-discriminatory principles enshrined in EU treaties and their increasingly assertive enforcement by the European Commission. One result has been a near-generalised preference for intra-country bank mergers rather than cross-border ones, especially in larger Western European countries. This has tended to exacerbate the too-big-to-fail problem, both before the crisis and since its start.

The discussion on possible remedies to the too-big-to-fail problem is not a simple one, and no silver bullet is at hand. There are different dimensions to the problem, each of which is associated with different policy options: absolute bank size (which may be addressed with size caps or capital surcharges), market concentration (which calls for competition policy or limits to market share), conglomeration (Glass-Steagall-like separations, or the more recent Volcker rule), internationalisation (requirements for local funding and/or capitalisation), and complexity (central clearing of transactions, living wills). Depending on the context, definitions of systemically-important financial institutions generally rely on a mix of these criteria. But many gaps remain in our analytical understanding of the too-big-to-fail problem. Furthermore, much of the available research tends to be focused on the US case, whose features may not be easily extrapolated to non-US contexts (Demirgüç-Kunt and Huizinga 2011).

However, these analytical gaps should not be taken as an excuse to avoid an in-depth debate on the too-big-to-fail problem in Europe; on the contrary. Moreover, given the potential risks to systemic stability, there is a case for policy action even in the absence of analytical certainty. The very large too-big-to-fail problem faced by most European countries should motivate a broad policy discussion on how to reform banking structures in Europe to mitigate it. The sooner the better.

References

• Bernanke, Ben (2010), Testimony to the US Financial Crisis Inquiry Commission, September
• BIS - Bank for International Settlements (2010), 80th Annual Report, June
• Cihak, Martin, and Jörg Decressin (2007), “The Case for a European Banking Charter”, IMF Working Paper WP/07/73
• Committee of Experts (2010), “Final Report of Committee of Experts for Limiting the Risks Posed by Large Companies”, Swiss Financial Market Supervisory Authority and Swiss National Bank, October
• Demirgüç-Kunt, Asli, and Harry Huizinga (2011), “Do we need big banks?”, VoxEU.org, 18 March.
• European Commission (2011), “Technical Details of a Possible EU Framework for Bank Recovery and Resolution”, DG MARKT working document, January
• Fonteyne, Wim, Wouter Bossu, Luis Cortavarria-Checkley, Alessandro Giustiniani, Alessandro Gullo, Daniel Hardy, and Sean Kerr (2010), “Crisis Management and Resolution for a European Banking System”, IMF Working Paper WP/10/70, March
• Geithner, Timothy (2010), “Rebuilding the American Financial System”, speech at NYU Stern School of Business, August
• Goldstein, Morris (2011), “Integrating Reform of Financial Regulation with Reform of the International Monetary System”, Peterson Institute for International Economics Working Paper 11-5, February
• Goldstein, Morris, and Nicolas Véron (2011), “Too Big To Fail: The Transatlantic Debate”, Peterson Institute for International Economics Working Paper 11-2, January
• Johnson, Simon (2009), “The Quiet Coup”, The Atlantic, May
• King, Mervyn (2011), Interview in The Telegraph, March
• Véron, Nicolas (2007), “Is Europe Ready For a Major Banking Crisis?”, Bruegel Policy Brief 2007/03, August
• Wall, Larry, Maria Nieto, and David Mayes (2011), “Creating an EU-Level Supervisor for Cross-Border Banking Groups: Issues Raised by the U.S. Experience with Dual Banking”, Federal Reserve Bank of Atlanta Working Paper 2011-06, March

 

Reform of the IFRS Foundation - Another Public Consultation

Once again, I responded to a public consultation on how to reform the governance of the IFRS Foundation, which hosts the International Accounting Standards Board - this time in response to a consultative report of the Foundation's Monitoring Board, currently composed of a limited number of public authorities. This follow my response last month to another consultation, by the Foundation's own Trustees.

It is a somewhat specialized debate, but if you have a taste for the politics of accounting you will certainly enjoy it.

My letter was posted by the Monitoring Board on the IOSCO website. Click here for a PDF version.

May update: Bruegel also published an adapted version in its Policy Contribution series.

London and the new European Supervisory Authorities

This article was published by Financial World this month, and expands on my February column. Click here for a PDF version.

New dogs unleashed – ones that can bite

It may not be the standard way of looking at it, but there is such a thing as a London-Brussels nexus. The clichés from both sides tend to be all about incompatibilities: between London’s free-marketeerism and the corporatism of Brussels; London’s light touch and the heavy-handed approach of Brussels; London’s private-sector-led self-regulation and Brussels’s politically-driven agenda.

Beyond the optics, though, the alignment of objectives and of outcomes between the City and the EU institutions was surprisingly strong throughout the pre-crisis decade. Both shared the same project: European financial integration, which is part of the EU’s mission statement and from which the City benefited enormously as the dominant pan-European financial hub.

There are obvious cultural differences but, unlike with some continental countries, no fundamental tension of economic philosophies, as the emphasis on eliminating national barriers and competitive distortions that lies at the heart of the EU legal and institutional framework chimes with the UK’s fondness for economic openness. The EU was happy to embrace a largely liberalising agenda as long as it did not contradict major political priorities within individual member states; and the City was fairly comfortable with the growing scope of EU legislation as long as supervision stayed in the hands of the local team, first and foremost the FSA.

However, the financial crisis has unravelled some underpinnings of this alignment, both in London and Brussels. Re-regulation is the new catchword and, even though it has many sceptics, it means that a new era is beginning. Probably nothing better symbolises this shift than the start of the three new European Supervisory Authorities (ESAs) on 1 January 2011. To some observers, the ESAs are only a continuation of the “level-three committees” that had been in place since the early 2000s. But in reality, the difference is as significant as between unarmed and armed security guards. Unlike those committees, the ESAs have an ability to make decisions in controversial cases and to have them enforced, which is firmly grounded in EU legislation that binds all member states. They can plausibly be labelled the world’s first supranational financial supervisors. What that means in practice is a major shift of public oversight of the City from the UK level to the EU level, which will eventually force a clarification of City attitudes vis-à-vis the EU.

As is common with watersheds, this one does not appear obvious when seen from close up and the real significance of the ESAs will only reveal itself with the passing of time. They start very small, each with no more than a few dozen staff, a paltry budget and severe constraints on pay levels. Their governance framework is highly problematic, as it gives each member state equal weight in crucial decision-making and, unlike at the comparatively better-designed ECB, does not give voting power to any representation of the EU interest beyond individual member states. Their first real-life tests, including the European Banking Authority’s coordination of this semester’s pan-European banking stress tests and the steering of supervisory colleges, are likely to lead to disappointing outcomes and to a dent in their credibility.

Given the diversity of supervisory cultures across member states, there is a risk that their initial orientation will be towards an excessively formal, “box-ticking” approach to regulation, which may not deliver the best outcomes in terms of both performance and stability of the financial system. The impact of their respective locations (London for banking, Paris for securities, Frankfurt for insurance and pensions) is hard to predict but may result in partial capture by the local financial establishments, at least in an early phase, even though there is no evidence of this in the track record of the level-three committees.

But over the medium term, these uncertainties and shortcomings will at least partly fade away. The main reason why the ESAs will not be rolled back into insignificance is not their legal basis, despite its strength; it is because the previous combination of member states committing to a single market while retaining essential autonomy for their domestic supervisors, including the FSA, has been deprived of credibility and rendered unsustainable by the crisis. As Lord Turner, FSA chairman, memorably put it two years ago, the crisis forces a choice between less Europe and more Europe. By endorsing the creation of the ESAs at a June-2009 EU summit, the UK has irrevocably taken the path of more Europe, at least in this area. One proof is the remarkable extent to which the Cameron government has kept to its predecessor’s commitment even as the European legislation creating the ESAs was still under discussion. This choice is in line with London’s overwhelming economic interest in Europe’s continued financial integration.

Thus, the City cannot credibly think of escaping the reach of the ESAs. But it would be misguided to see these new players as intrinsically hostile just because continental Europeans will form the majority of their staff – after all, continentals are also a majority in many of the City’s best firms. To a considerable extent, the ESAs’ regulatory philosophy is a blank slate that will be filled by future interaction with their constituents. If the City tries to resist their ascent, it will evidently find it difficult to communicate constructively with them. But if it chooses to engage, it will find them open to reasonable solutions, though certainly – and legitimately – focused on public-interest objectives rather than private-sector ones, nor without teething difficulties and a steep initial learning curve for all the reasons mentioned above.

On the face of it, then, the calculation should be easy and lead the City to embrace the ESAs’ authority unequivocally. What makes it thornier is that this puts the City at odds with its immediate environment. The UK supervisory and regulatory authorities are as eager to defend their existing turf as any other powerful public institution – they are aligned in this with their continental peers. This can, and will, lead them to be more hostile to the ESAs’ empowerment than the City itself should be. The deep euroscepticism of the British public, which is widely shared inside the Square Mile, is another complicating factor. All this means that the redefinition of City attitudes vis-à-vis the ESAs and the EU, while indispensable, will be far from straightforward. To avoid unnecessary bumps on that road in the next few years, the City needs more open and in-depth debate on its link with the EU institutions, both within itself and with the wider UK community.  

Nicolas Véron is a Senior Fellow at Bruegel, a Brussels think-tank, and a Visiting Fellow at the Peterson Institute for International Economics in Washington DC

Strategy Review of the IFRS Foundation

The Trustees of the IFRS Foundation, which hosts and funds the International Accounting Standards Board, have conducted a public consultation on the Foundation's strategy. In line with my previous writings on accounting standards governance, I sent a personal response in which I answer to the Trustees' specific questions.

Click here to download a PDF version.

What it will take to make the next stress tests a success

Yesterday EuroIntelligence published this column in which I update and detail my views on the conditions for the forthcoming European banking stress tests to serve their intended purpose. It has also published in Italian by La Repubblica.

Click here for a PDF version.

Too Big To Fail: The Transatlantic Debate

 

The Peterson Institute and Bruegel published this Working Paper, in which Morris Goldstein and I analyze historical and structural differences between the US and EU, which help explain the differences in policy debates and decisions on the "too-big-to-fail" problem which lies at the core of current prudential regulatory debates.

Click here for the PIIE version in PDF if the above link does not work, and click here for the Bruegel version as published in early February.

Update: Morris and I later published a summary of the argument for Vox and NRC Handelsblad.