In a freshly recorded interview with Steve Weisman, I comment on today's announcement of a government reshuffle in France, especially the appointment of Emmanuel Macron to replace Arnaud Montebourg as Economics Minister.
In a freshly recorded interview with Steve Weisman, I comment on today's announcement of a government reshuffle in France, especially the appointment of Emmanuel Macron to replace Arnaud Montebourg as Economics Minister.
The results of the European Parliament election of May 22-25 have been described as “a shock, an earthquake” by the French Prime Minister because of unprecedented gains by anti-establishment and in some cases xenophobic parties denouncing the European status quo. The long-term trends, however, indicate a different perspective.
Much of the pan-European comment, as always, comes from the London-based international press focusing on the outcomes in the UK and, to a lesser extent, in the familiar old neighbor across the Channel. True, the shifts in Britain and France have been among the most dramatic. The UK Independence Party (UKIP) came in first, as did the National Front in France, while the governing French Socialist Party did worse than ever. But the vote in other countries suggests a more nuanced view.
In Italy, the governing center-left and pro-European Union (EU) Democratic Party won decisively. In Spain, the dominance of the two mainstream parties was eroded, but the gainers were mostly pro-EU even when they were anti-system. Conversely in other countries, key parties were pro-system from a domestic perspective, some of them even governing in their countries, but nevertheless anti-EU – for example, Hungary’s Fidesz and indeed the UK’s own Conservatives. About everywhere, and as usual in European elections, national political developments overwhelmingly influenced voters’ choices.
A longer-term perspective is reflected in in the chart below, showing all European Parliament elections (one every five years) since the first one by universal suffrage in 1979. Political groups in the Parliament have occasionally changed name and composition in terms of national member parties, but there is enough continuity to observe trends.
The two main groups have always been the center-right European People’s Party (EPP) and the center-left Socialists & Democrats (S&D). The centrist liberals, now known as Alliance of Liberals and Democrats in Europe (ALDE), have also been present since inception, as has a group of communist and other left-of-center parties, now called European United Left / Nordic Green Left (EUL/NGL). The Greens appeared in the 1984 election in alliance with regionalists, and have had their own group continuously since 1989. The UK Tories joined the EPP in the 1994, 1999 and 2004 but have been the core of a Conservative group both before (European Democrats) and after (European Conservatives and Reformists).
Various other right-of-center nationalist groups have come and gone, most recently the Europe of Freedom and Direct Democracy (EFDD) party, which includes UKIP and Italy’s Five-Star Movement. There was also a separate regionalist group following the 1989 election, and a split centrist group following the one in 1994. Finally, each parliament has a number of independents, currently at record level since France’s National Front failed to join or constitute a group.
The chart shows the shares of total Members of the European Parliament (MEPs) for different political groupings on the basis of this typology. Given the EU system’s significant deviation from the principle of electoral equality, this breakdown may be somewhat different from the EU-wide popular vote. Also, the absolute number of MEPs has almost doubled because of successive EU enlargements, from 410 in 1979 to 751 today.
One obvious fact springs from the graph: Europe has been there before. Until the 1990s, the overall balance of political forces in the European Parliament was remarkably similar to the current one, even though its national components have changed somewhat. Compared with the heyday of the “European mainstream” in the 1999, 2004 and 2009 elections, the earlier period saw stronger parties both on the left and on the right of the centrist block of EPP, ALDE, S&D and Greens (who may be radical on certain policies but are here included in the “European mainstream” in terms of their stance on EU integration). Strikingly, the legislatures that followed the 1984 and 1989 elections were the ones when Jacques Delors was President of the Commission, an era often seen in Brussels as the halcyon days of European integration.
A key question for the future, of course, is whether the recent trend will continue, and whether the “anti” parties may increase their gains further in the next election, scheduled in 2019. While an extrapolation of the chart may suggest such a prospect, it is far from inevitable. An optimistic reading of the appointment of EPP lead candidate Jean-Claude Juncker, the former prime minister of Luxembourg, as Commission President (which remains to be confirmed by a vote of the European Parliament itself) suggests that the next election may differ markedly from previous ones, including this year’s.
Given the Juncker precedent, EU member states’ citizens may be motivated to elect a specific party with a positive outcome in mind (their preferred pick for the top job) as opposed to a protest vote. If confirmed, this could trigger another trend reversal.
Europe’s banking union, constituting a supranational pooling of most instruments of banking policy, was established two years ago, in the early hours of June 29, 2012. To a greater extent than was initially realized by most observers, this step marked a watershed in the European crisis by making it possible for the European Central Bank (ECB) to stabilize sovereign debt markets. The banking union will also profoundly reshape and realign Europe’s financial system and institutions, with consequences that will unfold gradually.
The summit declaration establishing Europe’s banking union made three points: the intent “to break the vicious circle between banks and sovereigns”; the integration of banking supervision within the ECB; and a suggestion that the European Stability Mechanism (ESM), the euro area’s common fund, would be allowed to recapitalize banks directly under certain conditions.
Developments in Spain soon encouraged cynicism about direct ESM recapitalization. Investors only started releasing the pressure on periphery sovereign spreads four weeks later, when Mario Draghi, the ECB’s president, pledged to do “whatever it takes” to defend the euro area’s integrity, a stance later formalized as the Outright Monetary Transactions (OMT) program of conditional sovereign bonds purchases.
But even though the definitive history of these crucial weeks of mid-2012 has yet to be written, and the ECB is bound to present its policy decisions as independent from the political process, it is doubtful that OMT would have been possible without the prior announcements on June 29.
In a recent speech, European Council President Herman Van Rompuy stated that “the Central Bank was only able to take this [OMT] decision because of the preliminary political decision, by the EU’s heads of state and government, to build a banking union.” In October 2012, Mr Draghi described OMT as a “bridge” that “must have a clear destination” and said the single supervisory mechanism was “a key step” in defining that destination. This follows a pattern of ECB actions coming after political breakthroughs: its Securities Markets Program came after the European Financial Stabilization Facility’s creation in May 2010, and the implementation of three-year Long-Term Refinancing Operations was undertaken after the Fiscal Compact in December 2011.
Subsequent developments have demonstrated how much the banking union was a game changer. Granted, the commitment about ESM direct recapitalization was gradually deprived of any substance. But the centralization of supervision at the ECB has been enshrined in remarkably strong EU legislation. The future bank resolution framework, with a European resolution agency to be created next year in Brussels, is an awkward compromise between national and European decision making and funding. But it strengthens the prospect that creditors will share a larger part of the future burden of restructuring failing banks than has been the case in Europe so far.
A new banking levy is a notable case of introduction of a quasi-fiscal resource at the European level, and a much sounder one than the headline-grabbing but ever-postponed financial transaction tax. Crucially, the ECB’s supervisory role is front-loaded with the ongoing comprehensive assessment of the bulk of the euro area’s banking system, which is likely to end (belatedly) the systemic fragility impairing credit in Europe for seven years. Beyond this transition, the ECB’s indifference toward protecting national banking champions, or forcing banks to buy specific countries’ sovereign debt, is expected to lead to stricter supervision and market discipline, cross-border financial integration, and less reliance on banks in the financial system.
Banking union is no panacea. The ECB could still be less than rigorous in its bank review this year, which would squander the opportunity to restore trust. Several countries face disquieting medium-term economic, social, and fiscal prospects. Perhaps the wildest card now that perceived sovereign credit risk has abated is that EU institutions remain in a state of flux. As the center gains increasing discretionary authority, new channels of democratic accountability must develop. The recent appointment process for the European Commission’s president represents a response to this need through the empowerment of the European Parliament. But this trend is exacerbating the tension with the United Kingdom, which has not yet adapted to what Chancellor of the Exchequer George Osborne memorably called the “remorseless logic” of political integration in response to the crisis.
Even so, the anniversary of Europe’s banking union is worth celebrating. Two years ago, and for lack of alternative options, Europe’s leaders avoided their usual muddling-through complacency to do something radical—and it worked. They may need to muster such stamina again.
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:
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:
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:
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.
The European Central Bank’s comprehensive assessment of euro area banks has had an encouraging start. But complacency could still lead to another failed attempt to fix Europe’s banks, with severe consequences.
The ECB’s bank review looks like it will be more credible than the discredited EU-wide stress tests in 2010 and 2011. The ECB has its own reputation at stake, and has strong incentives to ensure that legacy problems are addressed before taking over from captured national authorities as the banks’ direct supervisor.
Unlike earlier exercises, the assessment of banks’ soundness starts with an Asset Quality Review (AQR), which is an examination of the asset side of bank balance sheets as of the end of 2013. The exercise involves 128 banks and covers the vast majority of the euro area’s banking assets. Asset valuation adjustments following the AQR will feed into forward-looking stress tests factoring in adverse economic assumptions, on the basis of which the ECB will assess the banks’ capital shortfalls. Previously, banks and supervisors in different countries adopted different and often lax approaches to the valuation of assets, collateral and guarantees and to the classification of impaired loans. By using an army of auditors to assess non-performing exposures, collateral, and provisions, the AQR should enable the ECB to assemble and disseminate consistent information across banks and countries. In an encouraging sign, this exercise appears to have already spurred many banks to increase loan-loss provisions and capital.
But the most critical part of the exercise still lies ahead, and could be harder than many investors and policymakers expect. The technical and logistical challenges alone are daunting, especially because the ECB is still building its staff and skills.
In addition, national supervisors will still play a critical role. They can use their position on the new Supervisory Board within the ECB to promote the narrow interests of banks and authorities in their countries. For example, the published benign assumptions for the adverse scenario in the stress tests — such as only a mild decline in property prices in Ireland, or no allowance for deflation in countries such as Spain — were likely promoted by national authorities. Weak stress assumptions make it more difficult for the ECB reestablish trust that banks are sound.
Another danger is that the results may not be disseminated quickly enough or in a transparent manner. The AQR is to be completed at the end of July, followed by the stress test, but the ECB does not intend any disclosures until late October, and may delay necessary supervisory actions beyond this date. But securities laws may require earlier disclosure of any discrepancy between previous and new estimates of capital, for example.
In the absence of a common euro area backstop to protect market confidence, there is a further danger of regulatory forbearance in the form of understated capital needs. Many also fear that the ECB might single out problems in banks from smaller and less powerful countries in an attempt to make the exercise look credible, while papering over cracks in more powerful countries. Even in small countries, the ECB may hesitate to declare a bank insolvent if the national government appears unable to deal with it. Capital requirements may also be understated for technical reasons, because of the primary reliance on complex risk-weighted ratios that can be manipulated and because of the ECB’s own lack of deep accounting and valuation experience.
Closing unviable banks and recapitalizing and restructuring viable ones are inherently painful and politically charged steps. Structures to manage failed banks and assets remain inadequate in Europe. In addition, domestic bank governance structures (e.g., the role of foundations in Italy, regional cooperatives that control Crédit Agricole in France, or public shareholders in Germany) could impede the ability to raise new capital. Before the EU’s Bank Recovery and Resolution Directive takes full effect in 2016, the policy stance toward forcing losses on (or bailing in) unsecured bank creditors if there is a capital shortfall remains unclear.
Overcoming these handicaps is feasible but difficult. To maximize prospects for success, the ECB must first be prepared to mercilessly identify the weaker banks, including “zombie” banks that pretend to be sound, abetted by complicit national authorities. The AQR and stress tests should separate banks into three groups: those that are sound without additional corrective measures; those that can be made viable with corrective measures; and those that are not viable and should be closed in an orderly manner, which could include a merger with other strong banks. Kill the zombie banks, and heal the ones that are only wounded. Danièle Nouy, the euro area’s new chief supervisor, has acknowledged that some banks must disappear. Delivering on this will be critical.
This policy does not imply a target big number for the aggregate capital gap for the euro area. The critical success factors will be rigor and evenhandedness in identifying capital shortfalls in core countries as well as the periphery, and not shying away from declaring banks to be insolvent. Encouragingly, independent estimates of the aggregate capital shortfall such as those by Viral Acharya and Sascha Steffen suggest that even if public backstops are needed, their magnitude will not likely damage sovereign debt sustainability.
Transparency is essential. As Karl Whelan has pointed out, the standards must be higher than the cursory disclosure of AQR results by Irish banks in December 2013. Investors will want to know how supervisors deal with losses denied by banks claiming differences over asset classification or collateral valuation. Plans should be made to reduce the danger of chaotic dissemination of AQR results between July and October, emphasizing disclosure to provide uniformity and reduce unwarranted market turbulence. Although the stress test’s capital thresholds are defined in terms of risk-weighted assets, the disclosures should also include simple leverage ratios to provide a more complete judgment of whether banks are adequately capitalized.
Finally, member states need to adopt a rigorous approach to rectifying capital shortfalls while minimizing cost to taxpayers. Orderly resolution of insolvent banks should include writing down not only shareholders' equity but also hybrid instruments and subordinated debt. All member states that lack laws to do so should urgently enact them. Unsecured senior bonds should be “bailed in” to reduce the cost of resolving zombie banks. The corresponding requirements of the Bank Recovery and Resolution Directive do not come into full effect until 2016 and it is too late to amend EU legislation in time for the AQR results. Under these circumstances, a political agreement to adopt a common approach that imposes losses on unsecured senior creditors of zombie banks would avoid damaging divergence from one member state to another.
Shareholders of wounded but viable banks needing increased capital buffers should not be rewarded until satisfactory capital levels are attained. In addition, banks unable to raise sufficient private capital should come under state aid rules, making conversion of junior debt to equity a condition for public assistance. In sum, restoring confidence and clarity and minimizing cost to taxpayers should trump protections for subordinated and senior bank debt.
Closing dysfunctional zombie banks and restoring wounded ones to health will not be enough to pull the euro area out of its economic and political funk. But the hard work of recognizing bad loans and recapitalizing and restructuring banks will reduce the current drag on growth from banks that squeeze credit even from promising firms, and will contribute to economic expansion and employment. Europe’s policymakers need nerve and clear-sightedness for this opportunity not to be wasted.
The European Parliament election of May 22-25, 2014 has several unprecedented features. It is the first election under the Lisbon Treaty. As a consequence, and for the first time, the main pan-European parties – including the center-right European Peoples’ Party (EPP) and the center-left Socialists and Democrats (S&D) – are fielding lead candidates for European Commission President. Turning the election into a presidential horse race was intended to increase electoral participation and enhance the Parliament’s democratic legitimacy, even though it remains to be seen whether voters will actually see things these way.
The European citizens’ relative lack of interest in the European Parliament is often blamed by critics on its inherent inequality of representation. Voters in smaller member states are overrepresented. Germany’s Federal Constitutional Court, when ruling on the Lisbon Treaty on June 30, 2009, said that the European Parliamentary election process “does not take due account of equality.” In the Court’s view, this constitutes one of two key factors in the European Union’s “structural democratic deficit,” the other being the European Parliament’s “position in the European competence structure,” i.e. its lack of power compared to other EU institutions.
How much change would produce an acceptable level of equality of representation? Article 14(2) of the Treaty on European Union gives disproportionate weight to smaller countries, stipulating that “no “Representation of citizens should be degressively proportional, with a minimum threshold of six members [of the European Parliament] per [EU] Member State. No Member State shall be allocated more than ninety-six seats.” But the treaty does not provide a specific formula for representation, and the exact composition is to be adopted by unanimous decision of the European Council. The latest apportionment decision was adopted on June 28, 2013 (European Council Decision 2013/312/EU), in the run-up to the accession of Croatia as the EU’s 28th member state.
In the charts at the end of this post, we compare the skewed nature of the European Parliament’s representation of European voters with other lower houses of large or medium-sized democratic polities. The European Parliament is at the low end in terms of electoral equality. For each chamber, the chart shows the distribution of number of eligible voters per representative, from the one(s) representing the lowest number of eligible voters, on the left end, to the one(s) representing the most, on the right end. A flat distribution indicates a high level of equality of representation. A sloped or skewed distribution indicates inequality of representation.
These distributions are summarized in a “Voting Gini Coefficient,” akin to the familiar cross-country comparative measure of inequality of income. Here the Gini coefficient measures not income inequality, but voting power inequality due to skewedness of representation across territorial subdivisions of the relevant polity. A high Voting Gini Coefficient suggests a high degree of voting power inequality among citizens eligible to vote.
The comparison suggests that the European Parliament is indeed outside the norm of European countries in terms of equality of representation. In its own way, so is Germany, whose professed commitment to this principle is unparalleled among countries reviewed. Higher levels of inequality of representation may be expected in larger, more diverse polities where the political complexity of federal arrangements leads to awkward institutional compromises, which is definitely the case of the EU. In our sample, higher Voting Gini Coefficients are indeed also observed for the lower houses in India and Brazil, which come closest to the EP on that measure. For example, in Brazil voters from Sao Paulo state are notoriously underrepresented. Yet the US and Indonesia, which are also large and diverse, both display comparatively low Voting Gini Coefficients.
The implication is that the European Parliament would not need to reach a level of representative equality as high as the German Bundestag to join the norm of lower chambers in democratic polities. A modified distribution that would sharply reduce the EP’s Voting Gini Coefficient to a level around 10 percent could be achieved without entirely renouncing the principle of “degressive proportionality,” but would require lowering the minimum of six MEP seats per member state, and thus a modification of the Treaty on European Union.
If such a level were reached, our international comparison suggests that it would no longer be reasonable for the German Federal Constitutional Court or other watchdogs to label the European Parliament’s representative inequality as an element of “structural democratic deficit.” This labelling, however, does not appear unreasonable under the current arrangements.
 The court’s press release in English about its ruling on the Lisbon Treaty is at https://www.bundesverfassungsgericht.de/pressemitteilungen/bvg09-072en.html.
 For most countries reviewed, average voting-age population per government representative is based on the total population per relevant territorial subdivision (e.g. state or province), taken from each country’s census bureau, and on the “Voting-Age Population” (VAP) variable from the International Institute for Democracy and Electoral Assistance (IDEA)’s database (http://www.idea.int/). The charts depict the simple division of voting-age-population per territorial subdivision by the number of representatives in the lower house that serve that particular territorial subdivision. The number of government representatives from each subdivision was found in each country’s lower house website. Voting-age population per subdivision was calculated by multiplying the VAP number by the subdivision’s percentage share of the country’s total population. Percentage shares were calculated based on census data for total population from each country’s statistics bureau. IDEA estimates the VAP number based on data from the International Database of the U.S. Census Bureau. IDEA includes all citizens over the age of 18 within the scope of VAP. However, this figure does not take into account legal barriers, such as registration. It also excludes resident non-citizens from the pool. For the United States, we used data from the United States Elections Project at George Mason University (http://elections.gmu.edu/). For the United Kingdom we used the total number of parliamentary electors from the UK Office of National Statistics, which they define as “residential qualifiers, attainers and overseas electors” (http://www.ons.gov.uk/ons/taxonomy/index.html?nscl=Elections+%28Local%2C+National+and+European%29#tab-data-tables).
 Gini Coefficients were calculated with the STATA command ineqdeco on the variable "Voting Power." To calculate Voting Power, each representative’s share of the chamber (1/n, where n equals the number of representatives serving in the lower house) is divided by the voting-age population in the corresponding electoral district. This number represents the amount of representation each individual in the population has in the lower house.
 As an illustration, we find a Voting Gini Coefficient of 10.0% with a distribution of seats that is identical to the current one for the larger member states (Germany, France, UK, Italy, Spain, Poland), halves the number of seats of the smallest member states (Malta, Luxembourg, Cyprus and Estonia) from six to three each, and smoothens the distribution with a less sharp reduction in seats numbers for the remaining 18 member states.
The bid from General Electric (GE), a leading US-headquartered conglomerate, for the power division of Alstom, a maker of turbines and trains, has prompted much soul-searching in France. Alstom's acceptance of GE's bid is widely seen in France as symbolic of the country’s relative decline. The argument is that the glorious France of yesteryear could muster an array of vigorous national corporate champions, but these are disappearing or leaving the French territory one after the other.
The same litany of loss is repeated again and again. Pechiney, an aluminium producer, was purchased by Canada’s Alcan in 2003. Arcelor, the heir to France’s historically strategic steel industry, was merged into ArcelorMittal in 2006. More recently, Publicis, a communications behemoth, has considered moving its headquarters to the Netherlands as a consequence of its merger with Omnicom; Lafarge, a cement maker, is similarly moving its head office to Switzerland while merging with Holcim; and the purchase of SFR, France’s second-largest mobile phone company, implies it will become a subsidiary of Altice, a Luxembourg-based group. France is described as at risk of being left without economic centers of decision, a vassal of foreign business powers.
The description of mass corporate exodus fits a narrative of national decay. France’s exports are slumping. Its tax burden has grown unbearably high, feeding an inadequate state-centered economic model. Its credit has been downgraded by the leading rating agencies. It is unable to match either the performance of Germany or the structural reform of its southern neighbors. Its best minds and entrepreneurs are emigrating, discouraged by the lack of opportunity at home. It is rapidly losing soft power. Its cherished language is increasingly neglected internationally. Even its restaurants are falling behind.
But on the specific issue of corporate champions, this story is not backed by the facts. Compared with the rest of Europe and the world, France is not losing ground as the location of major corporate headquarters—if anything, the opposite is true.
To get a sense of the bigger picture, let’s look at a comprehensive set of the world’s largest companies, France’s position, and its evolution over time. A good proxy is the 500 biggest listed companies by market capitalization, as published regularly by the Financial Times (FT 500). We make minor corrections on head office location (which we define as the main center of corporate decision-making, while the Financial Times refers to the place of listing or incorporation—this only makes a difference in a limited number of cases). The omission of nonlisted companies creates little distortion in the case of France, most of whose large companies have been publicly listed since at least the early 1990s—the name of the local stock index, known as CAC 40, is routinely used as shorthand for the country’s largest businesses. Market value is subject to financial cycles, but, as these tend to be largely synchronous, it is a good measure for cross-country and cross-sector comparisons.
The following charts show the findings for the latest ranking, as of end-2013, and the earliest one, in September 1996. For each date, we look at the number of FT 500 companies headquartered in a given country in proportion to that country’s GDP (at market exchange rates, from the International Monetary Fund’s World Economic Outlook database), and compare the ratio to the global average. If the corresponding number is above 1, the country is overrepresented in the global population of corporate champions in comparison to its economic importance; if the number is less than 1, the country is underrepresented. The same calculation is then made on the basis of aggregate market capitalization instead of number of companies, to account for differences of corporate size within the FT 500 list. (The numbers are unaffected by the eventual fate of Alstom, Lafarge, and Publicis, whose respective market values are not large enough to be included among the 27 French companies in the list.)
As this chart illustrates, France is ahead of the EU average, let alone its peers in the euro area. Archrival Germany is well behind. The United States, the world’s leading corporate powerhouse, does even better, but not by a wide margin. Corporate champions from China (which in this calculation includes Hong Kong and Macau) and the other BRICs—Brazil, Russia, and India—remain well underrepresented in the global landscape and would be even more so if the measure of GDP used was calculated at purchasing power parity. When measured by market capitalization, the United States and Switzerland are further ahead, as they are disproportionately home to very large corporate concerns. But France’s relative position is largely unaffected in comparison with its European peers, which suggests that its champions are not particularly lagging towards the bottom of the FT 500 list.
Trend-wise, and implausible as it may sound to Parisian pundits, France is actually doing better in this competition than it used to. The earliest available FT 500 list shows France’s corporate champions comparatively underrepresented, and slightly behind the EU average, both in terms of numbers of companies and of aggregate market value. (This list shortly predates the Asian financial crisis of 1997–98 and illustrates a temporary overrepresentation of some Asian countries, but this factor does not create much distortion from a global perspective and only marginally affects the relative positions of European countries and the United States.) Strikingly, in less than two decades France has gained considerable ground in comparison with the two traditionally headquarters-rich EU countries, the United Kingdom and the Netherlands, and even with Switzerland, whose stability, discretion, and tax restraint has made it a global magnet for corporate head offices.
What factors lie behind France’s position? No general explanation is ventured here. Many factors influence the rise and fall of companies in the FT 500 list. However, one may note one aspect that resonates with the current Alstom saga. Of the 18 French companies in the 1996 list, four have been absorbed by a French peer but none by a foreign buyer; by contrast, among the 108 other European groups in that same list, 21 (or almost one in five) have been the targets of a cross-border acquisition. When Arnaud Montebourg, France’s opinionated economics minister, recently commented that “French companies are not prey,” he was in a way making a statement of fact. This distinction is probably at least partly policy-driven—i.e., the French government is more determined than its European peers to prevent its national champions from being taken over, and when such an outcome is unavoidable, it tends to favor national mergers over cross-border ones. This hypothesis fits with anecdotal evidence, such as when the French authorities appeared to dissuade Novartis from bidding for Aventis in 2004, PepsiCo for Danone in 2005, unnamed interested parties for Société Générale in early 2008, or indeed Siemens for Alstom, also in 2004.
Whether this policy serves the French national interest, as opposed to the special interests of the respective companies’ management and shareholders, is a matter of debate. Both the French elites and the wider public seem to take it as an article of faith that the more national champions, the better. In business matters, the French often appear to believe in intelligent design: Incumbency is viewed favorably, and any evolution in the corporate landscape is viewed with suspicion. Thus, the implicit premise of many discussions in France is that protecting, promoting, or otherwise helping established champions is good for the country.
By contrast, the economic case for such “neo-Colbertism” is far from self-evident. On the one hand, companies may have a home bias in locating their investments, and headquarters themselves are a source of high-quality jobs. On the other hand, the home bias appears to have decreased over time as the champions internationalize their production infrastructure and increasingly their research and development operations as well. The protection of incumbents erodes market discipline and encourages rent-seeking and ineffectiveness, and more dynamic new entrants are discouraged from the national market. The cost-benefit analysis of France’s “economic patriotism” is made even more difficult by the opaqueness of tax arrangements made with large companies (in France as in other countries), and the fact that, more generally, many of the corresponding costs are hidden. More economic research is needed on these trade-offs, the terms of which are continuously modified by globalization and technological change.
Irrespective of the economics, however, the factual observation remains unambiguous. French-headquartered companies are well represented among the population of global business giants, and increasingly so. France may have ninety-nine problems, but an extinction of corporate champions is not one of them.
In this new podcast interview with Steve Weisman, I comment on GE's bid for Alstom's power operations, Pfizer's offer on AstraZeneca, and the ambiguities and ironies of economic nationalism and corporate nationality.
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.