Given London’s current central role in the European financial system, Brexit will generate significant risks and opportunities for the financial system of the remaining members of the European Union (EU-27). With Britain’s departure from the EU single market nearly certain to occur before mid-2019, the EU-27 should not wait to adapt its financial regulatory structure to successfully manage the resulting shifts. The main risks relate to the supervision of wholesale activities of financial firms and capital markets. To address these risks, European leaders should reinforce the European Securities and Markets Authority (ESMA) with significant additional resources and an expanded responsibilities.
Market disruption is not the main risk for the EU-27’s single market: Most market participants have enough time to prepare for the worst-case scenario of a lack of agreement on “B-day” in early 2019. Rather, the main risk is the market fragmentation along national lines that would occur with the loss of the London hub . Fragmentation could result in less effective market supervision than is currently achieved by the UK authorities, a higher likelihood of misconduct and systemic disturbances, and a more onerous cost of funding for EU-27 corporates and households.
Fortunately, and thanks to wide-ranging reforms introduced during the past years of crisis, the EU-27 is much better equipped to face these challenges than it would have been a decade ago. All euro area banks are now supervised on the prudential side by the European Central Bank (ECB), directly for the larger ones and indirectly for the smaller ones, which minimizes the possibilities of regulatory arbitrage and of a concentration of systemic risk in a given country. However, on market activity and regulation—including securities firms (also known as broker-dealers), asset managers and financial infrastructure, e.g., central counterparties (CCPs, also known as clearing houses)—and the conduct-of-business oversight of banks themselves, the ECB has no jurisdiction. Many wholesale market activities will need to be relocated from the United Kingdom to the EU-27 so that financial firms can keep serving local customers within the single market.
ESMA was created in 2011 to help foster “supervisory convergence” and mitigate the vast existing differences of approaches, experience, and effectiveness between individual member states’ national authorities, such as BaFin in Germany, AMF in France, and Consob in Italy. ESMA also has some direct supervisory authority, but only over comparatively tiny market segments, namely credit rating agencies and trade repositories. ESMA has accumulated a decent track record, but its current mandate is not sufficient to integrate EU-27 capital markets and ensure high standards of compliance with EU regulations.
The obvious solution is to enhance ESMA's responsibilities, especially over those wholesale market segments that are currently concentrated in London and that require uniform, high quality supervision. Recommended expanded responsibilities include the authorization of significant investment intermediaries (e.g., banks and securities firms) under the EU Markets in Financial Instruments Directive and Regulation (MiFID/MiFIR); the registration, supervision, and resolution of CCPs, at least those that serve international clients and have a potentially systemic importance from an EU perspective; and also the supervision of audit firms and the enforcement of International Financial Reporting Standards.
In parallel, the governance and funding of ESMA should be overhauled to better suit an enhanced scope of authority. Its current supervisory board, in which only representatives from national authorities have a vote, should be reformed to include an executive board of, say, five or six full-time members vetted by the European Parliament, as is the case with the ECB and the recently created Brussels-based Single Resolution Board. And in line with international best practices, ESMA’s funding should rely on a small levy on capital markets activity under scrutiny from the European Parliament, instead of the current political bargaining through the general EU budget.
Moreover, ESMA should be the single EU-27 point of contact for all interaction with third-country (non-EU) authorities. It should represent the EU-27 securities regulatory community in international supervisory colleges wherever relevant, and in international standard-setting bodies such as the International Organization of Securities Commissions and the Financial Stability Board. It should also, importantly, be given oversight authority over non-EU financial infrastructure that is systemically important for the European Union, similar to what already exists in the United States. This would allow flexibility in handling the financial stability challenges linked to the location of derivatives transactions, especially those denominated in euros, without having to force a costly relocation of their clearing in the euro area in the short term.
These reforms are significant but can all be achieved within the current treaty framework and without having to wait for the actual UK exit, since they would all take the form of Internal Market legislation approved by a qualified majority vote. In fact, the United Kingdom can be expected to favor them all, for the same reasons it supported the inception of banking union in 2012–14: It is in the interest of the United Kingdom to have a well-regulated, well-supervised EU-27 financial system as its neighbor, for economic growth and financial stability reasons.
There is no compelling counterargument against financial market policy integration, especially now that the early achievements of banking union, including a broadly strong and effective European banking supervision led by the ECB, have provided a “proof of concept.” Significantly, the influential German Council of Economic Advisors (Sachverständigenrat) indicated in its latest annual report that “organizing the supervision of banks, insurance companies and financial markets at [the] European level is the right approach.” The European Commission will review its signature policy of capital markets union in June: This should mark the opportunity to announce the reinforcement of ESMA along the lines suggested above.
Other initiatives are also needed to make the best of Brexit for the EU-27 financial system. In particular, banking union is still an unfinished project that will need strengthening in order to better share the risks and benefits of the forthcoming relocation of financial activity from London. The distracting project of a European Financial Transaction Tax should be either reframed as a stamp duty on securities transactions or abandoned altogether. Most importantly, leaders should make it clear that the inevitable competition among European financial centers to attract business from London should not be based on financial regulatory competition, but on other, nonregulatory factors such as infrastructure, skills, quality of life, as well as labor and tax legislation within the boundaries set by EU law. A swift move towards a stronger, more authoritative ESMA would be the best way to cement this vision.
In this brief video interview with Eitan Urkowitz at the Peterson Institute, I answer questions on the likely impact of Brexit on the City of London and on the EU27 (EU minus UK), and what policy initiatives may be envisaged to prevent the worst outcomes.
I gave this lecture on January 24 at ESMT, the business school in central Berlin. While not a verbatim transcript of the presentation, the text below is based on oral delivery and on unpresented but prepared notes. It was also published online by ESMT (with a video of the lecture) and by PIIE.
At a time when there is much uncertainty in the world, this open lecture will focus on the challenges that are facing the European Union this year and, among them, on those that have a specific economic and financial dimension and may be addressed by European policy initiatives in the near future. I am very grateful to Jörg Rocholl, President of ESMT, for his generous invitation to speak today in this intimidating historic room, and to Michał Grajek who has kindly accepted to moderate the questions-and-answers session after my initial remarks.
The title of this lecture is an invitation to look forward, but it is also important to remember where we come from. The European Union is only slowly emerging from nearly a decade of continuous economic and financial emergency, which started with the first indications of major dysfunction in the financial system in the middle of 2007—including here in Germany, with the rescue of IKB in late July of that year. Financial and economic turmoil later morphed into disruptive political developments, which in turn generated economic and financial challenges of their own.
Of these political developments, at least one will certainly have lasting structural consequences—the choice made last year by the United Kingdom to leave the EU, or Brexit. Apart from the UK, there are many current challenges in European politics, but it remains to be seen whether they are of more than a temporary nature. The initial political impact of Brexit itself has been weathered by the rest of the EU, better than many observers (including myself) would have anticipated. There has been shock and disbelief, but no obvious contagion to other member states in terms of collapse of public support for European integration; if anything, the opposite has been observed in several opinion polls since June 2016. It is early in the year, of course, and a string of elections later this year will give us a number of new data points. As for financial system aspects, there is no question that Brexit represents a significant shift in the European landscape, given the central role of London as a capital markets hub for the entire European Union in the recent past and the present.
2017 is likely to mark the end of the EU’s decade-long sequence of economic and financial emergency. Such a statement may appear overly optimistic given all the catastrophist media headlines about the EU and the euro, which are routinely depicted as on the verge of collapse. But while that alarming picture was definitely appropriate during the transatlantic financial meltdown of the early autumn of 2008, or during the climax of the euro-area crisis in late 2011 and early 2012, or even during the high drama of the Greek crisis in mid-2015, it rings less true now.
The last major pockets of country-specific banking sector fragility—in Portugal and Italy—are belatedly on the way towards being properly addressed, at least if a number of important ongoing transactions are confirmed. These include the privatization of Novo Banco, the capital increases of BCP and Caixa Geral de Depositos in Portugal, and in Italy, the public recapitalization of Monte dei Paschi di Siena and that of the entity resulting from the announced merger of Banca Popolare di Vicenza and Veneto Banca. If and when all these are completed, which I hope and expect will be the case in a few weeks, a picture will emerge of a euro-area banking sector still in need of considerable restructuring but no longer in a situation of systemic fragility (even though smaller banks in Italy and elsewhere will remain a concern).
Similarly, while negotiations on continued financial assistance to Greece remain difficult, they are unlikely to degenerate into the kind of unreasonable brinkmanship that occurred in mid-2015. And while Brexit creates significant challenges for the financial system of the EU-27 (the 27 other EU countries, excluding the UK), it is unlikely to generate financial instability given the long lead times that will allow financial firms to adapt their structures and anticipate even the most non-cooperative outcomes. Altogether, in a broadly probable baseline scenario, there will be situations to manage in 2017 but they won’t be as existential as in every year of the last decade. Of course there are tail risks that could trigger severe financial instability—such as a far-right government in France, for example—but their likelihood should not be exaggerated. In a turbulent global environment, and somewhat ironically given the recent experience, the European Union (minus the UK) could even quickly become an area of comparative stability.
Even if one accepts this comparatively benign assessment, there is evidently no room for complacency. The European Union is far from having reverted back to a normal economic and financial condition. The clearest sign of this is the continuation of extraordinary monetary support by the European Central Bank, including in the form of the current program of quantitative easing. Greece is very far away from regaining market access for its sovereign financing. And as previously mentioned, the European banking system cannot retain its current structure; major changes in the financial landscape will have to happen before it becomes healthy again.
Thus, the desirable transition back to normal will only happen if further efforts are made, including in the area of new policy development. This lecture focuses on outlining a realistic agenda for such efforts, which should also draw appropriate lessons from the last almost-ten years of crisis. One hopes that 2017 will be a busy year for the EU policy debate, so that the new governments that will emerge from the sequence of elections scheduled this year in several key countries, including this one in September, will be able to initiate useful actions once they are in place.
Such new policy initiatives at the European level should not be thought of as overly radical. Experience suggests that paradigm shifts in EU governance only occur under massive short-term pressure and, as highlighted above, such pressure is not expected to be repeated in the year ahead, at least in a baseline scenario. In particular, there should be no expectation of treaty change in the immediate future. Indeed, treaty change would be very hazardous as long as the negotiation with the UK on Brexit is not completed.
In the same vein, there should be no expectation of fiscal union, understood as a fully-fledged system of debt issuance and revenue collection at the European level. The euro area has limited elements of a fiscal framework, such as size-bound financial firepower (including the ability to issue debt) at the European Stability Mechanism, and a limited-purpose levy on European banks to feed into the Single Resolution Fund, which is expected to become fully transnational by 2024. More longstanding arrangements include the European Investment Bank’s financial capacity and the EU’s own resources, such as customs duties and sugar levies. But these arrangements stop well short of a full fiscal framework. There is no expectation here that the political and legal parameters which so far have prevented the emergence of genuine fiscal union in the euro area will change any time soon.
Even within these constraints, a lot can be done. Four areas in particular can be singled out for bold reform. They may be labelled, respectively: a stronger banking union; a reframed capital markets union; a common information backbone for fiscal policy; and renewed thinking on how to achieve a true single market in regulated services sectors, which may also be thought of as economic union. The rest of this lecture is devoted to examining these four possible projects in a bit more depth.
Banking union refers to the pooling of banking-sector policy instruments at the European (in this case, euro-area) level to achieve the objective “to break the vicious circle between banks and sovereign” as memorably stated by the euro area political leaders in their landmark declaration of 29 June 2012, which started this project, and in subsequent pronouncements. This unusually clear statement of intent came from the painful lessons of the months preceding that mid-2012 policy breakthrough. During that period (late 2011 and early 2012), it became increasingly evident to all that the financial linkages between national banking systems and the respective sovereign issuers, through mechanisms that may variously be labeled implicit government guarantees of the banking sector, financial repression, and banking nationalism, were generating a destabilizing dynamic of contagion and escalation that came close to forcing an irreversible break-up of euro-area monetary integration. As long as genuine fiscal union was not on the cards, banking union was eventually, and correctly, identified as the only way to break that vicious circle.
Several policy initiatives came from this recognition: mainly the creation of a brand-new system of European banking supervision (also known as the Single Supervisory Mechanism) in which the central role was entrusted to the ECB, operational since late 2014; the acceleration and strengthening of the hitherto tentative shift from a default assumption of public rescue (or bail-out) of creditors of failed banks towards that of burden-sharing by private stakeholders (or bail-in), materialized in the Bank Recovery and Resolution Directive (BRRD) of 2014; and the partial centralization of bank resolution decisions in the euro-area through the establishment of the Single Resolution Board and Single Resolution Fund, both in place for more than a year now. But despite these path-breaking achievements, Europe’s banking union remains, to borrow the words (if not the full analysis) of Germany’s finance minister in a 2013 article, “timber-framed,” an unfinished construct that mitigates the bank-sovereign vicious circle but is not strong enough to break it. To achieve that aim, again borrowing Mr. Schäuble’s expression, a “steel-framed” banking union should replace the timber structure, and this requires further legislative reform.
The specific content of such reform requires public debate, which itself can only be fruitful once the European public, including observers in this country, has been sufficiently persuaded that the existing system works as intended, and in particular that European banking supervision is “tough and fair,” as its officials often put it. This requires clear indications of progress in countries such as Portugal and Italy, but also a sense of direction on high-visibility German cases such as Deutsche Bank or, in a completely different category, HSH Nordbank. The lack of that perception in the past goes a long way towards explaining, in particular, the lack of progress in the discussion on “strengthening banking union” during the Dutch Presidency of the Council of the EU in the first half of 2016. But if, as previously suggested, the picture of ECB supervisory effectiveness improves significantly in the near future, then a much broader space will be opened for further constructive steps.
There is not enough time today to describe in much detail what these steps should look like. But they should include at least three dimensions. First, the framework for bail-in should be made more consistent across member states, an aim that inevitably entails harmonization of bank insolvency law. Second, regulation should ensure that banks cannot be used by governments as instruments to get easy funding, which suggests a binding framework of well-calibrated exposure limits on banks’ sovereign debt portfolios, with proper transition arrangements. This is a complex and important matter that requires much more public debate than has happened so far, but the euro area will not escape that debate—nor can it be successfully delegated to international bodies such as the Basel Committee, because the problem is the unduly high home bias in euro-area banks’ sovereign debt exposures and this problem is essentially unique to the euro area. Third, there is a need for explicit risk-sharing to rule out the possibility that local banking problems, especially in smaller countries, may trigger sovereign default. This should take several forms, including the creation of a European Deposit Insurance System broadly along the lines suggested in November 2015 by the European Commission, a financial backstop from the ESM for the Single Resolution Fund and the future European deposit insurance fund, and also the ability for the ESM to intervene financially in precautionary bank recapitalizations under the conditions set by BRRD.
These three dimensions are mutually interdependent, not only politically but also on substance, and should be envisaged as a single policy decision package even though their implementation will inevitably occur in several stages. In addition, more work is needed on subsidiarity and proportionality in the banking union architecture, to ensure that smaller banks are subject to consistently high prudential and supervisory standards without burdening them with unnecessary administrative requirements. This latter objective may take more time to achieve but also deserves open discussion as soon as this year.
The EU project of Capital Markets Union (CMU) was initially announced in July 2014 as part of the broader policy program of the new European Commission led by Jean-Claude Juncker. At the time, the aim was to reduce an excessive dependence on bank intermediation in Europe’s financial system but also, plainly, to signal a financial-market-friendly attitude in the run-up to the UK referendum. But far from rendering CMU obsolete, Brexit actually adds to the project’s urgency and should force a reframing on how to achieve its aims.
The underlying reason is that London’s role as a central hub has meant that the EU’s wholesale financial markets were overseen in a consistent way—by the UK authorities—because they were overwhelmingly located in a single member state. In a EU-27 context post-Brexit, there is a major risk of oversight fragmentation, with different national authorities taking different approaches leading to regulatory loopholes, lack of enforceability of EU policies, and a higher cost of funding for the EU economy.
Even though banks represent a major share of financial intermediation, banking union per se doesn’t address this challenge, if only because many of its aspects are unrelated to prudential supervision. For example, the enforcement of the Markets in Financial Instruments directives and regulation (known as MiFID/MiFIR) is largely in the hands of securities authorities, not prudential supervisors, and in most member states (though not Germany) these are entirely separate organizations. Thus, the new incarnation of CMU in the changed context created by Brexit should put the emphasis on the reform of the oversight architecture (possibly complemented by regulatory harmonization projects), in order to reach a status in which, to borrow a recommendation from the last annual report of the German Council of Economic Advisers, “the oversight of financial markets [should be] located at the European level.”
In practice, this would require a reform and reinforcement of ESMA, the European Securities and Markets Authority created in 2011, to make it the hub of policy-setting in that area. Many individual decisions would remain in the scope of national authorities, but under ESMA’s binding oversight, in a hub-and-spokes framework akin to those for competition policy or for banking supervision. For example, ESMA should have authority over the enforcement of International Financial Reporting Standards throughout the EU, and similarly for the oversight of audit firms and of critical market infrastructure (such as clearing houses), as it already has over credit rating agencies and trade repositories (disclosure: I am an independent director in a trade repository supervised by ESMA).
This vision for “CMU 2.0” would also allow for the creation of third-country regimes that would allow European authorities, including ESMA and the ECB, to oversee market infrastructures located outside of the EU-27—for example, in London—if they play a critical role for the EU-27 financial system. Such a vision is not at all utopian, since a framework along these lines already exists for US authorities, which have arrangements in place to directly supervise and inspect some critical financial infrastructure in London and elsewhere. It is high time for the EU to revise its approach in this area and learn the right lessons, both from the American experience and from the shortcomings of its own frustrating past attempts to address this challenge through the means of equivalence recognition.
As mentioned earlier in this lecture, it is arguably not realistic at this stage to advocate decisive steps towards fiscal union—eurobonds, eurotaxes and euro-spending even if they’re not called that way. There is a sound intellectual case to be made for such things, but it is abundantly clear that Europe is not yet ready for them politically and can most likely overcome its current challenges without them. But that doesn’t imply that nothing can or should be done to improve the euro area’s current highly imperfect fiscal framework.
Sadly, the Maastricht treaty’s stability pact (later, stability and growth pact) has not worked as intended by its framers—and my country and yours, France and Germany, were the ones who first and foremost breached it almost fifteen years ago. Since then, increasingly complex patches have been applied, but their credibility has not been better. If the rules are simple, they tend to be too rigid and in many cases even “stupid,” as was memorably put by a former president of the European Commission; in order to better meet economic objectives, the framework requires more nuance and judgment, but then it quickly becomes overly complex and open to political tweaking, which is more or less the present situation.
Meanwhile, the EU does not appear to have fully drawn the lessons from its most obvious fiscal policy failure: the repeated misrepresentation by Greece of its true fiscal condition (under different political coalitions) that led to the well-known drama of 2010 and ever since. Some changes have been introduced to make national numbers more reliable, but they have not gone nearly far enough.
One case summarizes the problem: that of Mr. Andreas Georgiou, head of the Greek national statistical office for five years from 2010 to 2015 and, in that capacity, the one who established the definitive figures for Greece’s deficit and GDP developments in 2009 in particular. These figures have been validated by Eurostat and have not been questioned outside of Greece. Within Greece, however, they have become a matter of highly emotional controversy. The government has repeatedly declined—again under successive political coalitions, including but not limited to the current one— to vouch for them. Worse, Mr. Georgiou was accused of harming the national interest by publishing them and has been the target of a number of high-profile lawsuits that are still ongoing. It is evidently not acceptable that a statistician should be persecuted for doing his job with integrity and left to his own devices by both national and European authorities for his defense. As long as such a thing can happen, the potential for undue political interference in the production of national accounts and statistics is achingly obvious, and not only in Greece. This situation cries for reform.
What is needed is—with reference to the arrangements existing in the private sector and in particular those covering publicly listed companies—a proper accounting and auditing framework for European governments, with a robust enough central function to ensure relevance, comparability, reliability, and understandability. The accounting standards should be based on the age-old principle of accruals accounting, which has only recently been introduced into government accounting in some countries, including some EU member states but far from all of them, for example Austria but not Germany. Equally important, the current oversight by Eurostat should be transformed into a genuine euro-level auditing authority. These more centralized arrangements should also apply, with due adaptations in accordance with the subsidiarity principle, to the accounts of subnational governments, to the extent that they contribute to national aggregates. Such ideas are bound to be controversial, but the lessons from the Greek tragedy in general, and from the more specific but significant Georgiou tragedy in particular, must not be allowed to be lost.
The Four Presidents’ report of June 2012, whose lead author was then-President of the European Council Herman Van Rompuy, has popularized a framework of “fourfold union” to think about the missing pieces of euro-area policy: financial union (i.e., banking union and capital markets union), fiscal union, economic union, and political union. This lecture has already included suggestions for financial union and for a sounder information basis for fiscal policy even as fiscal union is left for a more distant future. Political union is not discussed here, beyond the observation of the EU-27’s initial resilience following the shock of the Brexit vote.
Economic union, however, deserves more debate and attention than it has habitually received since Mr. Van Rompuy’s report. Different analysts have used the expression in many different ways. It is proposed here that it may best refer to those structural economic policies that are conducted at the European level, not the national level. Viewed that way, economic union may be taken as just another name for the completion of the European single market, particularly in services sectors where EU-wide market integration is partial at best.
Single market policy has been very successful in markets for goods and unregulated services but much less so in regulated services sectors. This distinction is especially significant since regulated services tend to represent an increasing share of the EU’s economies, and this increase implies that national economies become less not more integrated if the EU is not able to complete the single market in such sectors. The underlying reason for the gap is that, in regulated sectors, market structures are shaped not only by the content of rules and regulations but also by the way they are implemented and enforced, which typically involves a degree of administrative discretion and judgment. If such administrative oversight and enforcement is in the hands of national authorities, as is habitually the case, then markets tend to be segmented across national lines. One aspect of this is the tendency of national authorities to give preferential treatment to “national champion” companies, as is being illustrated by the burgeoning cases about the control of car emissions—even though one would expect this type of technical standards not to be susceptible to national twisting.
“Capital markets union 2.0” as previously discussed, and indeed also banking union, can thus be viewed as early examples of a new and promising approach to promoting EU single market integration in regulated services sectors, by complementing the structure of national enforcement authorities with a European overlay, thus achieving a hub-and-spokes architecture comparable to the one that has long existed for the implementation of competition policy. This approach can and should be extended to an increasing range of regulated sectors, be it energy (e.g., electricity and gas networks), digital services (e.g., the enforcement of privacy protections), as well as various regulated professions, commercial health and education services, and more.
Overhauls of EU supervisory architecture through the creation of sector-specific EU-level authorities with a mandate for binding decision-making, not just loose coordination, has long been considered unachievable politically. But the initial successes of European banking supervision have led to a shift in perceptions. With the UK veto removed by Brexit, it may now be time for the EU-27 to envisage new initiatives to create appropriate institutional settings that would allow for the vision of a seamless single market to be achieved, in a broader range of economic sectors than has been the case so far.
The theme of this lecture has been that the EU-27 is just exiting a decade-long period of short-term emergencies, and now needs to consider fresh initiatives to reach a more consistent framework for banking, capital markets, fiscal (if only as regards the information base), and structural economic policies, building on the early achievements of recent shifts such as European banking supervision. This might strike some observers as an exceedingly optimistic way of looking at the EU’s current situation and challenges.
Only time will tell if there is too much optimism in this vision, but in any case it should not be mistaken for complacency. As previously emphasized, even assuming no new dramatic development in the EU-27 in 2017, the area is far from having returned to a normal economic and financial condition. This is precisely why a strategic, forward-looking policy debate is so important this year. As the old American saying has it, Europeans will hang together or hang separately.
A week ago, Bruegel published this Policy Brief which I co-authored together with André Sapir and Dirk Schoenmaker. We start from the observation that Brexit will generate major structural change not only for the UK but also for the financial system of the EU27, a side that has received comparatively little media attention so far. We present a ballpark estimate of the aggregate impact in terms of relocation of business and jobs, make the analytical case for a policy response that fosters financial market integration inside the EU27, and outline three main policy recommendations: a stronger ESMA, a strengthening of banking union, and a new policy regime for financial infrastructure.
Update (February 21): a lightly revised version of the same text was published today by the Peterson Institute.
Global cooperation on financial regulation has become increasingly important and valuable over the last decade, but its effectiveness cannot be taken for granted. Following November’s U.S. presidential election, Asia, and particularly China, needs to take a more central role to ensure the viability of the global system.
Compared with other modes of international economic cooperation, the global financial regulatory system is in a nascent stage of development. It is made up of a network of diverse organizations and groupings, many of them without legally binding authority, with the Financial Stability Board acting as a coordinating hub.
This system has grown in importance, particularly since the global financial crisis, and its impact has been overwhelmingly positive. The Basel Committee on Banking Supervision, for example, has helped to limit cross-border competitive distortions resulting from incompatible prudential rules and has been increasingly forceful in monitoring national compliance with its agreed standards. The widespread adoption of the International Financial Reporting Standards Foundation’s accounting principles has greatly enhanced the international comparability of listed companies’ profit statements, even if not yet on a universal basis. The Global Legal Entity Identifier Foundation has opened the way toward universal interoperable financial data formats by issuing codes to transaction participants that function in a way comparable to the internet protocol addresses that underlie the World Wide Web.
Such arrangements are even more valuable as the global financial system becomes increasingly multipolar and interconnected, enhancing the need for joint work by public financial authorities on a commonly agreed basis.
Aside from the above organizations, key participants in the regulatory system include treaty-based organizations such as the Bank for International Settlements, which hosts the Financial Stability Board, the International Monetary Fund, the World Bank, and the Organization for Economic Co-operation and Development and its Financial Action Task Force. These are complemented by independent groups such as the International Organization of Securities Commissions, the International Association of Insurance Supervisors and the International Forum of Independent Audit Regulators. The roots of the treaty-based institutions can be traced to the second quarter of the 20th century, but none of the other entities in this global network are more than 45 years old.
The global financial regulatory system has long been lopsided and in need of change as the emergence of new financial powerhouses, particularly in Asia, has challenged the dominance of North American and European states.
Significant improvement has flowed from the 2008 shift to tackling financial and economic issues at Group of 20 leaders’ summits from Group of Seven nation summits. The membership ranks of the Basel Committee and the Financial Stability Board, for example, have been expanded to include major emerging economies and financial centers.
But blatant imbalances remain. On a recent count, all but one of the 27 most senior leadership positions in this system were held by nationals from North Atlantic countries. Almost all entities in the network are similarly headquartered in the North Atlantic region, the only exception being the soon-to-be-established permanent secretariat of the International Forum of Independent Audit Regulators in Tokyo.
The system’s institutional fragility is about to be tested by the incoming administration of U.S. President-elect Donald Trump. His “America first” stance will surely create multiple challenges for all international cooperation frameworks, and financial regulation will be no exception.
The response to this test should include an accelerated rebalancing and reform of the global regulatory system to ensure its viability in the new environment. Asia, and specifically China, should claim a much more central position in the system than is currently the case and other nations should facilitate this evolution.
Specifically, China should propose highly qualified officials, of which it has an increasing number, for positions of leadership in global financial regulatory bodies and engage more proactively in their various workstreams. As with action against climate change, and given Europe’s current internal difficulties, China is fast becoming the indispensable anchor for sustainable joint efforts at the global level and should invest accordingly in its representation in global discussions.
In this context, Europe should streamline its presence in the system, as a logical consequence of its own ongoing reform and thus leave room for greater Asian and Chinese leadership. Specifically, Europe’s banking union implies that the representation of individual euro-area countries in bodies in charge of financial stability has become anachronistic and should be replaced by euro-area or EU-level participation. The Basel Committee is a case in point. Now that banking supervisory policy has been comprehensively pooled within the euro area, the separate membership of Belgium, France, Germany, Italy, Luxembourg, the Netherlands and Spain should be phased out.
The relevant bodies should then demonstrate their continued relevance by further improving the system’s effectiveness, even if the new U.S. administration does not initially join some of the resulting initiatives. For example, the Bank for International Settlements, IMF and others should further harmonize formats for financial statistics and data collection. Global regulatory standards should be forcefully developed in new areas in which their need is increasingly evident, such as derivatives. And steps should be considered toward establishing a global level of supervision for limited but critical segments of the financial system, starting with those with no likely fiscal or quasi-fiscal impact in a crisis, such as credit rating agencies or audit firms.
The events of the past decade have amply demonstrated the need for strong global regulatory and supervisory arrangements to keep the inherent risks of cross-border financial integration in check. The prospect of a more unilateralist America should force a rapid realignment in China, other Asian countries and Europe, so that the existing, beneficial financial regulatory system is not left to unravel.
This is a belated update on a paper I recently co-authored with Zsolt Darvas and Dirk Schoenmaker. "Reforms to the European Union Financial Supervisory and Regulatory Architecture and their Implications for Asia" was published by the Asia Development Bank Institute in November, and republished by Bruegel shortly thereafter.
We give an overview of the last few years' EU reforms, with a focus on banking union, and suggest a few lessons for Asia even while keeping in mind the vast differences between the two regions.
This op-ed was published yesterday by The Hill.
Italy’s banking problem has been left unaddressed for too long. Similar to Japan in the 1990s, it is best understood as a combination of structural and cyclical factors.
Most of Italy’s banks, many of which are small and local, have politicized governance features that blur commercial incentives. As a consequence, they were unable to rein in their lending during the downturn of the late 2000s.
Many of these loans turned sour in subsequent years and local connections prevented the banks from working them out, so they kept supporting borrowers in a pattern of “pretend and extend.”
The system’s non-performing exposures now total hundreds of billions of euros. Many of these loans are collateralized, but repossession is not really an option given the country’s antiquated judicial system.
It gets worse — many banks sold their own shares and debt to their retail clients, often without proper disclosure of the risks and at inflated prices. Such self-dealing is prohibited in many jurisdictions, but wasn’t prevented in Italy and even received favourable tax treatment until 2011.
Bank equity and debt became even riskier once the EU introduced legislation on the resolution (or orderly liquidation) of failing banks, a shift that was signalled as early as 2009-10 and became official in mid-2012.
By then, Italian authorities should have forced the banks to buy back their risky securities from non-professional clients. That they failed to do so was a massive failure of public policy.
This context largely explains the country’s subpar growth rate — banking system fragility results in credit misallocation and a severe drag on economic activity.
Particularly in the last half-decade, weak Italian banks have been culprits, not just victims, of economic sluggishness. In a telling contrast, Spain started cleaning up its banks in 2012 and has enjoyed comparatively dynamic growth since.
The problem was diagnosed more than two years ago by the European Central Bank (ECB) during its comprehensive assessment of the euro area’s 130 largest banking groups (of which 15 are Italian), which paved the way for its assumption of supervisory authority as part of a broader reform known as banking union.
Nine Italian banks were among the 25 that failed the exam, and four of them were still undercapitalized when the results were announced in October 2014.
Remarkably, they were the same that are widely believed to be in need of fresh capital now — Monte dei Paschi di Siena (MPS), Banca Popolare di Vicenza, Veneto Banca, and Carige.
The ECB did not immediately assert itself and, earlier this year, the constitutional referendum campaign deterred any forceful action. But the ECB appears to be moving into action now.
It is forcing MPS to find fresh capital before year-end. If this fails, the “world’s oldest bank” will face nationalization and drastic restructuring (with a specific protection scheme for victims of past misselling).
Similar initiatives are expected with the other three significant problem banks, and probably follow-up moves in the first half of 2017 to identify and handle weaknesses among the country’s hundreds of smaller banks which remain supervised by the Bank of Italy.
Mercifully, favourable market reactions to recent announcements by UniCredit, another large Italian institution, show that those banks that are not critically weak can still mobilize private capital.
Assuming reasonably competent handling, the entire system might reach broadly adequate capitalization to start seriously working out its bad loans by the summer of 2017.
This would have beneficial impact on three separate levels. First, putting an end to Italy’s banking fragility will revive the country’s growth, and also mark the near-completion of a protracted process of bringing the euro area’s banking sector back to soundness, in which Italy has lagged behind most other countries.
Second, it would herald the successful inception of banking union, with the ECB being a demonstrably more forceful supervisor than the national authorities it replaced in 2014.
Third, it could unlock a new phase of reform grounded on that success, including the long-debated creation of a European deposit insurance scheme and related policy measures to deepen Europe’s still unfinished banking union.
As usual in Europe, the path of progress is belated and tortuous. But it may well be that an important corner is just being turned.
Correction (January 2, 2017): the sentence in the column that reads "they were the same that are widely believed to be in need of fresh capital now — Monte dei Paschi di Siena (MPS), Banca Popolare di Vicenza, Veneto Banca, and Carige" is not fully accurate. The four banks that were assessed as undercapitalized in October 2014 were MPS, BP Vicenza, Carige and Banca Popolare di Milano. Veneto Banca was found undercapitalized as of December 31, 2013, but was viewed as having addressed its capital gap in the meantime. The author apologizes for this regrettable error.
The International Monetary Fund’s involvement in the euro area crisis has raised a lot of controversy. According to a widespread conventional view, the “Troika” of creditor institutions—the International Monetary Fund (IMF), the European Commission, and the European Central Bank (ECB)—demanded excessive fiscal austerity of Greece and other errant countries in return for their assistance, and this stance not only failed to restore Greek public credit but also prolonged economic weakness in other countries, including Portugal and Italy. Instead of calling for austerity, according to this view, the IMF should have forced a reduction of Greece’s debt (in other words, engineered an orderly default) from the start of its involvement in the spring of 2010. The IMF is also blamed for ignominiously forcing Ireland to bail out senior bondholders of its failed banks in November 2010 under orders from a dogmatic ECB, itself captured by European financiers.
An educated and comparatively nuanced version of this storyline was masterfully told by Peter Spiegel, then the Brussels bureau chief of the Financial Times, in a 3-part reporting series that was later published as an ebook titled How the Euro Was Saved. A less well-informed version of the same critique is voiced by Nobel Prize laureate Joseph Stiglitz in his recent book The Euro: How a Common Currency Threatens the Future of Europe, variations of which inform opinions on the euro area among (too) many observers in Europe and globally.
Paul Blustein’s useful new book, Laid Low: Inside the Crisis that Overwhelmed Europe and the IMF, at the same time propagates and debunks the conventional wisdom. This ambiguous contribution reflects how far we still are from a settled reference narrative of the euro area crisis. Blustein, a former Washington Post and Wall Street Journal economics reporter, is one of the world’s most seasoned journalistic observers of the IMF and now works for the Centre for International Governance Innovation (CIGI), which is also the book’s publisher. The book’s unique perspective is to observe the euro area crisis through the lens of the IMF, an important though ultimately peripheral protagonist. This leads Blustein to analyse two separate but interconnected issues, the crisis itself and the IMF’s performance in addressing it.
In several ways, Laid Low follows the standard, formulaic, Greece-centered account of the crisis. More than half the book’s chapters are entirely or mostly about Greece. Some major non-Greek episodes involving the IMF, such as the assistance program for Portugal, are near-entirely omitted. The introductory second chapter (chapter 1 being a digression on Strauss-Kahn’s sexual issues) and the concluding chapter 20, as well as the book’s title, embrace a narrative of the Fund “laid low” by abusive political interference from Europe that prevents it from fulfilling its technocratic mandate with philosopher-kingly integrity. Here Blustein refers to an IMF “bruised and enfeebled,” its “credibility sapped” by yielding to Europe’s masters. “One word aptly describes the IMF’s role as junior partner in the Troika: travesty,” he writes in his conclusion.
But in the 17 descriptive chapters between introduction and conclusion, Blustein’s chronicle is too honest to support this indictment. His storytelling is highly engaging, and his reporting is superb. Not only does he bring together an astonishing variety of sources (journalistic, policy, academic), he also adds a number of scoops of his own. For example, he reveals how Strauss-Kahn attempted in April 2011 to walk away from the assistance program for Portugal, which was then being negotiated, unless it included conditions on euro area policy in addition to those on Portugal. (Wolfgang Schäuble, Germany’s finance minister, called Strauss-Kahn’s bluff.) Such new information is significant, since one of the more compelling criticisms made of the IMF is that it never insisted on euro area–level conditionality, an option that is not set out in the IMF’s formal tools but conceivable in the negotiation of individual programs. In the same vein, Blustein reveals that in the fall of 2012, IMF staff had wanted to include direct recapitalization of Cypriot banks by the European Stability Mechanism, a newly-created euro area fund, in the forthcoming assistance program for Cyprus, but that the IMF did not insist on it when EU leaders expressed their reluctance in late 2012.
Against the conventional critique, Blustein demonstrates that, while Strauss-Kahn did envisage a restructuring of Greek sovereign debt in the spring of 2010 (an option known in IMF lore as “plan B”), it was never a genuine option, not least because of the opposition of the Greek government itself. IMF staff was divided on the principle of restructuring, with some departments (e.g. Research and Strategy) maintaining that it would be eventually inevitable and others (most notably Europe and Fiscal Affairs) arguing it might be avoided altogether. Similarly, Blustein refutes the view that the November 2010 decision on Irish banks was the result of a unilateral diktat of the ECB, and correctly emphasizes the role of then US Treasury Secretary Tim Geithner in rejecting a stance of “burning the bondholders” that might have created additional instability in European finance. On a broader level, Laid Low goes some way towards puncturing the fiscal-and-sovereign-debt-only narrative of the euro area crisis, most prominently in chapter 15, which aptly describes the bank-sovereign vicious circle and the inception of Europe’s banking union. From these chapters, the picture that emerges of the IMF is actually that of a strong institution, more able than most large organizations to learn from its mistakes, and generally effective in its engagement with Europe with a constant willingness to challenge the area’s occasionally incompetent leaders. While participating in the Troika, the IMF never compromised its decision-making independence as regards the use of its resources. It was not always right, as Blustein illustrates with the examples of Latvia in 2009 in chapter 4, or of Cyprus in 2013 in chapter 16. But it was often successful and almost always constructive.
To be sure, the IMF was constrained by European politics. But this was the flipside of the fact that in the euro area crisis, for the first time in more than three decades, the IMF has been intervening close to the core of the global financial system rather than in its less systemic periphery. An internal IMF document of January 2012, quoted by Blustein at the start of chapter 14, makes it refreshingly clear: “No economy—whether advanced, emerging or low income—is immune to an escalation of the [euro area] crisis. … Whereas country shocks in the 50 years prior could largely be considered idiosyncratic in that they did not destabilize the entire system, shocks in the advanced economy core … are now effectively systemic.” There can be little doubt that, should it be called to help with a crisis in China or the United States (God forbid), the IMF would not have a fully free hand either—even though China and the United States, unlike Europe, are not overrepresented on the IMF’s executive board. But the mere fact that the Fund intervened in “core” Europe demonstrates its relevance and its strength rather than any weakness. And the constraints on IMF staff and management decisions from the Fund’s shareholders are not a problem but rather the mark of a functioning governance framework. This framework can be improved—for example, by reducing Europe’s unjustifiable executive board overrepresentation as Blustein recommends—but the book does not make it appear fundamentally unsound.
This framing of the IMF’s role in the euro area crisis also provides greater clarity regarding its analytical blunders. If anything, Blustein is often too forgiving of these, perhaps inevitably given his reliance on interviews with current or former IMF staff. The main error on Greece was not to impose excessive austerity, or even to delay the inevitable restructuring. Miranda Xafa, a knowledgeable analyst and former IMF official, calculated that, had this happened in May 2010 instead of March 2012, the additional reduction in public debt would have been around 16 percent of GDP—a significant but hardly decisive difference. The IMF’s bigger mistake was an overestimation of Greece's institutional strength and capacity to reform, a so-called advanced economy, and, as a founding member of the Organization for Economic Cooperation and Development, presumed to be functionally governed. Similarly, the IMF erred in trusting the assessments of the local banks’ soundness by the Portuguese authorities, which it should have second-guessed instead. One lesson here is that the IMF’s traditional distinction between “emerging” and “advanced” economies is increasingly counterproductive, as other recent developments also illustrate. The IMF would be well-inspired to abandon this distinction altogether.
Overall, and despite the misleading nature of its title and of some of its framing, Laid Low is an important addition to the burgeoning literature on the euro area crisis. Its main contribution is to assemble essential factual material for further analysis, complementing other books such as Carlo Bastasin’s Saving Europe or Neil Irwin’s The Alchemists, as well as the in-depth study published last July by the IMF’s own Independent Evaluation Office (IEO). These and other forthcoming volumes will hopefully allow a gradual shift in the public’s understanding of the euro area crisis, from a cartoonish Hellenic-centered morality tale to a more complex but also more accurate story of financial fragility, multilevel governance, and multiple reverberations between banking, fiscal, and monetary imbalances.
Note: The author was a member of the IEO team that prepared the evaluation report mentioned in this post’s last paragraph. The content of this post is not based on the author’s work for the IEO, nor does it in any way represent a view of the IEO itself.
Bruegel just published an updated version of my paper on China's role in global financial regulatory reform, which had been prepared for a CF40-PIIE conference in Beijing in May and published by PIIE as a Briefing chapter in September. I argue that, in spite of post-Lehman improvements, China (together with the rest of the world outside the North Atlantic region) remains under-represented in the global financial regulatory system, and that correcting this imbalance would be in the long-term interests of all parties.