Nicolas Véron

Europe’s Cyprus Blunder and Its Consequences

This post was published on the Bruegel blog and on Peterson Institute RealTime, and republished by Vox.

The late Mike Mussa of the Peterson Institute, a former Chief Economist of the International Monetary Fund (IMF), noted about some episodes of the late-1990s Asian financial turmoil that “there are three types of financial crises: crises of liquidity, crises of solvency, and crises of stupidity.” This quip comes to mind when considering the developments of the past few days around Cyprus.

The March 16 announcement of an agreement backed by most European leaders and institutions as well as the IMF, which called for a tax (or possibly an unfavorable cash-for-equity swap) on holders of bank deposits, no matter how small, was a policy blunder likely to cost the European Union (EU) dearly.

The sequence that led to this “Saturday-morning plan” is well known. Greece’s sovereign debt restructuring a year ago hit Cypriot banks that had bought Greek bonds, raising doubts about the Cypriot government’s own solvency. Negotiations on a possible bailout by the EU had been seen as inevitable as early as mid-2012. But discussions were frozen until a general election in Cyprus last month. Unfortunately, the delay pushed the timetable of negotiation into German election cycle territory, constraining the latitude of the euro group, in which Germany is now the unquestioned central actor. Driven by the domestic German political debate, European negotiators were intent on forcing losses on large (read Russia-linked) Cypriot deposits as an indispensable component of the package.

To the surprise of many, the recently elected Cypriot president, Nicos Anastasiades, added a further twist to the tangled situation by suggesting a hit to small depositors as well. According to some reports, he wanted to limit the losses imposed on large depositors in order to preserve the island’s future as an international financial center. All negotiators seem to have accepted this offer before realizing, too late, how damaging it might be to trust in the safety of bank deposits well beyond Cyprus.

No easy or painless option was available for Cyprus. However, some of the Saturday-morning plan’s flaws were avoidable.

First, the plan disregarded the lessons of financial history about the high importance of deposit safety, particularly for middle-class households (which is why there usually is an upper limit for explicit deposit insurance, harmonized at € 100,000 in the EU since 2009). Based on the experience of the early 1930s, it is virtually undisputed in the US that a breach of deposit insurance will primarily hurt the “little guys.” Sheila Bair, the respected former Chairman of the US Federal Deposit Insurance Corporation, has expressed this view with reference to Cyprus. Similar lessons arise from the record of many recent emerging-market crises.

If it is true, as alleged, that Cyprus’s own president was the one who recommended hurting small depositors, European negotiators were not justified in going along. After all, in November 2010 the Troika of the EU, the European Central Bank (ECB) and the IMF rebuffed the Irish authorities’ proposal to “burn” the holders of senior unsecured debt in failed banks. Their concern was to prevent damaging contagion in the rest of Europe. A similar argument was more straightforward and sensible for Cyprus than it had been for Ireland, and should have led them to oppose Mr Anastasiades’ proposal from the outset.

Second, the festival of finger-pointing in Brussels and across Europe following the Cyprus debacle shows that the negotiators had no “plan B” were the Cypriot Parliament to reject their initial scheme. One must wonder whether the EU is ready to handle the complex Russian side of the Cypriot equation, including the wisdom of depending on Russian goodwill for a solution to the current mess.

Third, the Saturday-morning plan raised profound questions about the democratic nature of EU decision-making. The problem is not that hard measures were to be imposed on the Cypriot population. A loss of autonomy, alas, is the inevitable consequence of the Cypriot state’s inability to meet all its commitments on its own, as Mr. Anastasiades had earlier acknowledged. Moreover, Cyprus has earned no sympathy by rejecting the United Nations plan for the island’s reunification ahead of its entry into the EU in 2004, and for harboring Russian and Russian-linked financial activities widely presumed to be connected with money-laundering.

The problem, rather, lies in the extent to which the European crisis management is now being held hostage by German electoral politics. This dynamic is not new in the euro-crisis, but has reached new heights as Chancellor Angela Merkel’s main opposition, the Social Democratic Party (SPD), has identified Cyprus earlier this year as a “wedge issue” on which it could challenge her. The SPD calculation was to paint Ms. Merkel as too lenient with shady Russian oligarchs and their “black money” held in Cypriot banks, while she would presumably be prevented from responding because of a fear of destabilizing Europe’s financial system. In effect, Ms. Merkel called the SPD’s bluff by risking the euro zone’s first bank run. No wonder that placards on Nicosia’s streets carry slogans such as “Europe is for its people and not for Germany,” or that Athanasios Orphanides, until recently the governor of the Cypriot central bank and a member of the European Central Bank (ECB)’s Governing Council, complains that “some European governments are essentially taking actions that are telling citizens of other member states that they are not equal under the law.”

It is too early to evaluate the lasting damage, but it is likely to be significant. The Saturday-morning decision-making process leaves an impression of incompetence and groupthink, tainting all of the participating actors, including all euro zone finance ministers, the European Commission, the ECB, and the IMF. The EU’s earlier sense of purpose by committing to a banking union last June and delivering on its first step (the Single Supervisory Mechanism) in December has now been battered. So has the aura of statesmanship and control developed by Ms. Merkel and the ECB. Possibly most damaging, even if the deposit tax is reversed or adjusted, the trust of middle-class households throughout the Eurozone in the safety of their banking system has eroded. Hopefully there will be no immediate deposit flight in other countries than Cyprus. But in future crisis episodes, households will behave in a destabilizing way, assuming Europe’s deposit insurance arrangements are not profoundly reformed. There is an apt parallel with the Deauville declaration by Ms. Merkel and French President Nicolas Sarkozy, endorsing losses for Greek sovereign bondholders in October 2010, which started an 18-months cycle of increasingly negative market expectations throughout Europe.

What now? A week ago, the challenge in Cyprus was to close the fiscal gap with a bailout package. Now it is to close the fiscal gap, and to restore a minimal level of trust in the banking system, without which the economy cannot operate. This raises the bar. The obvious risk is of massive deposit withdrawals whenever the Cypriot banks reopen. Now that the seal on deposit safety has been broken, depositors will do their best to avoid additional taxation or expropriation in a few weeks’ or months’ time, no matter how many promises are made that this is a unique and once-and-for-all occurrence. Cypriot authorities are likely to address this with a mix of capital controls and deposit freeze, perhaps in the form of conversion of deposits to interest-bearing certificates of deposits, as recently proposed by Lee Buchheit and Mitu Gulati. But “financial repression” or even incarceration can only last for a limited period of time given the freedoms guaranteed by the EU treaty.

Unlike in previous euro-crisis episodes, there is little the ECB can do alone. The problem is fiscal at the core and must be addressed by elected leaders. They may conclude that it is best to let Cyprus default, impose capital controls and leave the euro zone, an option that was reported to be explicitly considered in European policy circles. But such a move would violate the promise of European leaders to ensure the integrity of the euro zone, no matter what, and potentially set off a chain reaction, including possible bank runs in other euro zone member states, starting with the most fragile ones, such as Slovenia and of course Greece.

On the other hand, it is difficult to see how the risky scenario of a Cyprus exit could be avoided without further fiscal commitments by euro zone partners, including Germany. Their help could be in the form of additional direct transfers to Cyprus to plug the fiscal gap, or some form of guarantee of deposits that would come from the European rather than the national level. A quick but imperfect way to achieve the latter would be for a European entity, possibly the European Stability Mechanism, to provide an unconditional guarantee for a limited but sufficient period of time (say, 18 months) to all national deposit guarantee schemes in the euro zone, up to the € 100,000 European limit. Such “deposit reinsurance” has been rejected absolutely by European policymakers so far. It would constitute a major contingent financial commitment, even though the trust-enhancing effect would arguably result in an eventual net fiscal benefit for all. But it would be a powerful preemptive tool to make sure a scenario of retail bank run contagion does not materialize, and might also become the only option available to restore confidence if such a scenario were to become reality.

Assuming that the current situation is somehow brought under control, longer term questions beckon, beyond the geopolitical considerations related to Cyprus and its neighborhood. The breach of the deposit guarantee, materialization of the bank run threat, and probable consideration of capital controls will cast the euro zone debate on banking union in a new and starker light. Since mid-2012 and until now, the policy consensus in Europe had been to pretend that the question of supranational deposit insurance, with its direct links to the currently-frozen issue of fiscal union, was important but not urgent, and should be left out of the explicit banking union agenda. This convenient stance will be harder to hold given the Cypriot experience. More broadly, the episode will contribute to an overdue debate about the democratic (or otherwise) nature of European decision-making and the effectiveness of its crisis management, two challenges more tightly connected than many observers realized. A first step might be to recognize the plan of March 16 as a mistake, and to have an honest debate about how it could have been avoided.

Many commentators are puzzled by the general lack of negative financial market reaction to the fast-unfolding events in Cyprus. The most likely reason, to be tested in the next few days, is that investors have been sufficiently impressed by last year’s whatever-it-takes commitments, particularly those by Ms. Merkel and ECB President Mario Draghi. The markets’ baseline assumption remains that a last-minute solution will be found after all the brinkmanship. Longstanding observers of the Eastern Mediterranean tend to project a darker mood, as they recall that this is a region in which individuals, groups and nations do not always act in their self-interest. One can only hope that the market’s assessment is the correct one.

Basel III: Europe's Interest Is to Comply

This post was published by Bruegel and the Peterson Institute, and a bit later by Vox. 

On February 14, European Commissioner Michel Barnier and Federal Reserve Governor Daniel Tarullo both indicated their agreement to quickly give the Basel III accord binding force over, respectively, European and American banks. This is welcome. But even more important than the speed of adoption is that implementation should stay true to what the accord stipulates. At this point, and contrary to many perceptions in Europe, this goal is more likely to be reached by the US than the EU.

Basel III is the work of the Basel Committee on Banking Supervision, which includes 27 countries as its members (plus EU institutions and the International Monetary Fund as observers) and is hosted by the Basel-based Bank for International Settlements with a small permanent secretariat there. It is the crowning achievement of the G-20’s financial regulatory agenda in the wake of the Lehman Brothers collapse in 2008. Other prominent initiatives have had only partial or mixed results, including the centralized clearing of over-the-counter derivatives, accounting standards convergence, the regulation of rating agencies, or restrictions on compensation practices or regulatory havens. By contrast, Basel III has moved ahead quickly and can be labeled a clear success for global financial regulation. It is already making a difference, and a positive one, in the way the global banking system operates. Credit for this goes to the Basel Committee’s members and to its successive chairmen and secretaries-general since 2007.

Without going into all the details of a rather long text, Basel III makes the definition of regulatory capital much more rigorous; increases minimum capital requirements dramatically, from 2 percent to 7 percent for the key ratio of common equity to risk-weighted assets; tightens the methodology to weigh the risk of assets; introduces a minimum leverage ratio (capital to non-risk-weighted total assets) to mitigate the risk of manipulation of risk weights; introduces additional requirements depending on the financial cycle and the systemic importance of some banks; and introduces regulatory standards and ratios for banks’ liquidity profile.

The accord has been criticized from all sides of the financial regulatory debate. Much of the banking community, including the Institute of International Finance, has argued that the increase in capital requirements would greatly impede growth and that the liquidity ratios would harm market functioning. J.P. Morgan Chase’s head, Jamie Dimon, has lambasted the additional capital requirements for systemically important financial institutions, including his own, as “anti-American.” But third-party studies suggest that bankers have been exaggerating the negative impact, and that the standards’ adverse effects will be more than compensated by the benefits of additional financial stability for the system.

Conversely, a number of academics and advocates argue that Basel III is insufficient, or even toothless. The critics call for the need for even higher capital requirements (see also here). They also criticize the widespread gaming of risk-weighting calculations; the excessively long phasing-in period for the standards to take full effect; and the recent announcement that liquidity standards would be less stringent than initially envisaged. But the authors of these critiques fail to present an obvious better alternative or address how to avoid banks circumventing the rules. Pushing minimum capital levels even higher would lead to widespread migration of financial intermediation towards the less-regulated shadow banking system. Risk-weighting is flawed, but the alternative of focusing on a ratio of capital to non-risk-weighted assets is even easier to game. Furthermore, Basel III’s leverage ratio creates a backstop against risk-weight manipulation that did not exist in Basel II. The phasing in now looks rather steep to many banks, particularly in Europe, and in any case was arguably the most acceptable price to pay in the compromise to get the accord through in spite of the opposition of some Basel Committee members. The watering down of liquidity ratios appears justified by the uncertainties about the impact of this new and untested regulatory instrument, and the lessons from the euro zone crisis regarding the possible credit risk and illiquidity of sovereign debt markets. In fairness, Basel III goes remarkably far for a consensus-driven Committee that had been much less bold in the past, especially with the previous comprehensive accord (Basel II), which now appears to have been embarrassingly complacent.

Beyond the accord itself, the Basel Committee, in an unprecedented (though arguably long overdue) move, has designed a three-level process to nudge its members to adopt and implement its standards rapidly and consistently. Level One checks that each member jurisdiction has adopted rules that legally mandate the application of Basel III by those for which it was intended, namely large internationally active banks. Level Two checks in detail the consistency of the legislation or regulation with all points covered in the text of Basel III. Level Three assesses how the accord is implemented in practice. The Basel Committee has published regular short reports to the G-20 since 2011, scoring countries’ progress on Basel III and the earlier accords’ adoption (Level One). The Committee also started in October 2012 to publish detailed reports on the consistency of adopted or proposed legislation/regulation with Basel III, with the first three reports devoted to Japan, the US and the EU (Level Two); and in January 2013 the Committee published its first study on actual implementation, devoted to the consistency of risk-weighting across a sample of banks (Level Three).

The picture that emerges is not uniform, but is encouraging from a global perspective. Eleven of the Committee’s 27 members (Australia, Canada, China, Hong Kong, India, Japan, Mexico, Saudi Arabia, Singapore, South Africa and Switzerland) have adopted Basel III and started implementing it in time on January 1, 2013 (India has a delay until April 1). In the EU, which includes 9 other Committee members (Belgium, France, Germany, Italy, Luxembourg, the Netherlands, Spain, Sweden, and the UK), the implementing legislation, known as the Capital Requirements Regulation (CRR) and Fourth Capital Requirements Directive (CRD4), was proposed by the European Commission in July 2011. It is in a final phase of discussion between the European Commission, Parliament and Council. (This phase is  known as trilogue in the Brussels jargon.) In the US, the three federal agencies jointly in charge – the Federal Reserve, Federal Deposit Insurance Corporation (FDIC) and Office of the Comptroller of the Currency (OCC) – have published a regulatory proposal in June 2012 and are currently working on a final version. Work is also in progress in the remaining Basel Committee members, namely Argentina, Brazil, Indonesia, South Korea, Russia, and Turkey.

Among the three jurisdictions reviewed in more detail under the Basel Committee’s Level-Two process, Japan gets high marks for essentially complying with the accord. The US (based on the June 2012 proposal) is compliant on all areas tested but one: its rejection of any reference to credit rating agencies’ assessments in bank prudential regulation, enshrined in Section 939A of the Dodd-Frank Act of 2010, creates differences with parts of Basel III which keep some references to credit ratings (even though the Basel Committee has also tried to reduce the extent of such references). The EU is found “materially non-compliant” in two areas: the definition of capital and an exemption that the review found too broad from one of the risk-weighting methods. The definition of capital is the more important of the two, as it goes to the core of capital regulation: it is no good to have high minimum requirements if the definition includes “funny equity” that is not genuinely loss-absorbing in a crisis.

These differences are attributable to differences in financial cycles and local politics. The EU is in a state of banking system fragility that has not been resolved by the recent improvement in market conditions. Forbearance is thus a temptation, even though experience suggests that forbearance is a losing crisis-management strategy. By contrast, Japan, Mexico and much of Asia have learned their lessons the hard way during the crises of the 1990s, and their banks have strong enough balance sheets for the early transition to Basel III to be an easy one. Banks in Canada and Australia have been thriving recently. Switzerland and the US, like the EU, have faced severe banking crises in 2007-08, but unlike the EU, have largely resolved them in 2009-10, which makes their implementation of Basel III requirements less challenging than in several EU member states.

The delay and spotty compliance in the EU stands in stark contrast to Europe’s championing and early adoption of Basel II, in the early 2000s. It is not uncommon for EU financial policy leaders to offer support for the Basel III process and to criticize it at the same time. In particular, the European Commissioner in charge of financial services has reacted angrily to the Basel Committee’s Level-Two report on the EU, arguing that some of its findings “do not appear to be supported by rigorous evidence and a well-defined methodology” while simultaneously affirming his “support [for] the Basel Committee’s intention to assess consistent implementation.”

The Commissioner implies in his reaction that the EU’s CRR/CRD4 legislative proposal was assessed unfairly and negatively in comparison with the reviews of Japan and particularly of the US. However, the Basel Committee’s Level-Two assessment process has involved Europeans prominently: they represent no less than half of the respective assessment teams for both Japan (6-member team led by the Banque de France’s Sylvie Mathérat and also including members from the German and Swedish central banks) and the US (6-member team including members from the French and Italian central banks and from the European Commission). As for the EU, the assessment team was led by Charles Littrell from the Australian Prudential Regulation Authority. It also included five other members from prudential authorities in Japan, New Zealand, Singapore, Switzerland, and the US. (The teams are formed on the principle of no self-assessment, which is why no EU member state is represented in the EU assessment team.)

The Basel Committee has put a lot of effort into ensuring the quality and consistency of its assessment methodology, and there is no convincing evidence of anti-European bias from a detailed reading of the Level-Two reports. The Committee’s policy so far has been not to react publicly to the European Commissioner’s critique. But it is evident from the content of the Level-Two report on the EU that the same arguments put forward in this critique have been carefully considered by the assessment team before completion of the report.

The reaction from many stakeholders in Europe to the US delay in Basel III adoption has been similarly shrill. The joint press release of the Fed, the FDIC and the OCC does nothing more than announce that the deadline of January 1, 2013 will be missed in the finalization of the rulemaking process, given the large number of written comments received on the June 2012 proposals that justify in-depth analysis. This has been widely denounced in continental Europe as a de facto abandonment of the effort, which would justify significant delaying of the EU’s own decision-making process on grounds of competitive fairness: the European Banking Federation sent a letter interpreting the US press release as implying that “our US competitors will not have matching obligations imposed on them in parallel [with the EU’s CRR/CRD4], or in a foreseeable future.” The head of the Italian Banking Associated said that “Basel III must be postponed, full stop.”

In fact, the EU and the US are likely to adopt Basel III around the same time, probably in both cases in the second quarter of 2013. As mentioned above, the procedures are different. In the EU, CRR and CRD4 are produced by a legislative co-decision process that involves the European Parliament and the Council, involving a degree of politicization. (CRD4, being a directive, requires further transposition in all member states’ national legislation, while CRR will be directly applicable in all member states once adopted by the European Parliament and Council.) In the US, the process is more technocratic. It is in the hands of the three federal agencies (Fed, FDIC and OCC) but is also subject to the scrutiny of Congress, which may still impose further delay.

On both sides, there is no indication that the points of “material non-compliance” found in the Basel Committee Level-Two preliminary assessments will be corrected in the final version. In the US, Section 939A of the Dodd-Frank Act prohibits reference to credit ratings in the prudential regulation of banks and is unlikely to be abrogated by Congress any time soon. The EU is ill-placed to criticize the US on this, as it has itself put much blame on credit rating agencies in the crisis context and submitted them to increasingly stringent regulation. In the EU, there is no indication that the revision of the non-compliant parts of CRR are among the points that the co-legislators in the European Parliament and Council intend to revise in the current final phase of legislative “trilogue.”

There would be sound justifications, however, for a second look in the EU that would enable the adoption of a Capital Requirements Regulation that would be fully compliant with the Basel III accord.

• First, the direct economic impact of the necessary changes would be limited, especially if the changes only apply to the large internationally active banks for which the Basel Committee’s standards are intended. In his response to the Basel Committee’s Level-Two report on the EU, the European Commissioner argues that the report’s reservations on the definition of capital of non-joint stock companies (presumably referring to so-called “silent participations” in some public banks in Germany) “concerns a single internationally active bank,” and that the other material issue about the treatment of insurance subsidiaries “can arise only in very few banks.” These points are designed to argue that the non-compliance with Basel III is not material. But the argument can be reversed in the sense that correcting the non-compliance would not have a systemically detrimental effect on the EU economy.
• Second, full compliance with Basel III would enhance trust in European banks. The EU’s deviations from the international accord feeds the widespread presumption in the investor community that at least some supervisory authorities in the EU tend to apply a high degree of forbearance to banks within their remit and are reluctant to force them to apply high and consistent capital standards. This market sentiment is detrimental to all EU banks, including those (presumably many) that are sufficiently capitalized, and thus puts a drag on the European economy as a whole. The cost-benefit balance is without a doubt favorable to bringing CRR to full compliance with Basel III.
• Third, the EU’s incomplete adoption of Basel III undermines the global authority of the Basel Committee, encourages other jurisdictions to introduce exceptions of their own, and diminishes the EU’s own moral stature in the global financial regulatory debate. In the past two decades, the EU has been a champion of global financial regulatory convergence, in particular with its endorsement of International Financial Reporting Standards in the early 2000s and support of Basel II and Basel 2.5 throughout the 2000s. The calculation was that global financial convergence and integration would support an agenda of harmonization and integration within the EU itself. This calculation remains relevant, even after the shift from a G-7 to a G-20 global framework in which the EU member states’ relative influence is less than it used to be. The European Union’s co-legislators should revisit their stance and make the Capital Requirements Regulation fully compliant with Basel III before they put their final stamp on it. 

 

Europe Takes an Important Step Forward on Banking

This post was published by the Peterson Institute, Bruegel, and Vox. 

The political agreement reached early on December 13 by Europe’s finance ministers makes it highly likely that legislation establishing a Single Supervisory Mechanism (SSM) with the European Central Bank (ECB) at its center will be enacted in March 2013. This is a big European success, high up on what was the range of possible outcomes.

Some features of the agreement and comments:

1. It respects the outlines and timetables set in the two declarations of EU heads of state and government of June 29 and October 18. For once, European policymakers delivered on their promises, and did so on time.

2. From press reports, the ECB will directly supervise all banks above €30 billion in total assets, as well as some smaller banks, and will have some form of backseat authority on all other smaller ones. (What that authority exactly consists of is still not entirely clear, including the crucial question of direct access to bank-specific information.) This covers not only large banks but also medium-sized ones, in total probably somewhere between 75 and 85 percent of the system’s total assets. The ECB recently estimated that 70 percent of euro area banking assets were in banks above €40 billion in total assets, so with the threshold at €30 billion and a few additional small banks included, the share must be somewhat higher. The exclusion of small banks is not really justifiable from a technical or analytical perspective. But it was also arguably unavoidable given Germany’s central role in the decision process and its unique political and banking structures, which grant enormous political influence to the savings banks. (This aspect is developed in my latest policy brief, pages 5–6.)

3. The legal basis, Article 127(6) of the Treaty on the Functioning of the European Union (TFEU), is reasonably robust even though it was clearly not drafted with this outcome in mind.

4. The agreement seems to go almost as far as possible in granting equal rights to non-euro area countries that may wish to participate. This is important as it potentially prevents deepening the divide between euro and non-euro countries in the European Union. The United Kingdom, Sweden, and the Czech Republic have said they would not participate. The other seven, including most prominently Poland and Denmark, have not yet made their position clear. Denmark can be expected to not make up its mind rapidly, but a quick decision might be expected from Poland and other Central and Eastern European countries.

5. From press reports it appears that the governance arrangements will be somewhat better than initially envisaged, with a compact steering committee in charge that may be able to drive better-quality decision making.

6. Compared to the European Commission’s initial plans, the implementation timetable is slightly delayed. The ECB would acquire full supervisory authority only by March 2014 if not later. Given the German election cycle, this is not much delay in practice, however. Alas relatively little action is to be expected next year in a baseline scenario (see also below on bank resolution).

7. The reform of the European Banking Authority (EBA) was eventually aligned with the UK position of requiring a majority of member states that do not participate in the SSM for EBA decisions. This is awkward, to say the least. It creates additional rights for countries that decide not to participate in a major EU initiative. However, there was no obvious, clearly superior option available in the short timeframe of decision making—and the United Kingdom has a veto on the whole process under Article 127(6), which gave it a strong negotiating position. So perhaps this unsatisfactory outcome was inevitable. In any case, a comprehensive review of the EBA is planned in 2014, so this may be seen as a temporary fix rather than a permanent arrangement.

8. The only significant remaining hurdle is for this compromise to obtain approval from the European Parliament (EP). Technically there are two texts (called regulations in the EU jargon, but they are really EU laws), one for the SSM and the other for EBA reform. The EP cannot block the SSM regulation because its role is only consultative under article 127(6). But it has co-decision powers on the EBA regulation. Thus in principle it can block the whole process, as the United Kingdom would probably veto the SSM if the deal on EBA was substantially altered. In practice, however, the EP will probably not want to obstruct the passage of what is assuredly one of the most constructive EU policy initiatives since the start of the crisis more than five years ago. It should seek being granted more direct accountability from the SSM, e.g., an EP veto on appointments of members of the ECB’s newly created “Supervisory Board” other than the heads of national authorities who participate ex officio. This would be in line with the European Union’s proclaimed aim that “further integration of policy making and greater pooling of competences must be accompanied by a commensurate involvement of the European Parliament” (point 14 of the December 14 Council conclusions).

9. Of course, this is only about supervision. None of it directly impacts crisis resolution or the cleaning up of Europe’s ailing banking system. But the discussion of how to envisage bank resolution, including the role of the European Stability Mechanism (ESM) to directly recapitalize weak banks, can now start. This discussion is bound to be long and difficult. An eventual agreement may have to be delayed until after the late-2013 German general election anyway. The December 14 Council conclusions include oddly complicated language on this (points 8, 10, and 11). It appears there will be three steps: first, an “operational framework” for direct bank recapitalizations by the ESM “should be agreed as soon as possible in the first semester 2013;” second, the currently discussed European legislations on national bank resolution schemes (Recovery and Resolution Directive) and deposit insurance (Deposit Guarantee Scheme Directive) should be finalized “before June 2013; the Council for its part should reach agreement by the end of March 2013″; and third but not least, “the [European] Commission will submit in the course of 2013 a proposal for a single resolution mechanism for Member States participating in the SSM […] with the intention of adopting it during the current parliamentary cycle,” i.e., in early 2014. But point 10 also indicates, in line with earlier Summit conclusions, that the ESM will only be allowed to recapitalize banks directly “when an effective supervisory mechanism is established,” which according to this week’s decisions will not be before March 2014. Thus, the baseline scenario seems to be one in which ESM intervention in the banking sector is delayed until after the adoption of the “single resolution mechanism,” which itself is likely to stop well short of a single resolution authority given the lack of corresponding provisions in the European treaties. (This point will be developed in a forthcoming blog post.) If this is confirmed, 2013 will be another year of delay for the decisive action necessary to restore trust in the European banking system and put an end to its current creeping zombification.

10. There is still zero appetite to discuss a European deposit insurance framework beyond the harmonization of national schemes, even though it is arguably a necessary component of a fully fledged banking union. But this reluctance is understandable as long as the debate on fiscal union is stalled. It is not an urgent topic—at least as long as no retail bank run happens in the euro area. Fingers permanently crossed on this.

Once again, centralized supervision is only the first step on the long and winding road towards European banking union. But the fact that this step is now essentially confirmed is almost unqualified good news.

Obama Should Think Globally in Appointing a New SEC Chair

This post was published on the PIIE blog and on the Bruegel blog, and translated by Caixin and El Economista. 

Mary Schapiro, the chair of the US Securities and Exchange Commission (SEC), has announced that she will step down from her position next month after four years in office. President Barack Obama appointed one of the four other SEC Commissioners, Elisse Walter, to replace her until a more permanent successor is chosen next year. The latter appointment is likely to have momentous consequences, not only for US securities markets but also, and perhaps mainly, for the global architecture of financial standard-setting after the recent systemic financial crisis.

The SEC was created as an independent federal agency in the 1930s as part of the Roosevelt administration’s response to the 1929 stock market crash and the Great Depression. In recent years it has operated under domestic political pressures on such issues as its inability to prevent the Madoff Ponzi scheme, the regulation of money market mutual funds, and various other cases of securities law enforcement. But the Commission’s impact does not stop at the US border: The securities markets on which it has jurisdictions are among the most internationalized parts of the financial world. The 1930s law grants the SEC decision-making authority in determining which accounting standards should be used by issuers of public securities in the United States. This makes it a crucial player in the global development of International Financial Reporting Standards (IFRS), a uniquely ambitious effort at harmonization of financial standards that has achieved remarkable milestones in the past decade. About half of the world’s 500 largest listed companies now use IFRS for their public financial reporting, up tenfold from a decade ago.

The SEC has had a somewhat paradoxical attitude toward IFRS. Broadly speaking, it has supported the International Accounting Standards Board (IASB), the independent London-based body that sets the standards, and has encouraged their adoption by other jurisdictions around the world, including the European Union in a landmark decision in the early 2000s. But it has been much more cautious about making IFRS part of its own US domestic order. Under Ms. Schapiro’s predecessor, former Republican Representative Christopher Cox of California, the SEC made it possible for non-US companies listed on US stock exchanges to use IFRS in their reporting, rather than the domestic standards known as US GAAP (Generally Accepted Accounting Principles). In 2007 under Ms. Schapiro’s tenure, the SEC designed a possible approach, colloquially known in the accounting community as “condorsement,” that would involve a gradual convergence between some US GAAP standards and their IFRS equivalents, combined with an endorsement of other IFRS that would thus be directly incorporated into US GAAP. But this no-nonsense, gradualist approach remains on the drawing board for now, as the SEC has yet to decide on it despite numerous reports and analyses from its staff. The lack of progress can largely be attributed to Ms. Schapiro herself, who as early as her confirmation hearings in January 2009 made it clear that she was “not prepared to delegate standard-setting or oversight responsibility to the IASB.”

Accounting standards are one of the most important intangible infrastructures of capital markets, and their global harmonization is both a consequence and an enabler of cross-border financial integration. True, IFRS adoption per se does not deliver instant global comparability of financial statements: Financial reporting under IFRS comes in many dialects and accents, because some jurisdictions have not adopted them in full and many also do not enforce their application rigorously enough. Some of the IFRS standards themselves are unduly complex. Several of the IASB’s standard-setting choices have been legitimately questioned—even though many of the criticisms, including some of those directed at the use of so-called fair value accounting, have been tainted by special interests or political jockeying among regulatory bodies. The IASB’s governance and funding framework remains unfinished business and will require further reform. But in spite of all this, the evidence suggests that IFRS adoption makes sense. Many jurisdictions have adopted them in the past decade. The transition has occurred at manageable cost to issuers. Investors have generally applauded the change. Moreover, none of the IFRS adopters is considering moving back to national standards. Like the headaches that occur when a country adopts the metric system, misgivings and nostalgia abound at first, but the larger benefits of a widely shared system quickly become obvious.

The analogy with the metric system is incomplete, however. This is because accounting standards, unlike physical measurement units, are embedded in a wider social and political context that makes them far from neutral from an economic standpoint. For this reason, the successes of initial IFRS adoption may evaporate if the United States continues to dither over adopting these international standards. In other words, if Ms. Schapiro’s successor is unable to chart a clear path as to whether and how the United States might incorporate IFRS into its domestic system, the momentum towards accounting harmonization could go into reverse. The IASB’s framework might suffer if it is not anchored by the US financial system, especially because most market regulators outside the United States are less committed to accounting standards that protect investors than the SEC.

In accounting as in other areas (such as the Basel III banking regulatory accord), US leadership is more needed now than before the crisis. The goal should be to ensure that global financial markets remain open to cross-border activity while subject to consistent and binding rules that foster orderly market functioning. Pre-crisis, the European Union could act as an alternative source of leadership, as when the European Union adopted IFRS or, in a different way, with the Basel II accord on bank capital requirements. But Europe is now too absorbed by its internal difficulties to project this sort of global impact. Meanwhile, no Asian stakeholder, including China, is yet ready to take the baton of leadership, and other players are too small to drive the global process. President Obama should select someone who is keenly aware of this larger context as the next SEC chair.

 

Global Financial Reform and Cross-Border Integration: Is Asian Leadership Needed?

This post was published by Bruegel and the Peterson Institute. It is based on a forthcoming paper presented at the joint conference “Asian Capital Market Development and Integration: Challenges and Opportunities” co-organized by the Asian Development Bank, Korea Capital Markets Institute, and the Peterson Institute, in Seoul on October 24, 2012.

Before 2007–08, most global financial reform initiatives were based on a near-consensus about the benefits from the free circulation of capital across jurisdictions and from free cross-border competition among financial services firms. As a consequence of the financial crisis in the United States and Europe, however, this near-consensus can no longer be taken for granted. One implication is the increasing possibility of a fragmentation of the global financial system.

Such a trend could take many forms. Rating agencies were unregulated in most of the world outside the US before the crisis (South Korea being one exception). But the G-20 recommended that they be regulated and supervised by all major jurisdictions. Implementing that recommendation raises the risk of incompatible or inconsistent regulatory frameworks and supervisory practices among different countries. Rating methodologies could vary even within the same rating agency. Another example of fragmentation could arise for over-the-counter (OTC) derivatives. Trading has until now been cleared bilaterally among market participants. The G-20 has mandated central clearing in regulated clearing houses starting in 2013, however. Many investors fear a division of corresponding markets along the borders of country or currency areas. A third new development would flow from the new standards at international financial institutions, particularly the International Monetary Fund (IMF), governing the adequacy of capital control measures under certain conditions. But these new standards could potentially run counter to the previously received wisdom of the so-called Washington consensus.

Across the globe, supervisors have nudged banks to separate and protect assets and maximize lending in their respective jurisdictions, in some cases pushing for subsidiarization of activities previously conducted through branches. In countries that have run into fiscal difficulties, domestically headquartered banks have been pressed to increase their purchases of national sovereign debt. “Financial repression,” an expression long reserved to economic historians, has reentered the mainstream financial vocabulary to describe the possibility of such pressure. These developments have been striking in the euro area, where countries are in principle committed to total openness to capital flows but where an abrupt U-turn from financial integration to financial fragmentation has been identified by policy authorities, including the European Central Bank (ECB). They are by no means unique to Europe, though, and variations of the same themes have been observed in most if not all main economic regions.

Simultaneously, the pre-crisis momentum for harmonization of global financial standards has run into setbacks in crisis-affected countries. The United States has delayed any decision about the adoption of International Financial Reporting Standards (IFRS), which it had endorsed for US-listed foreign firms in 2007 and had seemed on the verge of extending to US-listed issuers in 2008. In another example, the European Union, after championing the global use of the Basel II Accord on capital standards during the 2000s, now seems set to adopt legislation that the Basel Committee has deemed materially non-compliant with the new Basel III Accord adopted in 2010. For all the G-20 talk about global solutions to global problems, financial reform often seems more driven by politics in the post-crisis context than in the previous period. And as the saying goes, all politics are local.

This new reality poses an unprecedented challenge for Asian policymakers. Asia has gained from dynamic financial development in the past two decades, and is entering a new phase in which cross-border financial openness could improve the allocation of capital and make financing mechanisms more efficient. Asians generally are likely to benefit from the continuation or even the acceleration of global financial integration. Until recently, Asians could take such integration for granted, counting on the commitments to financial openness of both the United States and Europe, which dominate the global financial order as embodied by such institutions as the IMF, the International Accounting Standards Board, or the Basel cluster around the Bank for International Settlements.

But the assumption that the West will continue to champion further cross-border openness of the global financial system can no longer be taken for granted. As a consequence, Asians may have to take more leadership in global financial reform discussions to make sure that global financial integration is not reversed. This would be a new situation. Some Asian policymakers may feel ill-prepared for such a trend, but they could find its implications difficult to escape.

The First Step in Europe’s Banking Union: Difficult but Achievable

This column was published by Bruegel and the Peterson Institute, and also by Vox, the Globe and Mail (Canada), Caixin (China), El Economista (Spain), and RBC Daily (Russia).

The leaders of Eurozone countries made an unprecedented commitment when they issued on June 29 a statement starting with the words “We affirm that it is imperative to break the vicious circle between banks and sovereigns.” This statement officially acknowledged their intention to break the “doom loop” of mutually reinforcing deterioration of credit conditions afflicting weaker member states and banks headquartered in them. Spain is a prime example of the problem. Severing that feedback loop requires a transfer of vast parts of the banking supervision and policy apparatus from the national to the European level, or banking union. It is probably a prerequisite for maintaining the integrity of Europe’s monetary union in any crisis resolution strategy. Equally important, a failure to deliver on this clearly articulated pledge would severely impair investors’ already damaged confidence in the ability of the Eurozone governments to act collectively.

The action plan outlined in the June statement defines a sequence of two explicit steps. The European Central Bank (ECB) should first be endowed with broad supervisory powers and become the anchor of a “single supervisory mechanism” for participating member states. Then, once this mechanism is deemed “effective,” the European Stability Mechanism (ESM), which is the Eurozone’s newly-established intervention fund, would be able to recapitalize banks directly. Corresponding instruments remain to be clarified but would probably include common equity.

This sequence is unsatisfactory. Making European-level crisis management action (including bank recapitalizations by the ESM) contingent on the establishment of a permanent institutional infrastructure (i.e., an effective single supervisory mechanism) looks like a delaying tactic, in denial of the urgency of the present situation. Moreover, the leaders’ proposed sequence avoids essential elements of a credible banking union, such as a European banking charter, resolution authority and federal deposit insurance. This leaves the policy framework incomplete.

In spite of these frustrating flaws, however, the June statement is the boldest reaction so far of European leaders to the Eurozone crisis. They must now urgently transform this pledge into concrete decisions. The European Commission has done its bit by publishing a legislative proposal for the establishment of the single supervisory mechanism, on September 12. Three major issues of contention have emerged in the negotiations among member states.

First, the geographical perimeter: the June 29 statement identifies article 127(6) of the European Union’s Lisbon Treaty as the legal basis for the initiative, which means the new supervisor will be part of the ECB. But some non-Eurozone member states, including in Central Europe and Scandinavia, may legitimately want to join it, and they have a veto over decisions under article 127(6). They should be entitled to a voice in the new system’s governance, and to appropriate safeguards of their taxpayers’ interests. Even though one important member state, the United Kingdom, has unambiguously declared it would not join the single supervisory mechanism, the approach should be as inclusive and flexible as possible.

Second, monetary policy independence: banking policy and monetary policy are linked but ultimately different, which also justifies different geographical perimeters within the EU for currency union and banking union respectively. There is a legitimate concern that adding supervision, a politically charged task, to the ECB’s responsibilities, may compromise its cherished independence. The supervisory function should be strictly separated from the rest of the ECB, with full institutional autonomy possible in future reform steps.

Third, German savings and cooperative banks, which are local banks subject to a different policy regime from commercial banks, oppose their being brought under the new European supervisor’s authority. Given Germany’s pivotal position in all Eurozone discussions, some of its idiosyncrasies may have to be accommodated. There could be a separate European supervisory framework for systems of local non-commercial banks that would meet adequate conditions, for example.

Negotiators also need to ensure that the new supervisor’s governance is less dysfunctional than that of the ill-fated European Banking Authority, whose clumsy decision-making process was hampered by its reliance on diplomatic compromises among member states, in spite of a high-quality staff. Effective supervision requires that controversial decisions be made quickly, while guaranteeing genuine accountability to democratic institutions. At the same time, the legal basis for new arrangements must be robust and include mechanisms for judicial review. Further legal debate is needed on whether this is best achieved under article 127(6) or other Treaty provisions.

Creating Europe’s single supervisory mechanism is only one step on a much longer path towards crisis resolution and banking union. Compromise on it will be difficult but possible. Leaders must not lose the momentum created by their June 29 commitment, and should try to reach a final legislative decision before the end of this year.

In Memory of Olivier Ferrand

Olivier Ferrand, promising French politician, founder of a successful center-left think tank and a longtime friend of mine, died on June 30. This blog entry was published last Monday by Bruegel. 

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

Olivier Ferrand, the founder of French think tank Terra Nova, died of an untimely death on June 30 in the South of France, where he had just been elected deputy for the district of Marseilles North-East. He was 42.

Terra Nova, founded in 2008, owed its very existence to Olivier’s extraordinary drive. In a very short period of time it has already made multiple impacts – not least nudging France’s center-left Socialist Party into accepting the principle of open primaries to select their Presidential election candidate, as well as advocating for a constructive French posture in the EU and more structural reform at home. On the whole, Terra Nova has been a voice for enlightenment of the domestic policy debate, of which there are far too few in France. One can only hope that Olivier’s legacy will prosper in this promising institution.

As a prominent member of the new generation of deputies who were elected on June 17, he was also an inspiration for the entire French public and looked forward to promoting bold reform initiatives in the National Assembly. As such, his passing away is a sad loss for the cause of reform in France. My home country has a glaring need for assertive political entrepreneurship and willingness for risk-taking in policymaking, qualities that Olivier had in spades.

On a personal level, I had known Olivier since the late 1980s, and like all his friends I will severely miss his humanity, optimism, and boundless energy. All my thoughts are to his wife and daughter. 

 

Europe's Banking Union: After the Summit

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

Update (July 6): The same text was republished by Vox. 

Europe’s Banking Union: Possible Next Steps on a Bumpy Path

In their summit statement [pdf] of June 29, 2012, the heads of state and government of the euro area issued a declaration widely interpreted by investors as the founding act of a European banking union, about which European policymakers have been talking increasingly vocally in the past two months or so. Their commitment remains little more than a promise, with multiple caveats. But Europe’s leaders will now renege on this promise at their peril. The general perception is that an irreversible step has been made, with vast consequences that will unfold only gradually.

“We affirm that it is imperative to break the vicious circle between banks and sovereigns,” the heads of state and government declared. “The [European] Commission will present proposals on the basis of Article 127(6) [of the Treaty on the Functioning of the European Union] for a single supervisory mechanism shortly. We ask the [European] Council to consider these proposals as a matter of urgency by the end of 2012. When an effective single supervisory mechanism is established, involving the ECB [European Central Bank], for banks in the euro area the ESM [European Stability Mechanism] could, following a regular decision, have the possibility to recapitalize banks directly.”

The key commitment in this clumsily worded half paragraph is less the “single supervisory mechanism,” which can be interpreted in multiple ways, than the direct involvement of the ESM under a clear deadline of end-2012, meaning that the euro area fund would intervene into individual banks without having to rely on national authorities as intermediaries.

As German Chancellor Angela Merkel has made clear on recent occasions, funding cannot be envisaged without what she calls “control.” Therefore, the ESM will need to control those banks it would recapitalize, a process that the summit statement further describes as either “institution-specific, sector-specific or [presumably national] economy-wide.” Such banking institutions, sectors, or economies would presumably be irreversibly transferred under the policy framework of the banking union, in accordance with the objective to “break the vicious circle between banks and sovereigns.” This presupposes the existence of an operational capability to assess the financial position of the relevant bank(s) to prepare the recapitalization, which may itself include an array of instruments from subordinated debt to voting common equity. In other words, the statement implies the buildup of a euro area resolution authority.

Some policymakers talk about bank recapitalization as if it were some sort of automatic, mechanical process, but it is nothing of the sort: One needs only to think of the convoluted sagas of WestLB, Hypo Real Estate, Fortis, Dexia, or Anglo Irish Bank to realize each case will require time-intensive efforts and difficult and lengthy legal and financial judgments. We do not know exactly how many large European banks are insolvent, but the number is more likely to be in the double digits than single.

In a paper coauthored with my Bruegel colleagues Jean Pisani-Ferry, André Sapir, and Guntram Wolff, I argue that the capital assessment, recapitalization, and restructuring process would be best achieved through a temporary structure or task force, akin to the US auto industry task force in 2009 or, in the banking sector, the Swedish Bank Support Authority of the early 1990s. The motivation for establishing such a temporary framework is twofold: First, it can be set up more rapidly than a permanent institution, which would be hobbled by complex questions of governance and checks and balances. Second, the restructuring task is a thankless one that will win few friends, and it may exceed the strength of permanent institutions that must continuously care about cultivating future relationships. This framework was first proposed jointly by Adam S. Posen and me in a 2009 policy brief, [pdf] months before the beginning of the euro crisis but at a time when the European banking sector was already suffering from systemic fragility. In that piece we suggested as a further reference the Treuhandanstalt (or Treuhand), which—in spite of doing a more than decent job of restructuring and selling the former German Democratic Republic state-owned enterprises in the early 1990s—gained the gratitude of neither Eastern Germans, who thought it liquidated their industry, nor Western Germans, who thought it wasted their taxes. The Treuhand’s first head, Detlev Rohwedder, was assassinated in Berlin in 1991.

Policymakers will need to carefully consider the links between this resolution authority and its immediate partners. Among the partners are the ESM (which will provide public money for recapitalizations along with individual national treasuries), and the ECB, and national central banks ( which extend liquidity under the Eurosystem’s Long-Term Refinancing Operations and, in some countries, national Emergency Liquidity Assistance). The London-based European Banking Authority (EBA) could serve as another partner, though it can only be a peripheral player given the United Kingdom’s refusal to join a European banking union, even though it has crisis management competence under legislation adopted in 2010.

As for the “single supervisory mechanism,” one should not underestimate the complexity of the process of creating one. Here the summit statement raises a risk of paralysis. It mentions the establishment of that supervisory mechanism as a precondition for direct ESM intervention. One possible way of overcoming that precondition might be in the form of an early political agreement on the type of joint supervision as a sufficient milestone to unlock ESM intervention, even though the buildup of an actual supervisory capability could take many more months or perhaps years.

An immediate and much-debated question is the extent to which the “single supervisory mechanism” will be vested in the ECB, as the reference to Article 127(6) appears to suggest. That article of the Treaty reads: “The Council (…) may unanimously (…) confer specific tasks upon the European Central Bank concerning policies relating to the prudential supervision of credit institutions and other financial institutions with the exception of insurance undertakings.”

Intriguingly, the European Council Conclusions, [pdf] published on June 29 a few hours after the Euro Area Summit Statement, only refer to Article 127, which might suggest a less exclusive focus on the ECB (or perhaps only a typing omission). In any case, more debate is likely on the respective merits of the supervisor being inside or outside the ECB, even though the ECB can be expected to assume an anchoring role for all institutions of the future banking union. There are multiple arguments on both sides of the debate over the central bank’s role. Here again, as long as the United Kingdom and other member states stay resolutely outside of the banking union, the EBA cannot assume the role of single supervisor even if it retains important functions in the preparation of new banking rules that would continue to apply to the entire European Union. Specific arguments include:

• In favor of the ECB: it is a strong, well-established institution; it has been reasonably successful in its crisis management approach so far; there is a synergy between banking supervision and lender-of-last-resort liquidity policy; Article 127(6) provides a comparatively firm legal basis.
• In favor of a separate, new institution: the ECB would need to build supervisory skills from scratch because it does not now have a genuine comparative advantage; there is an inherent misalignment of interests between monetary policy and banking supervision, which may result in a bias towards monetary laxity or supervisory forbearance; in any case the ECB cannot be granted resolution authority because the process is too inherently political. Thus a parallel supervisory capability should be built in conjunction with the resolution authority (and possibly deposit insurance) resulting in overlap. Other arguments in favor of a separate institution include the concern that the ECB would become too powerful; that its governance would become too complicated if it is also to integrate national supervisors; and the likelihood of future supervisory failures might undermine monetary policy independence.

These arguments should be discussed actively so that the political decision on the creation of the single supervisor can be made rapidly, triggering direct ESM intervention as early as the late summer. Time is limited: Policymakers should not mistake the positive market reactions to their summit statement as an unconditional endorsement. Volatility is likely to remain in the markets. Rapid movement from promises to actions, including disbursements, is necessary to avoid further episodes of market dislocation.

In addition to major political issues, the legal challenges are also daunting and serious. One is the current legal basis and mandate of the ESM, which might require revision. Another is that the resolution authority (or task force, if this model is chosen) will need to be empowered by national legislation in all relevant member states. It should have the power to impose losses on creditors, in order to ensure that taxpayers are not the only ones to share the burden of restructuring. This is intrinsically controversial, and furthermore might play out differently under different national legal systems. Finally, if the political decision is made to open the banking union to non-euro area member states (such as Poland or Denmark), a single supervisor will have to coexist uneasily with (most likely) various deposit insurance systems in the different currency areas.

Moreover, depending on the next steps of crisis management, retail depositors might need to be further reassured. In some risk scenarios, the ESM could offer an explicit and unconditional guarantee on national deposit insurance systems. Such a step, however, would further strain the ESM both legally and financially even though it might be needed to reestablish public trust in deposits. In the medium term, the euro area will need an at least partly federal deposit insurance system as a necessary component of the banking union. This inevitably raises the issue of further fiscal union, because no deposit insurance can be fully funded without one. A credit line must be accompanied by a fiscal authority to ensure its credibility.

Ultimately, a European banking union cannot be considered in isolation from the other necessary “building blocks” to make the euro area policy framework sustainable—namely fiscal union and a “political union” to strengthen democratic accountability and federal executive decision-making capacity. It is conceivable that not all of these implications have been taken into consideration by all euro area leaders as they agreed on the summit statement shortly before 4 a.m. on last Friday. But they should not regret their move towards banking union, which is needed if the euro crisis is to be eventually resolved. Now, there is no turning back.

 

Is Europe Ready for Banking Union?

This column was published by Bruegel and the Peterson Institute, and separately by Vox, the Australian Financial review, the Globe and Mail (Canada), Caixin (China), FT Deutschland (Germany), El Economista (Spain), Les Echos (France), Il Sole 24 Ore (Italy), Publico (Portugal), and RBC Daily (Russia). 

Systemic fragility in the European banking sector predates the Greek fiscal crisis. It was revealed by the subprime/Lehman shock of 2007-08, and has never been properly addressed since then in spite of successive “stress tests.” In recent weeks, several senior policymakers have become more explicit on the need for a “banking union” – in other words, a federal framework for banking policy. Among them is Christine Lagarde, managing director of the International Monetary Fund (IMF), who on April 17 said, “To break the feedback loop between sovereigns and banks, we need more risk-sharing across borders in the banking system. In the near term, a pan-euro area facility that has the capacity to take direct stakes in banks would help. Looking further ahead, monetary union needs to be supported by stronger financial integration, which our analysis suggests should be in the form of unified supervision, a single bank resolution authority with a common backstop, and a single deposit insurance fund.” The European Central Bank President, Mario Draghi, echoed these words at the European Parliament on April 25, declaring that he saw “financial stability clearly as a common responsibility in a monetary union” and that ”ensuring a well-functioning Economic and Monetary Union implies strengthening banking supervision and resolution at European level.”

Many academic observers now agree that a banking union, together with some form of fiscal union, is a necessary condition for a sustainable Eurozone monetary union and for a resolution of the current crisis. But in spite of the creation of a European Banking Authority last year, the action taken so far has been modest. Spain is a case in point: Madrid could have appealed to the European Financial Stability Facility (EFSF) for a loan specially targeted at recapitalizing its banks, but it has preferred to go it alone with the nationalization of ailing champion Bankia, and a new round of property-related write-downs that have provoked much market skepticism.

Several reasons explain why banking policy integration is difficult. The UK, Europe’s dominant financial hub, is not a Eurozone member and resists any encroachment on its supervisory sovereignty. Some member states remain committed to bolstering national banking champions or to protecting links between local banking and political communities – links that effectively make the banks instruments of the state’s industrial policies. The ability of debt-burdened governments to pressure domestic banks into buying their sovereign debt, also known as financial repression, is another impediment to change. Of course, a banking union would potentially involve controversial financial risk-sharing or cross-border transfers.

These constraints prevent Europe from moving in one step to a consistent architecture for its banking union. European leaders eager to discuss how to prevent the next crisis are often in denial about the current one. Their rhetoric tends to evoke an imaginary world in which finance is stable, economic incentives are aligned with social responsibilities and moral sentiments, and public authorities understand the financial system perfectly. From a policy perspective, such flights of fancy are an increasingly unaffordable luxury, especially in light of the urgent need for crisis management and survival.

Three priorities are obvious. First, the banks must share risks as widely as possible. It is unreasonable for European governments to reimburse all creditors of failed banks, including senior unsecured creditors in all cases to date (except for two banks in Denmark and a few very tiny ones elsewhere) and subordinated creditors in almost all cases in Continental Europe. In the US, by contrast, almost all restructuring processes have forced creditors to take heavy losses, except for a handful of prominent cases (Bear Stearns, Fannie Mae, Freddie Mac, AIG, and the carmakers). A European approach should avoid the perverse incentives that have held taxpayers hostage to failed banks’ creditors. There are many complex legal and financial issues at stake, but ultimately the choice is political.

Second, Europe needs an operating capability to restructure banks without having to rely on national authorities that have failed their supervisory duties. This objective requires building up an effective temporary task force of restructuring professionals who can intervene quickly on behalf of the entire Eurozone and manage corresponding legacy assets. Such tools do not currently exist. The Swedish Bank Support Authority of 1992, or in a different context Germany’s post-unification Treuhandanstalt, are relevant precedents.

Third, and most urgent, retail bank runs must be prevented. The best way would be for the EFSF or its successor fund to explicitly guarantee all national deposit insurance systems in the Eurozone. Such “deposit reinsurance” would bolster the integrity of the Eurozone and immediately enhance trust in its banks. Of course, strong European-level supervisory structures should eventually be built to prevent moral hazard. It will take more time to combine these different pieces into a consistent European banking policy framework. The current moment calls not for perfect fine-tuning, but for swift and bold commitments.

Move the FSB Secretariat to Asia

This post was published by Bruegel and the Peterson Institute, and is forthcoming in a joint newsletter of Bruegel and the Korea Institute of Finance. 

On the face of it, the financial crisis of 2007-08 has helped rebalance the governance of global financial authorities, partially correcting the prior underrepresentation of emerging economies and of Asia in particular. From November 2008 to April 2009, the G7/G8 was superseded by the G20, the Financial Stability Board (FSB) was empowered and enlarged to include major non-Western economies, and discussions began on reconfiguring the governance of the International Monetary Fund and World Bank. The Basel Committee on Bank Supervision was also adjusted to broaden its membership.

Much remains to be done to enable Asians to feel a genuine sense of ownership, however. Membership may have been broadened, but these institutions, which were generally created by Westerners for Westerners, remain predominantly run by Westerners[1]. In a recent count of the 25 top full-time and part-time positions at the 11 main global financial authorities[2], 20 were held by Westerners, and only three by Asians, including two deputy positions (Véron, 2012). Meanwhile, Asia now represents 25 to 35 percent of the world’s economy and financial system (depending on the indicator chosen), a share almost certain to increase in the near future. Asians correctly perceive a mismatch between their role in the global economy and their voice in global institutions (Cho, 2011).

An important but underestimated contributor to this mismatch is the fact that all global financial authorities are located in the West, and almost all in Europe. (The two exceptions are the International Monetary Fund and World Bank, both in Washington.) This is obviously a legacy of history. The first such institution, the Bank for International Developments (BIS), was established in Basel primarily to solve a European problem, the payment of World-War-I reparations by Germany, which involved mostly European stakeholders. Once created, institutions generally do not move, and some of them spin off new ones in the same place. The BIS remains the host locale of five other global financial authorities, including the FSB. But the issue of location is not merely symbolic. Anyone who has ever had to plan a round trip from Beijing (or for that matter, Brasilia) to Basel knows that being physically close to global institutions, as are all Europeans, offers a practical advantage in international financial regulatory discussions.

For each institution, there is a perfectly good case to keep it where it is. Beyond the cost of moving, joint work among the authorities justify keeping them close to each other. In addition, Europe’s time zones make it easier to maintain liaison with both Asia and the US. But according to this logic, no global financial authority will ever be located in Asia, and it will be increasingly difficult for Asians to resist the impression that they don’t have an equal stake in the global system.

The G20 leaders should break this cycle. Fortunately, an almost ideal opportunity is at hand. Negotiations are ongoing under the Mexican presidency of the G20 to reform and strengthen the governance of the FSB, loosening its ties with the BIS both in terms of financing and of operational arrangements. The discussions are expected to produce an agreement at the mid-June summit of the G20 in Los Cabos. Much of the discussion concentrates on the future representation in the FSB’s structures of different policy sub-communities (central bankers, finance ministry officials, supervisors). But relocation of its permanent secretariat should also be on the agenda. Unlike the IMF, OECD or BIS, the FSB secretariat has only a small staff of about 20 professionals, most of whom are internationally mobile. And because its global role is increasingly important, a transfer to Asia would be more than a token gesture.

Where in Asia? Some obvious criteria need to be fulfilled: air travel accessibility; political stability; the rule of law; and amenities that make it possible to attract highly qualified international staff. Among Asian cities, Hong Kong, Seoul, Singapore, and Tokyo meet these criteria to a sufficient degree. Switzerland can be expected to resist losing the FSB, but it would gain from strengthening the global financial policymaking order. So would all Western players.

Relocating the FSB to Asia, of course, should not substitute for other initiatives to fulfill the G20 promise to deliver an effective global financial policy framework reaching the goals of stability, growth, and inclusiveness. Nor should it substitute for financial reform in Asia, where the allocation of capital remains inefficient. But tackling the mismatch, in which Asians are inadequately empowered even as their economic and financial position is increasingly central, has to start somewhere. Moving the FSB secretariat eastwards would be a reasonable place to begin.

 

References

Cho Yoon Je (2011), “What do Asian Countries Want the Seat at the High Table for? G20 as a New Global Economic Governance Forum and the Role of Asia,” ADB Working Paper Series on Regional Economic Integration No. 73, Asian Development Bank

Véron, Nicolas (2012), “Asia’s Changing Position in Global Financial Regulation”, Asian Development Bank / Korea Capital Markets Institute / Peterson Institute for International Economics, forthcoming

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[1] Defining the “West” according to common practice, as the US and Canada, Europe up to the current Eastern boundary of the EU, Israel, Australia and New Zealand.

[2] These are the FSB itself and its ten members which have a global scope, namely the Bank for International Settlements, Basel Committee on Banking Supervision, Committee on the Global Financial System, Committee on Payment and Settlement Systems, International Association of Insurance Supervisors, International Accounting Standards Board, International Monetary Fund, International Organization of Securities Commissions, Organization for Economic Co-operation and Development, and World Bank.