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.
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.
This article was published in the October/November 2016 issue of Financial World.
Breaking the vicious circle
Nicolas Véron argues that EU banking union can only be complete if the vast amounts of domestic sovereign debt held by many banks are reduced
The eurozone’s banking union has moved from vision to reality in a short period of time, with the European Central Bank now an established supervisory authority for the area’s large banks. This has already made a big difference to the many national banking champions that local supervisors had been treating with kid gloves. But the banking union’s ultimate policy goal, memorably defined by heads of state and government in June 2012 as the “imperative to break the vicious circle between banks and sovereigns,” has not yet been achieved.
One essential link in this vicious circle is the vast inventories of domestic sovereign debt held by many European banks. Reducing these holdings is now central to discussions on a more complete banking union.
The Dutch EU presidency in the first half of 2016 valiantly tried to make progress but could not overcome the stalemate of entrenched positions. Most countries want to keep the option of using national banking systems as buyers of last resort of their sovereign debt.
In May, the Governor of the Bank of Italy referred publicly to the need to maintain “banks’ ability to act as shock absorbers in the event of sovereign stress.” Even Germany, usually an advocate of strict fiscal discipline, is constrained by the role played by its local banks (the Landesbanken) in financing public-sector activities at local or regional level. But, at the same time, the German government refuses to endorse the creation of a European deposit insurance scheme (EDIS), a cornerstone in banking union, unless limits are put on banks’ domestic sovereign exposures. Its concern, not unreasonably, is that the risk-sharing inherent to EDIS could be exploited by impecunious governments. The fear is that EDIS could be used to get easier government financing conditions through outright financial repression or through the use of “moral suasion” on domestic banks.
The Ecofin meeting of finance ministers and central bank governors in mid-June decided that any new initiatives on the regulatory treatment of sovereign exposures will await the outcome of ongoing work at the Basel Committee. It is only then that EDIS be discussed “at the political level.”
But the issue of sovereign exposures cannot be simply wished away. To achieve resilience, the eurozone needs to enable banks to withstand sovereign stress, even in their respective countries of origin. Only then can the banking system act as a genuine shock absorber for the local economy – as happened, say, in the Baltic countries in 2009-10 when local banks were supported by their Scandinavian parents. Forceful regulatory measures are needed to sharply reduce home bias in banks’ sovereign debt portfolios and to ensure that it do not reappear.
This is a specific eurozone challenge that calls for a specific eurozone solution. In countries that have their own currency, including those inside the EU, the bank-sovereign linkages are less “vicious” since the central bank can act as a buyer of last resort of sovereign debt. Outsourcing the problem to the Basel Committee, therefore, will almost certainly bring no breakthrough. Conversely, the eurozone can strongly limit the home bias, without practically constraining the banks’ total holdings of euro-denominated sovereign bonds as “safe assets,” since these can be diversified across 19 issuing countries and there would be no adverse competitive distortion with banks from outside the eurozone. This could be done with a graduated capital charge on any individual eurozone government’s debt.
Holdings at banks of such debt under, say, 25 or 50 percent of own funds could face a limited capital charge, which is gradually increased once the threshold is crossed. That would vastly improve the banks’ incentives to avoid the current home bias. Such thresholds should not depend on a sovereign’s perceived riskiness but be applied to all Eurozone banks and member states in the same way. The inescapable reality is that there is no objective way of assigning any significant issuer-specific risk weights to sovereign countries and any attempt to do so may be damaging.
National debt management offices can be expected to lobby fiercely against limits on eurozone banks’ sovereign exposures, but financial stability demands such limits. Together with provisions for bailing-in the creditors of unviable banks, which are now in place, if not much tested in practice, sovereign exposure limits would avert the sort of contagion spiral that nearly broke up the eurozone in 2011-12. They would also bring some welcome fiscal discipline to member states – a good thing given the otherwise toothless eurozone fiscal framework. Several EU countries already exhibit low home bias in their banks’ debt portfolios, for example Finland, the Netherlands and Sweden. With adequate transitional arrangements, it can be done.
The Eurozone should aim for a package to strengthen banking union, including the introduction of sovereign exposure limits, the implementation of EDIS broadly as proposed by the European Commission last November, and additional harmonisation of relevant features of bank insolvency regimes, such as the hierarchy of liabilities. Given lingering banking weakness in Italy, forthcoming elections in Germany and elsewhere, the distractions of Brexit and the sheer complexity of the issues, this negotiation is unlikely to be concluded immediately – but the sooner it is conducted, the better.
This interview was published in late September by the International Financial Law Review in its Cross-Border Financing Report 2016.
Cross-border financing is more complex than ever. And Nicolas Véron, a senior fellow at Brussels-based think tank Bruegel and visiting fellow at the Peterson Institute for International Economics in Washington DC is as well placed to unpick it as anyone. His research is mostly about financial systems and financial reform around the world, including global financial regulatory initiatives and current developments in the EU. Here he touches on the key trends in global cross-border finance, his views on transatlantic capital flows, how best to regulate such flows and the challenges of a Chinese economy gradually integrating itself into the global system.
It depends where you look. In the eurozone, there has been significant financial fragmentation in the five years up until 2012-2013, and then a trend reversal. From a global perspective, however, and especially in emerging markets, cross-border financial integration has continued more or less on the pre-crisis trend. So Europe is an outlier, rather than indicative of a change in the global trend towards cross-border financial integration.
Europe has a very heavily bank-based financial system and certainly since the start of the crisis in 2007, banks have had to rely on implicit guarantees from governments. Whenever EU governments have triggered such guarantees, they have also asked that the bank in question focus its lending back to the country in which it's based. There's a famous quote – often attributed to Mervyn King but in fact from Thomas Huertas – that "banks are international in life, but national in death." That captures the European experience since 2007 quite well. What is happening now in Italy is a good illustration – triggered as it is by supervisory actions of the ECB under the new banking union regime, but still framed as a national banking sector problem. The eurozone is now a hybrid system: neither purely national nor truly integrated.
There are other factors as well. The wide-ranging reforms of over-the-counter derivatives markets, initiated by the G20 in 2009 and gradually implemented since, change significantly where some trades are booked, which has a large impact, especially on transatlantic capital flow numbers even if the real economic impact isn't that huge.
There is generally no such thing as a global cycle. To be sure, there was a coordinated moment of difficulty in 2008, but then the US resolved its financial sector problems much more quickly than Europe, and so did the UK compared to the eurozone. And that's leaving aside Asian and other emerging economies, where there was actually no financial instability in 2007-09 even though they were hit by the economic and trade shock.
So the big picture remains a long-term structural trend of global cross-border financial integration, and around that trend there are different financial cycles in different parts of the world, rather than one grand coordinated cycle globally.
Now we've had the Brexit vote everything is up in the air. As regards the large derivatives market already mentioned, it is important to remember that the pace of implementation of the G20 reforms, including mandatory central clearing for many derivatives, has been highly differentiated. These reforms are fully in place only in the US.
There are also a lot of unintended consequences. Two broad and perhaps interrelated issues come to mind. The first is the concentration of risk in clearinghouses, which are becoming systemically critical to financial institutions. The implications of this in terms of the regulation, supervision and potential resolution of clearinghouses hadn't been thought through when the G20 decisions were made, to put it mildly. Second, and even less thought through, is that there is no such thing as global supervision, and since clearinghouses require supervision and crisis management, and perhaps also some forms of public guarantees, the very notion of a globally integrated derivatives market is challenged. Supervision has to be conducted on a jurisdiction-by-jurisdiction basis, and actually country-by-country because the EU doesn't count as a single jurisdiction in this area. So there's a fundamental tension between the central clearing mandate on the one hand, and the global integration of OTC derivative markets as they existed before the reforms on the other hand.
We're only at an early stage of the learning curve as to how to address these challenges. It is also fair to say that having made such big decisions first, and then thinking about the consequences years later, is no great example of quality public policymaking. Personally, I remain somewhat agnostic on whether these G20 reforms were a good thing overall for financial stability. One problem is that many of the people who made these decisions are still those in charge. It's very hard for them to acknowledge that they had not properly considered the consequences when they made their decisions. That doesn't help bring about the debate that is needed.
The shenanigans between the EU and US on things like equivalent status for clearinghouses are in fact relatively marginal, compared to the challenges of finding a workable policy framework at the global level for these kinds of reforms. The policy debate on things like how to oversee clearinghouses lags behind the implementation of the reforms, which itself is way behind schedule. The risk of unintended consequences is very high, and some have crystalised already.
Until now, the CMU has been a very compelling rhetorical vision proposed by the European Commission, and largely inspired by the UK. But it has had little to show in terms of actual policy decisions, and that's also largely (though not only) because of the UK. This is because a credible CMU requires European enforcement of capital markets rules, and the UK didn't want to even consider such options as they would have been viewed as a Brussels power grab in the referendum campaign. So the question to ask now from an Americas perspective is whether the decision of the UK to leave the EU will kill CMU and destroy the rhetorical vision, or instead unlock CMU and make it more real, at least in the EU27 (current EU minus the UK). We probably won't know for some time.
Yes, to begin with. Initially, European Commission President Jean-Claude Juncker saw the CMU as an unambiguously positive project for the EU's relationship with the UK. But then everyone realised that things weren't that simple. Commissioner Hill ended up advocating an ambitious CMU vision, but at the same time being structurally prevented from implementing it, largely because of the UK veto against any institutional centralisation in this area.
I am still hopeful that the EU27 will move towards better integrated and more developed capital markets. There's really no early indication that the EU will adopt a more closed, protectionist or corporatist model as a result of the UK choice to leave the EU. These are obviously extremely early days so this point has to be made with caution. But it would be misleading to see the UK as the only driver of liberalisation or reform in the EU.
It's only natural that most market participants equate more regulation with being bad for business, but this is just not the full story. There's good regulation, and bad regulation. Smart regulation, and dumb regulation. If you only deregulate, if public oversight of markets becomes ineffective or powerless, there's ultimately a bad outcome for markets.
Markets need strong policy frameworks. They don't exist in a vacuum: to put it bluntly, capital markets don't work very well in Afghanistan. So a structured and effective framework of public policy and governance is needed for markets to thrive. One would have hoped that after 2008, the naïve and misleading view that less regulation is always better for business would have lost traction. But many people have short memories.
It's a constantly changing sweet spot, because there's always so much change in the financial world. Regulation has to change accordingly, and there's never really a perfect answer, let alone a steady state. It's not the same, over time, for the same place, let alone different places. Regulation really has to constantly adapt to its environment.
At this point, there's simply a lot of uncertainty about everything. When we know more about the future trajectory for the UK then it might be clearer as to whether London is to remain in the single market or not.
That's what really makes a difference for financial services. For now we just don't know. If London stays in the single market, Brexit doesn't change much after all: it's a bit more complicated than that, but that's a good first-order approximation. But if the UK does leave the single market, then the City will probably hollow out. It might be gradual or it might be sudden, but in all likelihood, leaving the single market will be extremely bad news for the City of London.
It would mean a lot of business would be up for grabs from other jurisdictions – some would go to New York but a lot would probably remain in the same time zone, which may mean several different places inside the EU.
For US financial firms, then, there is a plus and a minus. The plus is that New York may gain some of the global business that's currently being done in London. The less good news is that there are transition costs to relocating from London to the EU. In the end, US financial firms can adapt. For them, London has been a great place to do business in the past 20 years, but there's nothing that forces them to stay there if London loses its comparative advantage. And outside of the EU single market, London will certainly lose a lot of its competitive edge.
Capital markets are not in fact unfettered. There are obvious regulatory challenges, including the obvious fact that we don't have effective structures in place at the global level with which to deal with global markets and firms.
Thus it is difficult to have deeply integrated cross-border systems that are also properly regulated. But even so, there has been incremental progress. For example, the Financial Stability Board (FSB) has made a positive difference. The Basel Committee now monitors how its standards are implemented, and that is a meaningful step in the right direction.
Currently, we have a hybrid model where most global regulation is applied inside jurisdictions. This creates mismatches with the notion of global cross border financial integration. If one looks only at the European aspect, Brexit is a big loss but Banking Union is a huge gain. So it's not all bleak.
An even bigger challenge is China. For China, gradually integrating itself in a functioning global system may be even more complex than anything that's happening in Europe. Of course, China already has membership of bodies like the FSB and the Basel Committee, but it remains largely a financial island, not just for historical reasons but also for structural reasons. China is becoming a massive presence in global finance, and that creates increasingly real challenges in terms of global financial stability.
Another big theme is that, before the crisis, the EU was a big champion of global financial standards. Now, Europe still talks the talk but no longer walks the walk. The European Commission says it's in favour of global standards, but the EU has the worst compliance record with Basel III in the world. That's a bigger change than we've seen in the US, which always had a stronger stance on the sovereignty of Congress. If anything in the US, we've seen a move towards greater international commitments, especially in terms of implementing Basel III.
There are also fundamental questions about the analytical lessons of the crisis for cross-border financial integration. There is surprisingly little good literature on the trade-offs of cross-border financial integration for advanced economies, as opposed to developing countries. The reason is the conventional wisdom which implies that for developed economies cross-border finance is always good. After the last decade, there are second thoughts. The complex relationships between financial openness, financial development and financial stability require a lot more research than there has been so far, including better financial statistics to start with. There is progress, but it is slow.
It's actually easy to underestimate the benefits of cross-border financial integration, including in terms of financial stability. For example, everyone knows about German banks being hit by US subprime losses in 2007 and that's clearly an instance in which cross-border finance propagates financial instability. But think of what happened in Eastern Europe, and in the Baltics in particular, where the financial system being foreign-owned was actually a big stabilising factor in a domestic boom and bust cycle.
Bruegel and the Peterson Institute just published lightly edited versions of a background paper which I contributed to the evaluation of the role of the International Monetary Fund in Greece, Ireland and Portugal by the IMF's own Independent Evaluation Office.
Bruegel just published “The IMF’s Role in the Euro Area Crisis: Financial Sector Aspects” in its Policy Contributions series, and the Peterson Institute posted a near-identical text on its website. Both are lightly edited versions of a background paper on financial-sector aspects which formed part of a broader evaluation of “the IMF and the crises in Greece, Ireland and Portugal,” published in late July by the Independent Evaluation Office of the International Monetary Fund. The IEO report, which was accompanied by eleven background papers (including mine), received wide coverage in international media, and prompted a welcome debate on the weaknesses and shortcomings it highlighted at the Fund.
My work evaluated the financial-sector aspects of the IMF’s performance on two levels. For the euro area as a whole, I give the Fund high marks for its ground-breaking analysis of the vulnerabilities of the currency union’s banking policy framework, starting years before the crisis and developed near-continuously during the crisis itself. The IMF was the first public institution, and among the first observers more generally, to identify the vicious circle between banks and sovereign states, which then became increasingly widely acknowledged as the central driver of the euro area crisis, and which euro area leaders memorably pledged to break when first announcing the reform now known as banking union in late June 2012. As early as May 2009, an IMF working paper by Ashoka Mody is the earliest public description I found of that vicious circle, presumably inspired by his experience of Ireland at that time. It was shortly followed by a euro-area-wide analysis by Silvia Sgherri and Edda Zoli emphasizing the links between sovereign risk and financial-sector fragility.
In terms of euro-area-level policy recommendations, the IMF was an early advocate of what we now call banking union, including through a series of publications in 2007 and a detailed proposal in 2010, which can be seen as the precursor of the euro area’s single resolution mechanism that came into force earlier this year. (My own first contribution to the banking union debate in 2007 was largely inspired by joint work with two IMF economists, Jörg Decressin and Wim Fonteyne.) The Fund was an equally forceful champion of banking union in the immediate run-up to euro area’s decision to initiate it, with a landmark blueprint provided in a January 2012 speech by the IMF’s managing director, Christine Lagarde. The IMF’s advocacy of European banking policy was not entirely continuous and was occasionally weakened by internal disagreements, but deserves significant credit for its contribution for the major steps the euro area has taken since 2012 towards banking union, arguably the most important structural reform adopted by the euro area in response to the crisis.
At the level of individual countries, my assessment highlights the contrasts between different programs, as does the IEO’s main report. On financial-sector aspects, the first Greek program (2010-12) successfully prevented short-term financial instability but couldn’t avert the sharp deterioration of Greek banks’ balance sheets in the run-up to the sovereign debt restructuring of March 2012. The Irish program (2010-13) was as close as it gets to a textbook example of effective banking sector restructuring. By contrast, the Portuguese program (2011-14) missed the opportunity to bring Portugal’s banking sector back to soundness, a collective failure for which Portugal is now paying a significant price. The Spanish program of 2012-14, to which the IMF contributed in major ways even though not under the “troika” arrangement, was, like Ireland, a remarkable success. The second Greek program (2012-16) and Cypriot program (2013-16) are not covered by the IEO evaluation because they were still ongoing when most of the evaluation work was being done. The paper attempts to explain how these diverse outcomes resulted from different country contexts but also from internal circumstances within the Fund.
The paper’s title and context clarify what it is and isn’t. First, it was written as part of an evaluation of the IMF. While a number of facts and assessments are provided on other actors such as national governments and EU institutions, these are only intended to help pass judgment on the performance of the IMF itself. In other words, the paper does not seek to evaluate the actions of any of these governments and institutions, even though it provides material that may be used for such evaluations. Second, the paper focuses on financial-sector aspects, and to be more specific, on banking-sector issues, since banks represent the overwhelming majority of financial intermediation in the euro area. Fiscal and structural policy challenges, in particular, are covered in other parts of the IEO evaluation but are not assessed in this text. Third, as highlighted in a disclaimer on the background paper published by the IEO, the views expressed in the paper are mine and not those of the IEO. As the IEO puts it, background papers “are published to elicit comments and to further debates.” Only the main report represents views of the IEO itself.
My evaluation supports the view that the euro area crisis is best understood as a set of complex interactions between fiscal and financial-sector developments, even though mainstream narratives tend to focus single-handedly on the fiscal aspects (and, correspondingly, on Greece). It also highlights the IMF’s contribution as a highly valuable partner for the euro area throughout the crisis, despite flaws on which the IEO project has shed an unforgiving light. The IMF has acted as a welcome check against European tendencies for insular and inward-looking thinking, and has provided important insights into the European policy process based on the Fund’s experience elsewhere in the world, even though European policymakers haven’t always heeded the IMF’s advice as they should. The Fund should try to build on its successes and learn from its mistakes to keep bringing essential value to European policy decision-making in the years ahead.
Finally, I wish to express my personal gratitude to the IEO, particularly to Shinji Takagi who led this evaluation project and to the Office’s Director Moises Schwartz, for having allowed me to participate in their collective effort. The IEO, which started in 2001, is a unique institution. It has once again demonstrated its capacity for ruthless truth-telling to the IMF, which in turn supports the Fund’s capacity for ruthless truth-telling to its member countries. The ability of the IEO to prepare and publish independent assessments, and to enable background papers authors to express independent judgments of their own, is truly impressive. For me, contributing to the IEO’s work over the last eighteen months has been a great honour and privilege.
The British Prospect Magazine just published this article in which I explain why Brexit, if confirmed, is unmitigated bad news for the City of London, and as a consequence also for the UK and for Europe as a whole.
“Brexit frees us to build a truly global Britain,” enthused Boris Johnson in his Telegraph column immediately after being appointed Foreign Secretary. If anything presently embodies the vision of “Global Britain,” it is the City of London, that marvel of a world-leading, cosmopolitan, ferociously competitive and efficient financial centre that serves as a powerhouse for the entire UK economy. But just as the City owes much of its current awe-inspiring prosperity to European integration, the brutal realities of Brexit will make it shrink, not thrive.
The reason, in a nutshell, is that the European Union’s single market has always been much more than a free trade zone. From its very inception as the 1950s European Coal and Steel Community, the EU has been about removing “behind-the-border” barriers to business and creating a single economic space regulated by supranational authorities. (This is why EU-level competition policy is so central to the whole project.) Deep economic integration goes hand-in-hand with supranational administrative capacity, especially in economic sectors that require intrusive public oversight, such as regulated services and especially finance. As Dani Rodrik, the Harvard economist, put it in his 2011 book The Globalization Paradox: “Markets are most developed and most effective in generating wealth when they are backed by solid governmental institutions.” The EU project, for all its twists and turns, can largely be summarised as applying this insight to a continent-sized region. The fact that the single market vision is still far from fulfilled, especially in services sectors, does not invalidate the logic of deep integration.
Until now, the City has benefited disproportionately from the EU single market. London achieved its current dominant position in international finance in three phases: a head start in the 1970s with the development of international currency markets; a sharpened competitive edge in the 1980s thanks to the de-regulatory “big bang” of the Thatcher era; and in the 1990s and 2000s, a centralisation of most of Europe’s wholesale financial activity thanks to the aggressive dismantling of national barriers by EU legislation on investment services, financial instruments, fund management, accounting standards, market infrastructure, and much more. Crucially, the structure of the EU single market allowed non-EU financial firms, including financial behemoths in the United States, to conduct most or all of their European business from a single location—London—allowing for significant cost savings. On most measures of wholesale financial activity, London’s share of the EU financial market rose sharply after the early-1990s, typically to three-quarters or more, while the other contenders such as Frankfurt or Milan or Paris all shrank to single-digit percentages.
These benefits, of course, might be preserved if the UK stays inside the European single market. But the more one explores possible scenarios, the clearer it becomes that “Brexit means Brexit” not only from the European Union, but also from its single market. This is only partly about free movement of people, the issue that tends to dominate English debates. Even assuming all sorts of emergency brakes on foreign workers, UK membership of the European Economic Area (EEA) would provide the exact opposite of the “Leave” campaign slogan of “take back control.” On almost all non-tax issues of financial regulation, and many more in other sectors, the UK would have to submit to EU diktats in the preparation of which it would have no voice, an essentially unacceptable position for a sovereignty-focused post-Brexit government. It is no coincidence that all EEA members are nations whose independence is rather recent (1806 or 1866 for Liechtenstein, 1905 for Norway, 1944 for Iceland) and who make comparatively less of a fuss about national superiority. In other terms, and quite independently from the EU’s tactical choices and psychological stance in any exit negotiations, there is (to paraphrase George Osborne) a remorseless logic that will lead the UK to leave the single market as it leaves the EU, at best with a few years’ additional delay. Only a reversal of the entire Brexit process could prevent this from happening, but would certainly require a second referendum and for the moment appears improbable.
In sum, by far the most likely scenario for the City’s future post-Brexit is one in which there might be access to the single market, but from outside, as is currently the case for jurisdictions such as the US, Canada or Japan. In some market segments, EU regulations and bilateral agreements may allow for equivalent status, but not in all areas and presumably not forever. One may call this scenario “Switzerland-minus”. Switzerland is not a member of the EEA and has its own sovereign framework for financial regulation. It has agreements with the EU that grant its firms some access to the single market. But this stops well short of single market membership. Not coincidentally, much of the large Swiss banks’ services to EU clients are provided through their London affiliates, rather than directly from Zurich.
The impact on the City from being outside of the single market is inevitably a matter of speculation, given the complete absence of precedents. The optimistic view is that only a limited share of the City’s business, perhaps somewhere between 15 and 25 per cent of its activities, will need to remain inside the single market and thus will move outside the UK, with the rest unaffected by Brexit. It would be a significant blow, but far from a fatal one. This view, however, downplays the risk-management and cost advantages of keeping all parts of a business in one single entity. In the current system, the UK affiliates of large international financial firms internalise a vast array of transactions, exposures, and market segments, which would be split if a significant subset had to move to a separate jurisdiction. For at least some of these firms, it might be preferable to move the bulk of the business, rather than suffer the consequences of fragmentation. If so, the financial services that move onto the continent may drag a much larger volume of activities along. The network effect, which has been the City’s best friend in the past 20 to 30 years, could become its most implacable enemy.
Or look at it this way: the City has thrived in recent decades because it was the best place to do financial business in its part of the world, which the financial set refers to as Europe, the Middle East and Africa (EMEA). Post-Brexit, the loss of single market membership will become a clear disadvantage in comparison to EMEA financial centres inside the EU, which the City’s other comparative advantages may not offset. British firms such as, say, Barclays or Aviva may endeavour to keep as much of their business as possible in the home country. But non-domestic ones, whether from America, Asia, or the EU itself, will have no sentimental or otherwise non-bottom-line-related reasons to linger in London if there are better business conditions elsewhere. A number of places will surely jostle to eat the City’s lunch, including Amsterdam, Brussels, Dublin, Edinburgh (if Scotland has serious prospects of staying in the EU), Frankfurt, Luxembourg, Madrid, Milan, Paris, Stockholm, Vienna, and probably others as well. Given the enormous opportunity, these cities and their respective countries will compete hard to burnish their existing credentials and remedy some of their handicaps in terms of attractiveness for financial service activities. It may be that neither of the two most often cited contenders, Frankfurt and Paris, will be winners in this contest, because of unchangeable rigidities such as onerous labour regulations. But there are enough places in the EU with top marks in cultural vibrancy, physical infrastructure, English proficiency, independent judiciary, and other key factors, so that it is likely that at least one and possibly even several (in a first phase) will emerge good enough to become, as London has been so far, the best place to do financial business in EMEA.
Attitudes of regulators may further tip the balance. In the EU, national and euro-area authorities have been effectively prevented from discriminating against UK-based firms thanks to the single market framework and its forceful enforcement by the European Commission and European Court of Justice. Such protections will erode when the UK leaves. Perhaps less evidently, the US authorities’ stance may change as well. In recent decades, American federal regulators have tended to be rather accommodative in their relations with their British counterparts, since operations from the UK provided US firms access to the vast EU market. When this beachhead function disappears, one may expect them to become more demanding in terms of UK regulatory standards as they are with smaller offshore places—seeing no particular advantage in having US firms conduct activities from London rather than from New York, Boston or Chicago. Similar incentives may apply in other non-EU jurisdictions.
To be sure, London is set to remain the largest financial centre in EMEA for the foreseeable future. It is currently so dominant that it will presumably take a very long time for any of its regional competitors to surpass it. There are also factors that will make it burdensome for some activities to move elsewhere, such as the depth of case law from English courts that can’t be easily replicated. But that will be little comfort. For the reasons exposed above, the City is likely to decline in absolute size, and even more so in relative terms as global financial activity can be expected to keep expanding. The EU will probably pursue further cross-border integration, perhaps implementing its project of a Capital Markets Union alongside the ongoing reshaping of the euro-area banking landscape under the policy framework known as Banking Union. Meanwhile, financial activity will probably keep growing at a rapid clip in Asia. Over the long term, at least one major financial centre may emerge inside the EU, and at least one also in Asia, that would grow enough that they would eventually outrank London. Given the likely continued strength of New York, the City would then drop to fourth place globally if not lower. The future of London outside of the EU single market may resemble the present situation of Tokyo in Asia: a highly developed financial centre with respected institutions, but too insular to maintain itself in the truly global leadership league.
What can the British (or, if Scotland secedes, English) government do to improve the City’s prospects against this grim future? Two different paths may be pursued, and it is possible that both will be tried at different times, or perhaps even simultaneously, in the years to come. The first strategy, which may be labelled “near-remain,” is to stay as close as possible to the single market, by emulating most EU rules and maintaining close cooperation between UK financial authorities (such as the Bank of England and Financial Conduct Authority) and their counterparts in the EU. The second strategy is of “going alone,” enhancing the difference between the UK and its larger neighbour and boosting the City’s competitive edge on at least some market segments through more favourable tax and regulatory treatment, as most off-shore financial centres do. But these two strategies are largely incompatible with each other. Furthermore, none of them is exactly a winning one: “near-remain” will never be as good as being in the single market in terms of mainstream EU financial business; “going alone” implies focusing on a limited number of niche segments and losing the one-stop-shop position that the City currently enjoys—not to mention possible retaliation from the EU and others in case the stance becomes overly aggressive. Different firms in the City, and different factions within government, can be expected to advocate either strategy. If, as may be the case, UK policy shifts from one to the other and then back, it will fail to reap the full benefit of either.
All this is bleak news, not just for the City but for the national economy. London’s financial sector is a huge generator of tax receipts for the government: according to the City of London Corporation, in the year to March 2015, the City paid £66.5bn in tax, equivalent to almost two thirds of the national education budget. It also provided revenue and profits for innumerable non-financial businesses, not to mention easier access to capital for many UK companies. For all the anger directed at fat-cat financiers, their mass emigration will do the nation no good. The market reaction has been rather muted so far, but this may only be because the harsh reality of Brexit has not fully surfaced yet. Reliable data about the “Leave” vote’s impact on investment or capital outflows will not be available until this autumn. Moreover, the international financial media, being largely headquartered in London, have various incentives to focus on the bright side. The London-based financial community, which normally acts as a ruthlessly unemotional processer of information, may also be biased in its initial judgment, not least because so many of its members have themselves voted in the referendum. The rest of the world, including non-European investors, is critically dependent on these two clusters of sources—London-based international media, and City analysts—for their own assessments. On this particular issue, then, global information channels may be viewed as temporarily impaired. But this gap cannot last forever.
Recognising the high probability of the City hollowing out as a consequence of Brexit is not about “talking down” the UK economy, but rather acknowledging an impending tragedy. The future described here is terrible news not just for London and England, but for Europe as a whole. No prediction is ventured here about the pace of decline, which, among many other things, will be highly dependent on the occurrence of financial crises. But its reality appears inexorable, and only secondarily dependent on the specific political motivations of policymakers in London, Brussels, Berlin, Washington and elsewhere in the years ahead. The golden age of London in the 2000s and early 2010s, a place of blatant excesses but where everything seemed possible, that made Paris and even New York or San Francisco feel provincial, a de facto capital of the world, may be wistfully remembered as a fleeting wonder. It will be sorely missed by many.
The G20 and Financial Regulation: Early Achievements and Structural Gaps
Financial regulation was very prominent in the initial stages of the G20 as a venue for coordination among global political leaders. This early emphasis led to significant successes, but also to a sense of disillusionment as delivery of consistent outcomes could not be sustained and divergence among key jurisdictions became increasingly noticeable. It is argued here that the causes of the G20’s shortcomings are largely structural, linked to a lopsided architecture of global institutions for the preparation of financial regulatory policy. These structural gaps are inherently hard to correct. Any efforts during the Chinese and German presidencies of the G20 to identify and acknowledge them would help to pave the way for future progress towards fulfilment of the G20’s proclaimed objectives.
The G20’s financial regulatory track record: achievements and disappointments
Following the great financial crisis of 2007–08, G20 summits started with a very strong focus on financial regulatory matters. The first G20 Leaders’ Summit, held in Washington DC on 15 November 2008, listed no fewer than 39 actions to be taken in the area of financial regulation alone, or 83 per cent of the 47 points in the summit declaration. This was accompanied by highly aspirational rhetoric. Following the Washington Summit, for example, the then French President Nicolas Sarkozy immediately declared that “this summit is historic” and that it had introduced “a new regulation of financial markets so that such a crisis could not happen again” and “a new, more effective and fairer global economic governance”.
The actual achievements, of course, were more nuanced. The two subsequent summits, held in London in April 2009 and in Pittsburgh in September 2009, resulted in a series of wide-ranging financial regulatory decisions. The assessment of policy reforms is never a matter of universal consensus, perhaps even less so in the area of financial regulation than in other areas of economic policy. Nevertheless, some of the changes resulting from successive G20 summits can be labelled successful.
The prime example for this is arguably the Basel III accord on capital, leverage, and liquidity, initially formulated in December 2010 and updated since by the Basel Committee on Banking Supervision (BCBS). Compared with the previous Basel II accord of 2004, which it replaced, Basel III considerably reinforces the requirements for banks’ capital as measured as a share of their risk-weighted assets; introduces an additional leverage ratio, thus creating a check against the possibility of risk-weighting manipulations by banks; and creates an entirely new framework for bank liquidity regulation. Basel III has been criticised from various corners, both for being too rigorous and for being too lax. But there is no question that it is an improvement on the prior global Basel II regime, and little doubt that it owed its rather quick finalisation to the political impetus provided by the G20.
Aside from Basel III, there are other global financial regulatory reform initiatives that came in the wake of G20 discussions and are unquestionably useful. One of the more significant, though scarcely visible, is a joint effort to improve financial statistics, coordinated by the International Monetary Fund (IMF) and the Financial Stability Board (FSB) and known as the ‘Data Gaps Initiative’. Even though progress in this area tends to be slow and incremental, this has led to an improvement in the quality and quantity of information available to policymakers and to the wider public to analyse financial systems and their evolution. One particularly pioneering aspect of the Data Gaps Initiative is the creation of an International Data Hub on global systemically important banks at the Bank for International Settlements (BIS), in Basel, which to an extent transcends traditional jurisdictional boundaries of banking supervision on a global scale.
Still, other G20 endeavours, even after more than seven years of discussions, remain largely a matter of work in progress. To start with, the Basel III accord is not yet fully implemented, and some of its requirements will only be fully in place in 2019. International Capital Standards for internationally active insurers have not yet been agreed on, let alone implemented. The FSB’s approach to the orderly resolution of future crises involving global systemically important banks, grandly labelled ‘Ending Too-Big-To-Fail’ since 2011, has not attracted an enthusiastic reception from jurisdictions other than its initial promoters in the European Union, Switzerland, and the United States. The approach to the so‑called shadow banking system has been generally long on rhetoric and short on actual policy, reflecting the imprecision of the concept of shadow banking itself.
There has also been a journey of discovery on many of the reforms, involving initially unforeseen consequences. For example, the G20 in 2008–09 decided to impose profound structural changes on the market for financial derivatives transactions, which until then had been only lightly regulated. One of the key measures was the requirement to move the clearing of many derivatives contracts from bilateral relations to central clearing houses, also known as central counterparties (CCPs). But this leads to massive risk concentrations inside the CCPs, and also raises questions about the possibility of fragmentation of derivatives markets across jurisdictional lines, since CCPs are supervised on a country-by-country basis. It is increasingly clear that these challenges had not been comprehensively evaluated at the time the G20 made its decision, as is apparent from a still widely open policy debate about the future framework for the resolution of CCPs in systemic crisis scenarios.
Yet other G20 initiatives have simply failed to come to fruition. One clear example is the G20’s initially expressed ambition to achieve global convergence of financial accounting standards. In spite of the existence of a tried-and-tested set of such standards, known as International Financial Reporting Standards and adopted by the European Union and many other jurisdictions in the course of the 2000s, accounting standard-setters in the United States and in other countries have successfully resisted pressure to converge towards this global framework. The mantra of convergence towards a single set of high-quality global accounting standards was initially announced by the G20 with a mid-2011 deadline; that deadline was extended several times, then was entirely dropped, and then the mere mention of the commitment to global accounting standards convergence was quietly abandoned.
Another impactful G20 innovation was a major enhancement of the arrangements to monitor the implementation of reforms from a global perspective. The Basel Committee, in particular, has established a pioneering program to monitor not only which jurisdictions have transposed Basel III into their laws and regulations, but also the precise level of compliance of such transposition with the global accord, and also some aspects of its practical implementation. In this, the BCBS has established strong methodologies to ensure the neutrality of the assessment, and has not shied away from ‘naming and shaming’ — for example, in a 2014 report, the BCBS found the European Union, its biggest jurisdiction in terms of total banking assets, to be “materially non-compliant” with Basel III. The FSB has regularly collected information about the application of all G20 reforms since 2008, and since 2015 delivers annual reports to G20 Leaders summarising its findings across the entire financial regulatory scope, including some elements of economic impact assessment.
Unsurprisingly, the G20’s efforts have not put an end to the considerable diversity of financial system structures around the world. Different jurisdictions have diverse histories, levels of development, and political and social arrangements which all stand in the way of cross-border convergence. Even so, there has been a remarkable shift of the policy consensus, in different ways in the European Union, China, Japan, and other jurisdictions, towards a recognition that their financial systems’ present domination by banks (as opposed to a large role for securities markets to finance the economy, as is most notably the case in the United States) may not be in their best interests from the standpoint of both economic growth and financial stability. This acknowledgment has motivated the ongoing EU policy of ‘capital markets union’ and various other initiatives around the world to develop capital markets. The G20, however, has played no direct role in this shift, and it remains to be seen how much impact it will have on the actual evolution of financial systems.
Overall, the action of the G20 since 2008 qualifies as the most ambitious and impactful coordinated effort ever to overhaul financial regulation at a global level. But its achievements are lopsided, and far from the vision initially expressed by political leaders (especially European ones) of a globally consistent approach to financial regulatory policy.
Institutional imbalances and prospects
The contrasted landscape of G20 successes, half-measures and failures is not only the product of randomness. There is a degree of correlation between G20 achievements and the strength of existing international arrangements. Perhaps unsurprisingly, treaty-based institutions such as the IMF and World Bank have been able to deliver more quickly on the G20’s early initiatives than looser coordination bodies. Furthermore, it is not a coincidence that Basel III stands out among G20 reforms for effectiveness and impact.
The Basel Committee, created in late 1974, is one of the oldest and most established bodies for global financial regulatory coordination, and is itself hosted by the Basel-based BIS, established by treaty in 1930 and thus the dean of all public international financial organisations. Both the BCBS and BIS, together with other lesser-known bodies such as the Committee on the Global Financial System (CGFS) and Committee on Payments and Market Infrastructures (CPMI), rely on the global community of central banks and central bankers, which is comparatively more cohesive than other networks of national regulatory authorities. By contrast, securities markets authorities, even though they gather in the International Organization of Securities Commissions (IOSCO, created in 1983), have been collectively less effective in the promotion of common standards, as illustrated by the fiasco of G20 efforts to promote accounting standards convergence.
Furthermore, issues which are relevant to both central banks and securities regulators, such as reforms of the over-the-counter (OTC) derivatives markets, have been characterised by a near-complete inability to effectively set standards at the global level. To remedy this gap, there has been a proliferation of initiatives which have not achieved much more than underlining the problem, including an OTC Derivatives Supervisors Group (ODSG) since 2005, an OTC Derivatives Regulators Forum (ODRF) since 2009, an OTC Derivatives Regulators Group (ODRG) since 2011 and an OTC Derivatives Coordination Group (ODCG) since 2012, with largely overlapping compositions and mandates.
It is striking that the financial crisis of 2007–08 has not led to the creation of any significant new global institution for financial regulatory reform. The G20 itself, as a grouping of countries if not a format of top leaders’ summits, was born of the Asian crisis of 1997–98, as was the FSB (the successor to the Financial Stability Forum). In 2008–09, a number of existing bodies — including the FSB, BCBS, CGFS, and CPMI — expanded their membership to large emerging economies, but there was much less institutional creativity than in the wake of the Asian crisis. It is tempting to correlate this observation with the fact that the 2007–08 crisis affected the core of the global financial system, including the United States and European Union, while the Asian crisis had been more contained from a global financial standpoint, even though it covered a very large area in terms of geography and population.
Even after the shift of Leaders’ Summits to the G20 format and the above-mentioned expansion of membership of several key organisations to include emerging economies, the structure of global financial bodies remains markedly imbalanced. Europe is still significantly overrepresented — especially now that the implementation of the set of reforms known as ‘banking union’ implies that national authorities from the 19 euro area countries no longer have policy autonomy, in either banking supervision or monetary policy. Furthermore, almost all global financial regulatory bodies are led by westerners, and headquartered in either Europe or the United States.
Next steps: where to from here
Evidently, it is comparatively easier for the G20 to change the content of financial regulations than the architecture of the institutions which prepare them. Nevertheless, some of the gaps in the current organisational arrangements should be addressed if the G20 is to become more effective at achieving its financial reform objectives. For example, it would be sensible to empower a global body with relevant membership and a clear mandate to issue standards for the global derivatives markets. Some categories of regulated market participants which handle crucial cross-border information, such as credit rating agencies, trade repositories and audit firms, may need to be supervised at a supranational level, as is now partly the case in the European Union. Even some entities that may require public financial assistance in a crisis scenario, such as CCPs, may require more internationally centralised supervisory arrangements in the future than is currently deemed feasible. Among existing entities, future choices of leadership should tilt much more towards diversity of jurisdictional background (and of gender), and, to ensure better legitimacy and acceptance, the relocation of some away from the North Atlantic should be seriously envisaged.
Such suggestions run against considerable institutional and political inertia. The G20 itself is a consensus-based venue, but many of the specialised global public financial regulatory bodies are even more driven by the need for unanimity. In other terms, it would be unreasonable to expect the FSB or any of its members to take the initiative of proposing changes to the existing architecture, even changes that are sorely needed — such initiative belongs to the political leaders. The heads of state who will gather in Hangzhou later this year would do well to reserve part of their time for an open-ended discussion on this theme that might crystallise a process of recognition of at least some of the current institutional gaps, possibly leading to a first set of proposals as early as the G20’s German Presidency in 2017. Going forward, incremental and not-so-incremental changes in the set-up and organisation of global public regulatory and oversight bodies will eventually be needed to enable the maintenance of a decently regulated, globally integrated financial system.
 Nicolas Véron is a Senior Fellow at Bruegel and a Visiting Fellow at the Peterson Institute for International Economics. He is also an independent board member at the Global Trade Repository arm of the Depositary Trust and Clearing Corporation.
 Stéphane Rottier and Nicolas Véron, “An Assessment of the G20’s Initial Action Items”, Bruegel Policy Contribution 2010/08, Brussels, September 2010, http://bruegel.org/wp-content/uploads/imported/publications/pc_2010_08_fin_reg.pdf.
 Transcript of the joint press conference of Nicolas Sarkozy and José Manuel Barroso, 15 November 2008, accessed at http://www.g20.utoronto.ca/summits/2008washington.html.
 See Basel Committee on Banking Supervision, “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems’, December 2010 (revised June 2011), http://www.bis.org/publ/bcbs189.htm, and “Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools,” January 2013, http://www.bis.org/publ/bcbs238.htm.
 See, for example, Institute of International Finance, “The Cumulative Impact on the Global Economy of Changes in the Financial Regulatory Framework,” September 2011.
 See, for example, Anat Admati and Martin Hellwig, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It (Princeton NJ: Princeton University Press, 2013).
 For more information, see Financial Stability Board, “FSB Data Gaps Initiative: A Common Data Template for Global Systemically Important Banks: Phase 2”, 6 May 2014, http://www.fsb.org/2014/05/r_140506/.
 See Financial Stability Board, “Second Thematic Review on Resolution Regimes”, 18 March 2016, http://www.fsb.org/wp-content/uploads/Second-peer-review-report-on-resolution-regimes.pdf.
 G20, Leaders Statement, Pittsburgh Summit, 24–25 September 2009, http://www.g20.utoronto.ca/2009/2009communique0925.html.
 Basel Committee on Banking Supervision, “Regulatory Consistency Assessment Programme (RCAP): Assessment of Basel III Regulations — European Union”, December 2014, http://www.bis.org/bcbs/publ/d300.pdf.
 See Financial Stability Board, “Implementation and Effects of the G20 Financial Regulatory Reforms”, 9 November 2015, http://www.fsb.org/2015/11/implementation-and-effects-of-the-g20-financial-regulatory-reforms/.
 See, for example, Sam Langfield and Marco Pagano, “Bank Bias in Europe: Effects on Systemic Risk and Growth”, European Central Bank Working Paper No1797, May 2015, https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1797.en.pdf.
 Stéphane Rottier and Nicolas Véron, “Not All Financial Regulation Is Global”, Bruegel Policy Brief 2010/07, August 2010, http://bruegel.org/2010/08/not-all-financial-regulation-is-global/.
 To the author’s knowledge, the only exception is the Global Legal Entity Identifier Foundation, established by the FSB in 2014 with a fairly narrow remit.
 Still, the central banks of Belgium, France, Germany, Italy, Luxembourg, the Netherlands, and Spain remain full members of the BCBS, alongside the European Central Bank (ECB) and its Single Supervisory Mechanism; and the national central banks of France, Germany, Italy, the Netherlands, and Spain all retain representation in the FSB’s Steering Committee, alongside the ECB.
 See Nicolas Véron, “Asia’s Changing Position in Global Financial Reform”, in Asian Development Bank and Korea Capital Market Institute, Asian Capital Market Development and Integration: Challenges and Opportunities (New Delhi: Oxford University Press, 2014), http://www.adb.org/sites/default/files/publication/31180/asian-capital-market-development-integration.pdf. In terms of location, the only outlier is the International Forum of Independent Audit Regulators (IFIAR), which in April 2016 announced plans to establish a permanent secretariat in Tokyo.
 The European Securities and Markets Authority is the sole supervisor of rating agencies and trade repositories for all 28 member states of the European Union, including the United Kingdom.
 Nicolas Véron, “Move the Financial Stability Board’s Secretariat to Asia”, RealTime Economic Issues Watch (Blog), 10 May 2012, https://piie.com/blogs/realtime-economic-issues-watch/move-financial-stability-boards-secretariat-asia.