25 October 2012

Bundesbank/Dombret: As goes Ireland, so goes Europe?

Dombret said that the Irish experience held valuable lessons on how to overcome the crisis. He also said he believed that two regulatory reforms, a comprehensive bail-in of creditors and an adequate risk-weighting of sovereign bonds, were needed to complement the envisaged banking supervision.

The way forward

Breaking the link between banks and sovereigns is vital for making the euro area more stable. A banking union can very well be a major step in that direction – but by harnessing the disciplinary forces of the market, not by doing away with them. Core elements of a banking union therefore have to be: First, a comprehensive bail-in of bank creditors, and second, an appropriate risk-weighting of sovereign bonds.

In order to minimise the risk that bank rescues pose to government finances, creditors have to be the first in line when it comes to bearing banks’ losses. Implicit guarantees have to be removed as taxpayers’ money can only be the last resort. By the same token, sovereign bonds need to be risk-weighted appropriately when it comes to the adequacy of capital buffers. Riskier bonds have to become more expensive in terms of the amount of equity that they tie down, as is already the case for non-sovereign bonds. This serves two purposes: On the one hand, surcharges of this kind should translate into lower demand and, hence, into larger spreads, which gives a disciplining signal to the respective sovereign. And, on the other hand, banks would become more resilient in the event of market turmoil.

Adequate risk-weighting of sovereign bonds helps to prevent fiscal difficulties from translating directly into financial instability. If fiscal autonomy remains with national Member States, which is still the status quo in the EU Treaties, this is crucial. Banks have to internalise the fiscal position of sovereigns in a similar manner as they take into account the risk of corporate bonds or loans. Otherwise, the envisaged recapitalisation of banks via European funds could turn out to be a backdoor for mutualising sovereign solvency risks.

I therefore believe that these two regulatory reforms – a comprehensive bail-in of creditors as well as an adequate risk-weighting of sovereign bonds – need to complement the envisaged European supervisory mechanism. In principle, this single European supervisor can help prevent future crises by enforcing the same high standards irrespective of the banks’ country of origin and by taking transnational interdependencies into account.

At the moment, it looks as though this task shall be carried out by the European Central Bank. This is, first of all, an expression of confidence in the competence of central banks in general and in the ECB in particular. But conducting monetary policy and financial supervision does not come without risks. If the institution responsible for ensuring the financial soundness of banks simultaneously influences banks’ financing conditions via its monetary policy, conflicts of interest may arise. Besides, the resolution of banks implies intervening in property rights, which requires democratic accountability. If the ECB is to be tasked with supervising European banks, there will have to be a strict separation of monetary policy and supervision. Such a separation will be difficult from both a legal and an organisational point of view. In this respect, there still are questions that need to be resolved.

A banking union will contribute to financial stability, if its design preserves sound incentives for all actors involved. This holds true not only for future risks, but also for risks that have already materialised. Economically speaking, a banking union is basically an insurance mechanism. And, as with any insurance, only future losses or damages that are unknown ex ante can be covered. No doubt, the banking union is an important building block for a more stable monetary union. But, as such, it is meant to mitigate future risks and not to cover past sins.

In this context, I fully understand that Ireland is closely following the conditions under which euro area Member States will provide financial assistance to Spain for the recapitalisation of its financial institutions. One specific point is the degree of bondholders’ participation in the Spanish restructuring process. The Eurogroup stated in July with respect to Ireland: “Similar cases will be treated equally, taking into account changed circumstances”. However, as this issue is currently under discussion I prefer abstaining from public comments. Instead I like to share my view with you on the issue of legacy assets in general.

Legacy assets are those risks which evolved under the responsibility of national supervisors. From what I have already said, it follows that these assets have to be dealt with by the respective Member States. Anything else would amount to a fiscal transfer. It may be that such fiscal transfers are desired or even deemed necessary. But then, they should be conducted via national budgets and subject to approval of national parliaments, rather than under the guise of a banking union, which would then have to start under a heavy burden. And, in the event of such transfers the proper sequencing of events is the key. We should not end up in a world where risks from bank balance sheets are rapidly mutualised, while an effective single supervisory mechanism would be slow in coming.

A banking union will therefore not be a quick fix. But it can be an important milestone towards a more stable and prosper monetary union and hence instrumental in regaining confidence in the euro area.

Ireland has made enormous progress in the process of regaining trust and confidence. Important financial market indicators are an expression of this fact. CDS premia for the Irish sovereign have fallen continuously in 2012. In the meantime Irish CDS premia are below those of Spain and even Italy. The same development can be observed for the spread over German bunds. All of these developments are the result of “leading by example” with structural reforms. Hence, I see no reason for Irish CDS changing the course, and I doubt that this would truly be in Ireland’s best interest. I suggest not to jeopardise what has been achieved so far.

© Deutsche Bundesbank