17 January 2013

Michael C Bonello: The changing nature of economic and financial governance following the euro area crisis

In his speech, the Governor of the Central Bank of Malta addressed the ramifications of the European crisis, as manifested in the banking system, in sovereign debt markets, and in the economic slowdown.

The ECB has adopted various non-standard measures, which have included long  term refinancing operations that inject ample liquidity into the financial system. The ECB has  gone a step further by announcing an Outright Monetary Transactions (OMT) programme. This is designed to repair the link between policy rate cuts and ample liquidity provision, on  the one hand, and lower borrowing costs, on the other. It is also meant to counter the so-called redenomination or convertibility premium that compensates investors for the perceived  risk of a break-up of the monetary union. OMT are actually equivalent to traditional open market operations that central banks have long resorted to in order to provide stability and a  better functioning of the monetary transmission process that can get impaired in certain  circumstances. 

The unfolding of the crisis has revealed various intertwined dimensions of the existing fragilities and a broad range of imbalances. In various ways, the problems that are evident in the euro area are of a structural nature, resulting in a number of governance reforms that are currently underway. Inappropriate banking practices, weak regulatory frameworks, fiscal  slippage and deterioration in competitiveness are now recognised as the main sources of the  crisis.

A fundamental aspect of the banking crisis is the failure of regulation, which allowed financial  institutions to engage in excessive risk that was not matched by adequate capital protection. Systemic risk was exacerbated via strong linkages between financial institutions. 

On the fiscal side, governance has been enhanced by the strengthening of the Stability and Growth Pact. There appears to be broad consensus that to avert the recurrence of the crisis, fiscal consolidation should be enshrined in the governance structure of every country. Surveillance is enhanced and the monitoring of economic policies is becoming more comprehensive. To this end, the Fiscal Compact obliges all euro area countries to run a structurally balanced budget. In particular, the problem of sustainable budget planning is addressed by introducing a country-specific medium-term budgetary objective, which involves a cap on growth of public expenditure that is in line with the medium-term rate of growth. The Fiscal Compact also accelerates the application of the excessive deficit procedure by introducing sanctions when the debt and deficit to GDP ratios are excessive.   

Fiscal surveillance has been extended to a broader excessive imbalances procedure, which goes beyond fiscal imbalances and seeks to identify and correct a range of macro imbalances and shortcomings in competitiveness. In fact, various euro area Member States ran into problems despite of their adherence to the SGP criteria, to the extent that they nonetheless manifested other types of imbalances, such as excessive private indebtedness. Preventive recommendations are provided to member countries at an early stage in the formation of imbalances. 

The severity of the financial crisis has also exposed the inadequacy of the current financial sector regulation and supervision. As already indicated, macro-prudential risks were overlooked and the link between sovereigns and banks was underestimated. In reaction to this, European institutions and Member States have engaged in a major overhaul of bank regulation and supervision with the objective of creating safer, sounder and more transparent  financial institutions.

Regardless of the particulars of the eventual governance changes, it is clear that the economic and financial crisis has been the spark for reforms that may reshape economic institutions and financial supervision at both the national and international levels. These high level governance reform changes will also filter down to the corporate level, especially at the level of financial institutions, affecting also borrowers and lenders across the economy.

Full speech

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