28 November 2013

Bundesbank/Dombret: The euro area – Routes to a stable monetary union

From a financial stability angle, the contagion channels were the key hallmark of the crisis. In the first phase of the financial crisis, beginning in 2008, banks infected each other. The second phase of the crisis then saw banks infect the real economy, and the global financial crisis triggered a global recession. In Europe, banks ultimately infected sovereigns – and sovereigns infected banks. It was this sovereign-bank nexus which fuelled the crisis in the euro area. Essentially, what we are talking about is a "doom loop". If government budgets run into difficulties, this weighs on banks – for example, if they hold government bonds on their balance sheets. Looking at the loop from the opposite direction, if a host of banks – or an individual large bank – experiences problems, then the government has no option but to come to the rescue if the worst comes to the worst. 

Severing the anti-clockwise loop (1) means giving banks better protection against distressed government budgets. Breaking through the clockwise loop (2), means making public finances more resilient to faltering banks.

(1) If it is the anti-clockwise doom loop we are looking to tackle, there are essentially two ways in which we can shield banks against distressed government finances: First, we can make government budgets inherently more stable, thereby reducing the likelihood of them getting into trouble. This could be done either by way of a fiscal union and transfer of sovereignty, or by an improved Maastricht framework. Second, we can introduce regulatory requirements to ensure that banks are better protected in the rare event of a sovereign running into difficulties. In this scenario, it is government bonds we must target. From the perspective of prudential regulation, there are two factors which play a role here: One factor is banks’ capital which under the current regime, banks do not need to hold capital against the risks of loans to sovereigns – unlike other loans. The other factor is the issue that capital alone is insufficient. A crucial tool of risk management is diversification. A cap on loans to an individual sovereign should therefore also be introduced.

(2) But we have to sever the doom loop in the other direction, too – clockwise. We have to protect government budgets from problems in the banking sector. This requires the same underlying strategy we have already applied. First, we have to make banks more stable so that distress is less likely. Secondly, we have to ensure that, if banks do run into trouble anyway, this does not put a burden on public budgets.

If we bring up the subject of how banks can be made more stable, we open up a large field which reaches far beyond the boundaries of Europe. Reforming banking regulation is a global topic and is being conducted at the global level. The G20 leaders have developed a comprehensive reform agenda, a large portion of which has already been completed. Central pillars of necessary regulatory reform are new capital rules and new liquidity rules. And, here, we have come a long way since the crisis. The new rules under Basel III require banks to hold more and higher-quality capital than ever before. At the same time, we have agreed on an international liquidity standard for the very first time ever. As soon as the new rules are finally in place, banks will be much more stable.

Joint supervision will also make it possible to supervise banks everywhere according to the same high standards. That will prevent regulatory arbitrage. Finding a solution to the "too big to fail" problem will be critical in order to protect public budgets from banks’ distress. What we need is a resolution mechanism which will allow even large banks to be resolved without jeopardising the financial system or requiring the taxpayer to foot the bill. On the whole, the Banking Union is a key milestone on the way to a stable monetary union, not least because it will help to sever the sovereign-bank doom loop – at least clockwise.

Thus, to sever this loop, we will have to pull levers at several different places: We have to improve the framework of monetary union, especially with regard to the rules for sovereign debt. We have to adapt banking regulation. We have to elevate banking supervision to the European level. And we have to establish mechanisms which allow

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