12 February 2016

VoxEU: Safeguarding the euro – balancing market discipline with certainty

The eurozone crisis has shown that the eurozone is still not a properly functioning currency union. There are three areas of further reform: disentanglement of sovereigns and banks, completion of a banking union, and an institutional convergence for a fully integrated financial system.

Disentangling sovereigns and banks

[...]The task is thus to separate governments and banks, in reality and in perception. It is almost too obvious to state – and so I will not focus on this – that continuous talk about a Grexit will undermine this task, but there are other important steps to be taken.

First, ‘europeanise’ Greek banks; i.e. there should be no influence of the Greek government authorities or the Greek central bank over the domestic Greek banks. The recent ouster of the CEO of one of the major Greek banks clearly shows that this has not been achieved yet. Even the impression of a link between government and banks, however, will put in question the solvency and liquidity of Greek banks, if and when the Greek government gets into trouble.

Second, the ECB should not be part of the Troika and thus creditor of the Greek government, as it faces a clear conflict of interest by: being a lender to the Greek government; supervising the banks that hold Greek government bonds; and having the task to keep Greece within the Eurozone. This conflict of interest came clearly to light during the recent stand-off in July when the ECB had to decide on a daily basis whether to extend liquidity support for the Greek banks or not, based on (in)solvency assumptions of the Greek banking system, which in turn depends on assumptions about the solvency of the Greek government.

Third, regulatory safeguards have to be strengthened to disentangle governments and banks. This would require putting concentration limits on government bonds of any government, similar to single borrower exposure limits. In the long run, the development of non-bank financial institutions will help by diversifying the holdings of government bonds across a large array of investors.

Fourth, it would be good to revive the idea of synthetic Eurobonds as collateral instrument for ECB refinancing purposes, built out of portfolios of individual countries’ government bonds (e.g. Brunnermeier et al. 2011, Beck et al. 2011), which would per construction limit the exposure of Eurozone banks to their government’s debt.

Finally, there is the broader question of the sustainability of large government debts across several Eurozone countries (Eichengreen and Panizza 2016), an issue beyond the financial sector and requiring a political solution. [...]

Completing the banking union

As much as the current banking union structure is beyond even the most ambitious dreams of economists in 2008/9, several important elements of a fully functioning banking union have been missed, including a purely supra-national European bank resolution and a proper funding mechanism. [...]

A second issue is the creation of a truly European banking system. This does not imply the absence of local banks; it rather implies cutting the unhealthy entrenched relationships between dominating local banks, supervisors and politicians. [...]

One important issue is the regulatory perimeter. The brief of the SSM seems to be limited to regulated banks and cannot be easily – i.e. without further European-level legislation – be extended to bank-like or non-bank financial institutions seen as systemically important. This puts the regulator at a disadvantage as financial intermediaries shift risk towards outside of the regulatory perimeter. Second, what is the role of the SSM in macro-prudential regulation and its relationship with the ESRB (which covers the whole European Union and not just SSM members)? While the SSM can use macro-prudential tool covered under the CRR and CRD IV, it cannot use other macro-prudential tools, which will remain exclusively under national authority (Sapir 2014). Given that not only micro- but also macro-prudential decisions have externalities beyond national borders, this seems another gap in the banking union. The ESRB, which does not have any formal powers beyond issuing warnings and recommendations, cannot completely fill this gap.

Finally, what is the relationship with non-Eurozone countries, both those that will join the SSM and those that will not? The critical difference for non-Eurozone members of the SSM would be an asymmetry in their financial safety net, with lender of last resort and resolution funding strictly on the national level, although solutions such as access to liquidity lines might be considered (Zettelmeyeret al. 2012). Cooperation with the Bank of England, which will stay out of the SSM for the near future will be critical, given the importance of London as financial centre. Ultimately, tailor-made solutions are necessary for arrangements with European countries outside the Eurozone (Beck and Wagner 2016).

By reducing banking nationalism within the EU, carefully designed regulatory reforms in banking can thus also contribute to the recently advocated Capital Markets Union. Ultimately, however, the banking union will not be able to stand alone without further integration along other policy dimensions, most prominently fiscal policy. From an optimistic viewpoint, banking union might open the door to such reforms; from a pessimistic viewpoint, further reforms might be prevented by the lack of a fiscal union. [...]

Aiming for institutional convergence

A Single European Market in Banking as well as a Capital Market Union rely on convergence in the underlying contractual and informational institutions. A lot of progress has been made in the regulatory area for the banking system within the eurozone (in the form of the above discussed banking union). Plans to create a eurozone-wide credit registry are under way and will also help both for stability and competition purposes. Other plans for strengthening regulatory institutions and clearing systems are very welcome to foster the integration of capital markets across Europe and help the development of other non-bank components of the financial system. The necessary institution building for integrated capital markets, on the other hand, is more difficult to undertake, given that legal codes, including contract and insolvency laws, are historically grown and entrenched. Similarly, the institutions to apply and execute these laws (courts, registries, legal profession etc.) have developed over generations and centuries. A convergence process in the legal framework is thus a much longer-term process than regulatory convergence. However, it is never too early to start on this.

Full article on VoxEU

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