While the current economic situation justifies an expansionary monetary policy stance in the euro area, it is also appropriate, in my view, that the Governing Council, at its last policy meetings, refrained from loosening it any further. And we shouldn't ignore the fact that, even with monetary policy rates unchanged, the increase in inflation rates automatically leads to lower short-term real interest rates and, therefore, to a further loosening of the monetary policy stance.
Given the long and variable time lags in monetary policy, it is important to give the measures taken enough time to have an impact on the inflation rate. In this regard, we should bear in mind that the ECB's definition of price stability aims at an inflation rate of below, but close to 2%, in the medium term. [...]
Fiscal policy in the euro area has been loosened again noticeably over the past few years. What governments are saving in interest payments isn't being put towards the urgent goal of reducing debt, but spent for the most part. Germany is no exception here, by the way.
Furthermore, the low-interest-rate environment is impairing the profitability of banks and life insurance companies.
Admittedly, bank profitability and the sustainability of life insurance and pension companies' business models is not a target of a monetary policy geared solely to preserving price stability. But monetary policy cannot afford to ignore these developments if banks' health problems endanger the monetary transmission mechanism, or doubts about the stability of life insurance or pension companies prompt households to increase their precautionary savings, because both could depress the outlook for price stability further still. [...]
Today, however, there are some who mistrust the welfare-enhancing effect of international trade and who stress what they believe to be its negative effect on the distribution of income and wealth in society. National tendencies to turn inwards are becoming increasingly popular - the UK's Brexit vote is one example of this; another is the exhausting CETA negotiations which very nearly failed due to very fundamental concerns raised by the region of Wallonia. [...]
So as for Europe, we do not need a less open market but a more open one. It would be counterproductive if the difficult political situation in Europe - caused not least by the Brexit vote - were to bring to a standstill Europe's efforts to complete the single market for services, achieve a digital single market, or build up a capital markets union. [...]
3. Reform of European monetary union
Implementing economic reforms at the national or European level as a way of strengthening the euro area and restoring trust in the agreed rules of European monetary union (EMU) is also important to improve the cohesion in the euro area, which has undoubtedly suffered from the financial and sovereign debt crises. What's also crucial, however, is to make the institutional setting of EMU more stable. [...]
If banks assume they are too big to fail, they will be tempted to make the most of this implicit insurance and take on excessive risks, at the expense of society at large. This is exactly what happened before the financial crisis.
This kind of implicit insurance is not altogether unfamiliar to the framework of EMU, where a single monetary policy exists alongside 19 largely autonomous economic and fiscal policies.
As the crisis taught us, this set-up potentially exposes EMU to vulnerability because at the end of the day, the community may have to foot the bill for unhealthy developments in individual member states if it wishes to prevent the stability of the union as a whole from coming under threat. [...]
[...]striking an even balance between liability and control is crucial for the functioning of EMU - and that's a point I made in my last speech in Amsterdam 2½ years ago. And I also said in my speech back then that there are two possible ways to restore the balance between liability and control: deeper integration, or more individual national responsibility on the part of the member states.
The first solution would be to create a fiscal union with centralised decision-making powers. Only within this framework would fiscal transfers and mutual liability via Eurobonds be consistent and put control and liability back on an even keel.
While a fiscal union would not guarantee sound fiscal policymaking, it could certainly mitigate the deficit bias of individual member states. And interestingly, even for Karl Otto Pöhl, the former Bundesbank President who was a member of the Delors Commission, the "fiscal union approach" was the intuitive one: "In a monetary union with irreversibly fixed exchange rates, the weak would become ever weaker and the strong ever stronger. We would thus experience great tensions in the real economy of Europe. For this reason alone, monetary union without the simultaneous integration in fields like fiscal policy as well as regional and social policy is completely inconceivable."
But let's be honest here: a fiscal union approach was not on the cards 2½ years ago, and it has become ever more improbable since then.
The outcome of the Brexit referendum has laid bare the scepticism about the European project and a tendency to reject further integration steps. Surveys reveal that many citizens in the EU doubt whether the existing process of integration is still sustainable. This is possibly not unrelated to the fact that the ongoing debate over the right response to the crisis in the euro area has brought out into the open the persistent differences of opinion in fiscal and economic policy matters.
This is all the more astonishing because the euro-area countries had actually already established a consensus on the appropriate role of fiscal policy - as documented in the Stability and Growth Pact. So building trust in the rules we already have today is paramount before we engage in major new integration steps.
To cut a long story short: a fiscal union, which would require member states to surrender substantial national sovereignty, hardly seems feasible at the moment. And as long as there's no willingness to transfer national sovereignty to the European level, there will be no basis for mutualising sovereign risks - and that's why the proposal to establish a European Deposit Insurance Scheme (EDIS) isn't the right institutional response to restore the balance between liability and control in the euro area.
As long as actions taken at the national level, such as drafting insolvency law or very high stocks of government bonds on banks' balance sheets, can have a substantial impact on the health of financial institutions, EDIS would allow risks to be shifted to the European level. This would send the wrong incentives to banks and investors alike. The mutualisation of risk would not go hand in hand with the necessary mutualisation of control rights - irrespective of the Single Supervisory Mechanism that was put in place.
The second way of restoring the balance between liability and control, meanwhile, would be to strengthen the Maastricht approach based on individual responsibility. This would leave economic and fiscal policy, as well as ultimate liability for public debt, in the hands of the individual member states. But how could such a decentralised approach work better in future than it has done in the past?
One of the problems in the run-up to the crisis was that the fiscal rules were incapable of effectively limiting the increase in public debt. Although the rules were changed after the crisis, the European Commission was granted more flexibility in interpreting them. And it has used this flexibility quite a few times so far - and always to interpret the rules very loosely. As a result, the binding force of the budgetary rules is weaker than ever before, as we can see, for instance, in the budgetary developments in France, Spain and Portugal.
One way of ensuring that the rules are binding would be to install a new and independent authority, a fiscal council. This institution would not be exposed to the same political conflicts of interest as the Commission, which has to assess whether national budgets comply with the Stability and Growth Pact and hammer out political compromises between the interests of the different member states. [...]
Binding fiscal rules and an institution that observes their adherence are just one component of a consistent reform agenda. Additionally, it is important for capital markets to resume their role of disciplining national fiscal policy. More deeply indebted countries ought to pay higher interest rates. This will only happen if the no bail-out clause in the Maastricht Treaty really has teeth. Therefore, it must be possible to restructure public debt without posing major risks to the financial system.
The July edition of the Bundesbank's Monthly Report describes what needs to be done to make this possible. There are two reforms I'd like to mention in the following.
First, we need to sever the sovereign-bank nexus. The European banking union already marks a huge step towards untangling this dangerous embrace. However, to this end, and to complement the banking union, it is also crucial to do away with the preferential treatment of sovereign debt in banking regulation. This implies that sovereign exposures will need to be backed by capital and also be part of a large exposures regime.
A second measure concerns the design of the European Stability Mechanism's financial assistance programmes. The ESM is there to provide resources to countries that apply for an ESM financial assistance programme. However, these funds are generally not only used to cover budget deficits, but also to redeem maturing sovereign bonds. By implication, when a programme is activated, European taxpayers are, in essence, bailing out the respective country's creditors. If a haircut ends up being the only way to restore a country's debt sustainability, taxpayers, rather than investors, would shoulder the bill.
This does not exactly foster any willingness on the part of member states to agree to restructure a programme country's debt. Instead of a truly viable solution being reached, when push comes to shove, a strategy of muddling through would win the day.
That's why the Bundesbank is proposing to add a clause to the government bonds of euro-area countries which automatically extends the maturity of bonds by three years if the member state in question applies for ESMassistance. This way, the initial creditors would remain liable, and if the government debt really does need to be restructured, that could be done in an orderly fashion without jeopardising financial stability.
Our proposals would help to sever one direction of the sovereign-bank nexus: banks would be better shielded from a deterioration in public finances. The financial crisis showed, however, that wobbling banks can lead to stumbling sovereigns. To cut this direction of the nexus, financial market regulation will need to be enhanced further.
4. Financial market regulation
[...] The goal of the Basel III framework, then, is to strengthen the resilience of the financial system. But to achieve that goal, it is important for Basel III to be implemented completely. This is especially the case for the currently debated elements of the Basel III framework, which are scheduled to be finalised by the end of this year.
But a well-functioning banking system is essential for financing the real economy, and it is therefore crucial for an ongoing economic recovery in the euro area. That's why it's important to reiterate that we shouldn't introduce a "Basel IV" framework through the back door. The GHOS are absolutely right to stress that finalising Basel III shouldn't lead to a further significant increase in banks' capital requirements, and - might I add - the outcome should also be regionally balanced.
Finalising Basel III is not an easy task. While I would admit that the distinct differences in how banks' internal risk-based models assess credit, market and operational risks need to be reduced, an approach consisting of excessively high parameter floors that would effectively undermine the risk-weighted approach taken in Basel III would not be an appropriate solution.
Risk-weighted measures were initially introduced by Basel II to encourage banks to enhance their internal risk management and rating models by adapting to the regulators' standards. This general route is still appropriate. However, while the financial crisis revealed that banks still underestimated certain risks, Basel III rightly continues to adhere to the risk-based approach.
A regulatory framework following the non-risk-weighted approach would be fraught with problems of its own. It sets banks problematic incentives to take greater risks. And so it was decided to improve regulatory standards within the Basel III framework. The comparability of parameters between banks' internal models and regulatory models as well as across different financial institutions and jurisdictions has to be adjusted with a sense of proportion.
Nevertheless, the leverage ratio - as a non-risk-weighted instrument - is a useful complement as a backstop. I therefore agree with my colleague Mark Carney from the Bank of England who once said in this context that it is sometimes good to wear a belt and suspenders to prevent your trousers from falling down.
Last but not least, I would like to come back to a point I mentioned earlier on today, which is directly related to financial regulation: Sovereign exposures on banks' balance sheets still represent a channel for the dangerous sovereign-bank nexus which acted as an accelerant in the euro-area crises. It is essential, then, for sovereign debt to be incorporated appropriately into banking regulation. [...]
Full speech
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