The important aspect to stress is that we cannot have a CMU without the existence of a European risk-free rate and the absence of significant financial fragmentation and redenomination risk. In this way, only the idiosyncratic credit risk should matter for asset valuations in any region of the monetary union without having to consider redenomination risk.
Completion of Banking Union
Completing the Banking Union would seem to be an easier goal to achieve. Launching the EDIS with a firm unconditional timetable and deciding on the fiscal backstop both for EDIS and the Single Resolution Fund (SRF), as proposed by the ECB in its Public Opinions, would be the logical steps in a project that all countries claim to support. The need for a backstop, both for EDIS and the SRF would recommend the merger of EDIS with the Single Resolution Mechanism (SRM) to form a sort of European FDIC, which would economise resources and the gathering of information.
A large amount of risk reduction has occurred over the past few years in the more vulnerable countries and their banking sectors. All countries have economic growth; all countries now have positive budget primary balances (the Spanish one is still slightly negative) and all show positive current accounts, and their banks’ capital ratios have significantly increased. Risk was also reduced with the Bank Recovery and Resolution Directive (BRRD), the practical disappearance of the ESM bank’s recapitalisation programmes that now require the previous application of the BRRD, the creation of the SRM, the implementation beginning of the Minimum Requirements of Eligible Liabilities (MREL) and the visible reduction of non-performing loans under the pressure of the ECB/Bank Supervision.
The truth is that so far the Banking Union project has been exclusively about risk reduction and no specific element of risk sharing has been introduced.
In an exercise of changing the goalposts whenever the defined ones are on the brink of achievement, several stakeholders consider that more risk reduction has to be delivered before decisions about EDIS can be taken. Perhaps there are concerns that EDIS will imply significant transfers across countries in case of a new banking crisis. In the recently published ECB’s Occasional Paper, by simulating severe banking crises we precisely demonstrated that with proper risk-based banks’ contributions a almost negligible cross-border subsidisation occurs.
Another aspect of risk reduction refers to the holdings of domestic sovereign debt by banks. Indisputably, the credit risk situation of sovereigns affects banks via several channels, including the amount of debt they hold. However, the influence of the sovereign on national firms, both banks and non-banks, seems to be similar through the powerful effect that a sovereign in difficulties spreads to the whole economy. Over time, for European countries, CDS premia of non-financial firms and banks are impacted in a similar way when the country the sovereign credit rating severely deteriorates. During the crisis, CDS premia do not even show that banks with higher ratios of domestic public debt did significantly worse than others with lower ratios. It is difficult to presume that, with some degree of diversification, the situation of banks can be significantly disconnected from the sovereign position. This “macro channel” dominates the impact and also plays an important role when Credit Rating Agencies decide on banks’ ratings. [...]
A last aspect to underline is that no country can reduce the accumulated stock of debt in a few years and has to ensure its annual rollover needs, naturally having to heavily rely on the holders of the redeemed debt. Some countries have to rollover several hundred billion euros every year. The issue therefore is not just about new debt flows, where things would be easier to change.
Despite all this, I have supported a change to positive risk weights for holdings of domestic debt in different fora. The weights would start at low levels and increase with the degree of concentration (measured by the ratio between holdings of domestic sovereign debt and Tier 1 capital), particularly above a ratio of 150%. The justification for this threshold is twofold: first, the regulatory imposition related to the Liquidity Coverage Ratio (LCR), requires holdings of sovereign debt that represent an average close to 100% of Tier 1 capital; second, the radical reduction of the unsecured interbank market in favour of the use of secured transactions (repos) that mostly use sovereign paper, further increases the need for banks to keep a sizable portfolio of sovereign debt. [...]
Additional reforms to complete banking union must include harmonisation of insolvency laws, direct implementation powers to the SRM and the creation of a scheme of provision of liquidity in resolution that only the ECB can implement, with appropriate government guarantees as is the case in other jurisdictions.
Creating a European safe asset
The only good solution to achieve a degree of diversification in banks’ holdings of sovereign debt is to introduce a new European safe asset, built on the basis of national sovereign bonds. This asset would have other, more important roles to play by creating a benchmark rate, thereby making a Capital Markets Union with a sizable and deep European bond market possible.
I am not referring to the type of Eurobonds that would substitute national sovereign debts as a joint liability of member States, as this would require a deep political union. Among the various proposals put forward, I will concentrate on just two: a variant of the ESBies or SBBS and the e-bonds as proposed in the Monti Report.
The current proposal of the SBBSs refers to a tranched, synthetic bond backed by national sovereign bonds. The proposal tries to demonstrate that the structure would assure a senior tranche with lower risk than German debt as a result of the diversification gains based on historical correlations. Market players and rating agencies have been sceptical of the instrument. [...]
Their main concern is a perceived lack of diversification to ensure that the senior tranche can be indeed as safe as claimed because correlations among several countries’ debt could increase in a stressful situation (as occurred during the financial crisis). Also, it may be difficult to sell the junior tranche at coupon levels that do not compromise fatally the overall economics of the synthetic security issuance. Indeed, if the junior tranche had to be placed at a relatively high coupon, then the senior tranche would need to offer a lower coupon than Bunds, a doubtful selling prospect. This would render the economics of the SBBS inviable, which would be very unfortunate.
These obstacles could be overcome if, for instance, a small first loss tranche were to be covered by a public guarantee, jointly provided by member states. Such contingent liability could be limited to a reasonable level. The success of the synthetic European bonds would have significant benefits for financial integration and for the banking and capital markets union. This would be my preferred solution.
The alternative of e-bonds issued by a European entity as a pure securitisation of sizable amounts of national sovereign bonds but with higher privileged credit status over them would be less efficient and could increase the cost of issuing the non-preferential part of pure national debt. This could even act as a disciplining device and would not necessarily imply an increase in the costs of the total debt issuance. For instance, according to a recent working paper of the Peterson Institute, in order to have an expected five-year loss rate of 0.5% or lower, the European entity could securitise 50% of a country’s debt or 25% of its GDP. The benefits of having a European safe asset would be enormous to strengthen the overall resilience of the euro area. [...]
Creating a genuine Capital Markets Union
An integrated European bond market as a central piece of a Capital Markets Union (CMU) cannot ultimately exist without a European safe asset. A single-term structure of risk-free interest rates could serve as a euro area pricing benchmark for the valuation of bonds, equities and other assets. The safe asset could also be used as collateral, for example for repo and derivatives transactions across the euro area.
An advantage of a CMU is of course, the promotion of private income and consumption smoothing across the whole area, thus mitigating the effects of localised, recessionary episodes. The evidence shows that in the U.S., the three channels of income smoothing across states (public transfers, capital markets income and credit) are able to smoothen around 60% of economic income shocks, whereas in the euro area that number decreases to 20%. The studies behind these findings normally use historical data that include periods of normality and, as a 2015 IMF working paper highlights, risk sharing is significantly reduced in periods of severe downturns as a result of the quasi disappearance of the credit channel. This provides one rationale for the creation of a European fiscal risk sharing mechanism. [...]
Developing a well-functioning capital market which supports economic growth across Europe requires a comprehensive approach, with a much more ambitious agenda. To that end, Europe needs to boost the supply of equity finance. Policies which stimulate individual ownership of traded shares, such as reducing the tax advantage of debt over equity or enhancing financial literacy, can have a material effect on public equity markets in Europe. At the same time, because stock markets often penalise companies which undertake radical, but uncertain, innovative activities, the contribution of private equity – particularly in the form of early-stage venture capital finance – is indispensable, as a critical mass of angel investors who can provide financing for medium-size projects is also needed. Only with a deep, liquid market is it possible to launch IPOs of successful projects that can offset the losses with projects that fail. [...]
We should however, be well aware that CMU requires a European safe asset, the harmonisation of taxes on financial products, a convergence of company law, including on bankruptcy, the creation of a single rule book of regulation for markets activity and ultimately a European Single Securities Market Supervisor. The other big condition is a rock solid monetary union so that assets’ risks and returns are not significantly influenced by redenomination risk but exclusively by their idiosyncratic features. A heavy toll, I know, but I will believe that the CMU project is possible when I see authorities start making inroads in some of those difficult issues.” [...]
A macro stabilisation function
A central fiscal capacity for the euro area has been identified as a necessary reform to correct a basic deficiency of EMU — the absence of appropriate macroeconomic management beyond monetary policy. The necessary central fiscal capacity has two elements: an effective institutional mechanism to ensure co-ordination of national fiscal policies in order to discuss and decide an adequate euro area fiscal policy stance; second, a complementary central Stabilisation Fund that can take several different forms. [...]
What is necessary is a stabilisation fund in periods of significant shocks, in the form of a “rainy-day” fund that would provide transfers to be used in public spending with high multipliers for maximum effect, like investment or income support to the unemployed. The European Stabilisation Fund (ESF) transfers should not permanently benefit the same countries and, to avoid moral hazard, the use of the ESF should be conditional on past compliance by countries with the existent fiscal rules. The design of the Fund should also include sufficient features to avoid disincentives in the implementation of structural reforms. Triggering the transfers should be automatically dependent on a threshold indicator based on the unemployment rate. [...]
Stability Pact review
A crucial contribution towards a stable monetary union must come from the proper behaviour of member states in avoiding domestic imbalances and promoting healthy growth. The Stability and Growth Pact (SGP) and the Macroeconomic Imbalances Procedure (MIP) are two important instruments to nudge countries in that direction. [...]
Conclusion
[...]
A solid, effective monetary union requires national and European institutions that can ensure a cohesive economic and financial performance thus avoiding excessive imbalances, financial fragmentation and significant persistence of redenomination risk for member states. In turn, these features imply my order of priorities for the reforms I consider necessary: acceptance that the ECB has no excuses not to intervene in the sovereign bond market to deal with acute liquidity stress; creation of a central fiscal stabilisation function for macroeconomic management, including a Stabilisation Fund; introduction of a European safe asset; completion of Banking Union; a quantum leap in creating a genuine Capital Markets Union, using an enhanced co-operation to speed up the process; an improved fiscal rule to discipline countries’ fiscal policies. [...]
Full speech
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