20 August 2016

VoxEU: The glass is still half-empty: Eurozone stability under threat of a ‘bad shock’

Why financial stability in the Eurozone cannot be taken for granted             

I see three main reasons why the Eurozone remains exposed to a new shock bad enough to endanger its survival. First of all, the re-emergence of severe stress in the Eurozone financial markets is likely to lead to the same acrimonious and publicly voiced disagreements on the source of the shock and its remedies as when the Greek public sector woes first came to full light in 2010. In this regard, failure to agree on working risk-sharing arrangements for sovereign and banking risks reflects fundamentally different, and indeed incompatible, views on the way to bring about lasting financial stability to the Eurozone. The latest manifestation of this is the recent decision by the ECOFIN Council to freeze ‘political’ negotiations on EDIS until “sufficient progress has been made on measures for risk reduction” and, furthermore, that any such negotiation will resume in the framework of an inter-governmental agreement, requiring unanimity, and no longer under the normal Community decision making under Article 114 (the legal basis for the internal market legislation). I view this decision as an official declaration that the sovereign-bank doom loop may restart at any time.

It is also unclear that the task of meeting a new bad shock could be left solely to the ECB, as has happened so far. For one thing, a repeat of the 2014 OMT hocus-pocus to stabilise the sovereign debt market of a member state under attack without real interventions would probably not work. However, real market interventions could only be initiated after the country concerned had signed up to an economic programme with the ESM entailing “strict and effective conditionality” – i.e. another intergovernmental negotiation, possibly highly divisive, possibly too slow to allow the required swift action by the ECB. Similarly, a lot of the goodwill of the ECB with German policymakers has been consummated to justify quantitative easing, perhaps entailing a reduced ability for the ECB to make ‘unlimited’ resources available for the stabilisation of financial markets in the periphery. Investors would of course recognise the predicaments of the central bank. An ominous sign, in this regard, has been that peripheral sovereigns’ risk premia over the Bund have returned to levels that had not been seen since the start of quantitative easing, following the Brexit referendum.

Finally, the reason why a bad shock cannot be ruled out is that the Eurozone is still plagued by severe imbalances in its banking and financial system. According to the IMF's latest Global Financial Stability Report, one in three banks in the Eurozone must confront severe challenges due to legacy issues (900 billion of non-performing loans and an unspecified amount of toxic assets), and the need to revise business models to respond to a sharply modified economic environment, and adapt to taxing regulatory changes. Let me note in passing that the Italian banking system only makes up for about a third of the bad loans, and is virtually clean of other toxic assets. As bank stocks often trade at heavy discounts from book value, raising fresh capital in the market can be prohibitively expensive, raising the cost of capital well above the banks’ ability to remunerate it. This aggregate fragility has come to the fore after the British referendum, with bank stocks sinking to new lows throughout European markets.

The rules on burden sharing and bail-in for state aid to banks

The new rules on state aid and the BRR directive require that shareholders and creditors share the cost of any public intervention to shore up bank capital, but they provide the leeway necessary to suspend burden sharing when financial stability may be put at risk. This risk is stronger when extensive weaknesses plague the banking system.

In such circumstances, expectations of the use of burden-sharing and of the bail-in tool by competition and resolution authorities directly affect the risk of capital instruments in the banking sector and, if not properly governed, may actually become a source of instability rather than firming up the system. [...]

Full article on VoxEU

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