The ECB’s Outright Monetary Transactions framework helped address severe market distortions and improve the efficiency of monetary policy. The completion of the ESM firewall, the extension of official loan maturities to programme countries, the improvement in the policy coordination framework, and the agreements on Greece and Cyprus have also been instrumental in combating the crisis. And national governments have made progress in restoring the health of public finances and implementing structural reforms. Together, these actions have helped tackle dangerous tail risks for EMU and led to positive spillovers outside the euro area.
Nevertheless, the centrifugal forces across the euro area remain serious and are pulling down growth everywhere. Financial markets are still fragmented along national borders and the cost of borrowing for the private sector is high in the periphery, particularly for smaller enterprises. Ailing banks continue to hold back the flow of credit. In the face of high private debt and continued uncertainty, households and firms are postponing spending—previously, this was mainly a problem of the periphery but uncertainty over the adequacy and timing of the policy response is now making itself felt in falling demand in the core as well. Needed fiscal consolidation is also weighing on growth. And with unemployment, especially among the youth—at record levels, there is a risk of long-term damage to potential growth and to political support for reforms, including for further progress on EMU architecture.
Stronger bank balance sheets are essential for economic recovery. Faced with high funding costs, weak banks are unable to recognise losses. This perpetuates uncertainty about the quality of their assets, hinders fresh private capital injections, and ultimately restrains credit. To reverse these dynamics, bank losses need to be fully recognised, frail but viable banks recapitalised, and non-viable banks closed or restructured. A credible assessment of bank balance sheets is necessary to lift confidence in the euro area financial system. A comprehensive, forward-looking asset quality review should quantify any capital shortfalls, but with a clear plan on how to meet potential capital requirements. A credible backstop is also essential to prevent pre-emptive deleveraging. Where private capital is insufficient, support from the public sector will be needed if fiscal space is available. In some cases, the ESM will need to be the effective backstop. It is therefore essential that the framework for direct ESM recapitalisation be finalised by the time the asset quality review is conducted. Equally important, the involvement of an independent third party would ensure the transparency and credibility of the exercise.
Full banking union is necessary to reduce financial fragmentation. This would introduce a systematic approach to supervision and incentives for early intervention in frail banks; halt ring-fencing at the national level, and weaken bank-sovereign links. This calls for expediting the reforms in train. The recent agreement by the European Council on the Bank Recovery and Resolution Directive (BRRD) helpfully lays out the pecking order in the event of bank intervention. The next steps on the agenda include: adopting the enabling legislation for the Single Supervisory Mechanism, reaching final agreement by the European Parliament on the BRRD, and making progress on the Deposit Guarantee Scheme Directive. A strong single resolution mechanism is critical to ensure timely and least-cost resolution of banks. The goal should be a centralised authority with power to trigger resolution and make decisions on burden sharing. By contrast, compromise solutions that leave resolution at the national level while supervision is centralised carry significant risks, including of perpetuating bank-sovereign links and potential conflict between national supervisors in cross-border resolution.
More support from the ECB could also help reduce fragmentation. While monetary policy alone cannot address underlying weaknesses in bank balance sheets, it can provide additional funding to avert a further contraction in credit until the more comprehensive actions to restore banking system health take hold. The ECB could build on existing instruments—such as a new LTRO of longer tenor coupled with a review of current collateral policies, particularly on loans to small and medium-sized enterprises (SME)—or undertake a targeted LTRO specifically linked to new SME lending. Consideration could also be given to direct purchase of specific private assets, when efforts to expand the securitised asset market are more advanced.
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