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Restructuring Europe’s financial sector
To ensure that we take the right road, I see three responses as key.
The first is to carry out a comprehensive clean-up of the banking system so that the price mechanism is no longer obscured by uncertainty about asset valuation and bank funding models, and banks can free up balance sheet capacity to extend new loans.
The ECB will take up its supervisory responsibilities in about a year from now, and as part of this we will conduct a comprehensive assessment of 128 significant credit institutions covering 85 per cent of euro area bank assets. We announced the details of this exercise on Wednesday last week. It aims to increase transparency, to identify the necessary corrective actions and to build confidence in the banking system.
With such steps, and provided that sources of capital are clearly identified, including public backstops when private sources have been exhausted, I firmly believe we can put the banking system on a sounder footing and enable it to support the economy’s recovery.
The second response is to reduce financial fragmentation. Despite having a single market for capital in Europe, liquidity is not fully fungible between and even within cross-border banks. This means that liquidity usage is not optimised – surpluses in some countries are not used to fund deficits in others. The result is a greater divergence in bank funding costs and lending rates than would be warranted by the underlying economic fundamentals, and euro area companies being unable to tap a single pool of savings to fund their development.
The third response is to explore avenues for non-bank financing – that is, to develop debt and equity capital markets in Europe. Around 75 per cent of firms’ external financing in the euro area comes from banks, which makes the economy particularly vulnerable to crises that spread through the banking system. Measures are being introduced in Europe to develop capital markets for long-term financing and deepen markets for the securitisation of loans to small and medium-sized enterprises.
However, having a well-functioning financial sector is only one part of the story. To leave the crisis behind us, we also have to ask: what in fact does that sector finance? Again, we can learn from the Asian crisis: we need to foster growth and total factor productivity with new business models.
Fostering growth: new business models
Due to its length and severity, the economic downturn has already caused a permanent loss in output and a rise in structural unemployment, and we cannot rule out that the growth rate of potential output has been affected too. To repair this damage, investment in both physical and human capital has to be a key component of the recovery. Clearly, there is spare capacity in the euro area economy. Total investment in the euro area is currently 17 per cent lower than it was in 2007. But some of this capacity is in sectors which will not be future engines of growth – such as commercial real estate in some of the stressed countries. What we need is investment in new business models that will raise total factor productivity and provide the sources of future growth.
Politicians are not the best placed to decide what these business models will be. The market economy will take care of that. The important thing is that we create an environment that encourages innovation and entrepreneurship so that new models can emerge, and capital and labour can be reallocated to a more efficient use. This is in the best interests of the people of Europe, both as workers and as savers, beginning with those who have been hit hardest by the crisis. It nevertheless implies changes at both national and European levels.
At national level, we need to prioritise public spending towards productivity-enhancing investment, ensure that labour and goods market are flexible, cultivate a supportive regulatory, judicial and educational environment, and open our economies to spur competition and encourage the emergence of new actors.
Opaqueness and vested interests are not only defining features of developing economies. Successful reform in European economies hinges on efforts to curb rent-seeking behaviours. For example, doesn’t the Single Supervisory Mechanism have the objective of freeing bank supervision from national politics?
At European level, we need to provide a framework that supports and incentivises the introduction of such national policies. This is the role of economic union in the euro area, the “E” of EMU. I would stress, however, that economic union does not mean defining a single economic model across all countries. On the contrary, its purpose is to create the conditions for each country to identify and develop its comparative advantage. Paradoxically, it is only by encouraging difference – comparative advantage – that the euro area can achieve convergence – that is, a more even distribution of economic outcomes.
Avoiding re-nationalisation and protectionism
Europe needs to avoid protectionist temptations and calls for re-nationalisation. Protectionism and beggar-thy-neighbour policies would lead to further losses of welfare at both European and global level.
Fortunately, there has been no significant surge in barriers to global trade in recent years – unlike during the Great Depression – thanks to global and regional policy coordination. These efforts remain important. Barriers to trade in goods and services cannot be raised within Europe thanks to our Single Market and competition rules which are enshrined in European laws, but the Single Market can be further enhanced.
Savings have been partly re-nationalised as a consequence of financial fragmentation. This is a trend that, if left unchecked, can be fatal to the Single Market. Completing the Banking Union is key to halt it, and I welcome EU leaders’ resolve to swiftly agree on a Single Resolution Mechanism.
Finally, Europe should remain open to the world. Further progress on bilateral or regional free trade agreements, and cooperation in implementing the new financial regulatory standards, are the best signal in this respect.
Crises, despite their negative consequences, can have positive effects. They can galvanise efforts and focus minds. They can drive change and bring about progress. They can pave the way for innovative solutions. But to secure these gains, cooperation across national borders is crucial, in other words, there must be a willingness to work towards common goals and to learn from each other and resist protectionism. This spirit will be essential to tackle the challenges still ahead of us, not only in the euro area but also at a global level.