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Completing banking union
The first task ahead is to complete the banking union. Each of its three pillars, notably the Single Supervisory Mechanism (SSM), the Single Resolution Mechanism (SRM) and the planned European Deposit Insurance Scheme (EDIS) address the risk of fragmentation. They are also all necessary to ensure a proper balance between markets and regulations, and liability and control at European and national level.
The SSM ensures that banks are subject to the same set of rules and supervised on the basis of common standards. This reduces the risks of spillovers from bank failures to sovereigns and provides a common framework conducive to further integration in the banking markets, a process which has been lagging.
Since bank failures cannot always be avoided – and indeed this may not be desirable either, as it may undermine market discipline – we need a credible and well-functioning crisis management and resolution mechanism.
This is ensured by the second pillar of the banking union. With the setting-up of the BRRD, the Single Resolution Mechanism and the Single Resolution Fund (SRF), we have made a quantum leap in the institutional organisation of the EMU. However, the framework is still incomplete. Most notably, it requires a common public backstop to the SRF, which is essential to inspire full confidence in the resolution regime. In addition, it would be desirable to eliminate national divergences in the insolvency and liquidation of credit institutions, and in the implementation of the BRRD through national resolution laws. Allowing these divergences to persist ultimately implies that the geographical location of a failing bank may still influence the outcome of the resolution, which is inconsistent with the idea at the heart of a banking union.
Finally, in order to complete the banking union, we need a single, fully-fledged EDIS. The EDIS would strengthen depositors’ confidence through an equal level of depositor protection across Member States and therefore promote financial integration. Ultimately, a fully-fledged EDIS would be strengthened by the pooling of resources, thus building confidence in the single currency, throughout the Monetary Union. The finalisation of the banking union through its third pillar would require an adequately sized fund, built and financed by banks by raising ex-ante contributions, accompanied by a public backstop as recommended by the ECB opinion on EDIS. The calibration of these contributions should help to minimise the risk of some banking systems subsidising other banking systems in the event of a crisis. A recently published ECB Occasional Paper simulating severe banking crises, demonstrates precisely that, with proper bank risk-based contributions, an almost negligible cross-border subsidisation occurs. For this reason, a crucial element of a fully-fledged EDIS would consist of risk-adjusted contributions to the fund based on bank-specific strengths and weaknesses benchmarked at the banking union level.
Progress is also needed in the framework for macroprudential regulation. I regard this as a precondition for safeguarding financial stability in an integrated market and therefore protecting the Single Market. The CRR/CRD IV, the ESRB and the SSM Regulations already define the key elements of the macroprudential framework, but as the framework is tested and more experience is gained the rules will need to be steadily revised. Authorities with a mandate in this area must have well-defined roles and responsibilities, including a distinct set of instruments. Current overlaps between instruments should be eliminated, and more flexibility in the macroprudential policy framework should be maintained, so that authorities can implement those measures in a consistent and timely manner, which would require significant changes to Article 458 of the CRR.
A more integrated financial market will support the emergence of new types of risk and also require extending the toolkit with new instruments. For the banking sector, this includes complementing the toolkit with borrower-based instruments (such as limits on loan-to-value, or loan-to-income ratios) as well as sectoral buffers and a time-varying leverage ratio add-on so that all aspects of systemic risks can be addressed in the banking union. Finally, the mandatory reciprocity framework needs to be expanded so as to ensure the effective mitigation of cross-border spillover effects and regulatory arbitrage across jurisdictions in the EU.
The significant progress we have made with our banking union needs to be recognised also from the international regulatory framework perspective. A case in point is the G-SIB framework, which currently penalises cross-border transactions within the banking union by attaching a higher systemic risk score to banks with more transactions of that kind. This goes against the very rationale of the banking union, as it reduces the incentives for cross-border transactions and risk diversification, thus making banks more vulnerable to local shocks.
At the same time, we also need to remove the remaining obstacles to further integration within our banking union. Such obstacles are often due to regulatory fragmentation and ring-fencing of national markets. For example, a number of national options and discretions, such as diverging large exposure rules, are hindering the free flow of liquidity and capital in the banking union and should be harmonised further.
Turning to other parts of the financial system, we can expect that the CMU will provide further impetus to the growth of market-based finance and may present new challenges to financial stability.
Additional steps should be taken to strengthen the ability of European regulators and supervisors to address systemic risks stemming from the non-banking part of the financial sector. This could be achieved by expanding the mandate of relevant authorities and, in the medium run, by creating a single supervisor for the capital markets.
Adequate macroprudential instruments need to be envisaged as well, including instruments targeted at market-based finance. Macroprudential tools for this area either still need to be provided to authorities or need to be further clarified in respect of their application. For Securities Financing Transactions (SFT) and derivative markets, macroprudential margins and haircuts have been identified as potentially powerful tools for reducing the excessive build-up of leverage and procyclicality in these markets. For alternative investment funds, the existing macroprudential leverage limit needs to be operationalised. The forthcoming review of the Alternative Investment Fund Managers Directive provides an opportunity to resolve any issues that may hinder the future implementation of this leverage limit.
Moreover, as the ESRB recently recommended, for the investment fund sector, the role of authorities when using their powers to suspend redemptions needs to be further specified in law. In addition, European Securities and Markets Authority should have a general facilitation, advisory and coordination role in relation to the National Competent Authorities’ powers to suspend redemptions in situations where there are cross-border financial stability implications.
The need for a European safe asset
The stability and integration of financial markets in the Monetary Union is also closely related to the creation of a euro area-wide safe asset, for a number of reasons. First, it could help reduce the excessive home bias in banks’ sovereign exposures, which exacerbates the feedback loop between banks and sovereigns. Reforms to the resolution regime (i.e. BRRD) have tackled the issue from one direction, from banks to the sovereign. However, at present, there is no clear solution for tackling it in the other direction, from the sovereign to the banks. The creation of a euro area-wide safe asset, composed of a pool of sovereign bonds, would lead to a reduction in the home bias of banks’ portfolios by facilitating de-risking and diversification.
Second, a euro area safe asset would be crucial for the financial integration and the capital markets union. In fact, it is necessary for the creation of an integrated, deep and liquid European bond market as a central piece of CMU. 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.
In principle, several options are available for creating a safe asset. Some options are not politically viable, while others may not be economically sound.
I am not referring to the type of eurobonds that would replace national sovereign debt as a joint liability of Member States, as these would require a deep political union. Various proposals have been put forward, but I will concentrate on just two: a variant of the European safe bonds (ESBies) or sovereign bond-backed securities (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 senior tranche would have very low risk levels, presumably below German debt, as a result of the diversification gains based on historical correlations and of the protection granted by lower-grade tranches. Market practitioners and rating agencies have been skeptical about 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 coupons that do not fatally compromise 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 likely render the economics of the SBBS as unviable, which would be very unfortunate.
These obstacles could be overcome if, for instance, a small first loss tranche were to be covered by 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 unions.
Alternatively, a European entity could issue e-bonds as a pure securitisation of sizable amounts of national sovereign bonds but with a preferred creditor status over national sovereign bonds. Such a structure would be less efficient and could increase the cost of issuing the non-preferential part of national debt that is not included in the securitisation. However, this could even act as a disciplining device and would not necessarily imply an increase in the costs of the total debt issuance. The amounts achieved could nevertheless be considerable. 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.
Capital Markets Union, financial integration and economic growth
A European safe asset is crucial for the CMU project which in turn important for economic growth. A big and liquid market, both of debt and equity, would spur innovation and enable the development of an efficient venture capital market. This relates to the importance of boosting the euro area’s capacity to engage in activities conducive to innovation and productivity growth. In the years since the Great Recession, the pace of productivity growth in Europe has been persistently slow. In fact, European productivity growth had already started to stagnate during the mid-1990s. While some economists have argued that this is all part of a global secular decline in growth, driven by factors such as an ageing population and growth convergence across emerging markets, others believe that scientific progress will keep pushing the technological frontier forward.
In any case, it is vital that we have financing mechanisms in place in Europe that can support science and technology’s contribution to economic growth. One powerful way in which policy can assist this process is by stimulating the emergence of deep and integrated European capital markets. Capital markets, after all, play an important role in sharing economic risks and in smoothing consumption. But even more fundamentally, they contribute greatly to innovation and growth. Evidence increasingly suggests that while both banks and markets are important for the financing of economic growth, non-bank financial intermediation provides a relatively more powerful contribution to innovation and productivity-enhancing activities in modern sophisticated economies, also in the euro area. Importantly, complementarities between banks and markets increase, as the economy develops, and so deep capital markets will end up complementing banks as sources of financing. While the European Commission’s current CMU initiative is an important step in the right direction, a much more ambitious agenda for bolstering capital markets in Europe is needed in the future.
Developing well-functioning capital markets which support economic growth across Europe requires a comprehensive approach. 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.
Harmonising insolvency rules across jurisdictions would be a major step towards supporting capital markets. This is critical for mobilising finance through capital markets, as it would create incentives and favourable conditions for institutional investors to overcome the home bias in their investment strategies. This is especially true for pension investment, as large private pension funds tend to be a complement to deep capital markets. We need to establish a harmonised regulatory environment for new types of finance, such as crowd funding. The emergence of increasingly complex financial products needs to be accompanied by adequate consumer protection of financial investment, in order to safeguard financial stability and ensure the protection of individual investors.
The second component of a comprehensive approach entails policies that will stimulate entrepreneurship. High-tech entrepreneurial firms that aspire to go public should be supported and facilitated by stock exchanges specialising in IPOs for young innovative companies. A reduction in the wedge between corporate income taxes and personal income taxes has already been shown to have a strong positive effect on high-tech investment in a European context. Last but not least, the efficient application of R&D tax incentives and increased public funding of private research universities, whose labs often make key scientific and technological breakthroughs, are other important avenues for stimulating innovation and the commercialisation of science. [...]