Market Discipline on Eurozone Public Debt - amend SGP Regulation and CRD IV

25 April 2010

Apply higher capital requirements and limit “large exposures” for banks lending to eurozone Member States that fail to implement Excessive Deficit Procedure recommendations by Council. Easily structured via Regulation and Directives without Treaty changes.

The role of market discipline on fiscal excesses in a monetary union was examined in Graham Bishop’s writings from 1990/3. These papers were controversial during the Maastricht Treaty negotiations as they doubted the willingness of finance ministers to discipline profligate states.
 

Market Discipline on Eurozone Public Debt

The outlook for public debt is being questioned to the extent that it is now necessary to add a provision in CRD IV that would apply higher capital requirements and limit “large exposures” for banks lending to eurozone Member States that fail to implement Excessive Deficit Procedure recommendations by Council. This can be structured so there is a progressive reduction in the EU banking system’s exposure to a deteriorating state.
A policy along these lines could be implemented quickly as the only requirements would be a change in the Regulations setting up the SGP; appropriate language in CRD IV and corresponding changes in other sectoral legislation – just as the Omnibus Directive is doing for the creation of the European Supervisory Authorities (ESAs). The changes may sound modest, but they would be profound in protecting the European Union from the all-too-apparent risk of fiscal crises as the baby-boomers move into an expensive old-age.  
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The basic proposal The forthcoming revision to the Capital Requirements Directive (CRD IV) gives a legislative opportunity to change the treatment of banks holding government exposures when that government becomes subject to the EDP due to its deteriorating finances. The essence of the EDP procedure is set out in the article and the key is what happens if the State fails to comply with the Council’s recommendation. Self-evidently, that government’s debts have become more risky than they were, so the proposal is that any new debts (or roll-overs) would incur a capital charge automatically and corresponding limits be placed on exposures to this new debt.

On each occasion when the state fails to comply with the Council’s recommendations, the riskiness must be presumed to have increased so the credit quality would be automatically (perhaps subject to an over-ride by a super-QMV) moved down a “quality step” by the CRD IV rules. Thus any eventual decision to impose sanctions would also be accompanied by a “junk” capital backing and exposure limit. Moreover, exposures to that state should be marked to market so the rising level of its interest rates would compel banks to increase their provisions against that borrower, diminishing their appetite for further losses.

There would be a presumption that the ECB would match the eligibility rules for its “repo” facilities to correspond to the official perception of increasing riskiness.

As this process would take a number of years, the relevant government would have time to adjust but would also be fully aware that if it went to the brink of default, then the EU’s banking and financial system would have adjusted to that risk already and would not be undermined. Ideally, at the brink of default, the EU financial system would have a relatively small exposure and would be fully provisioned already.

Graham Bishop

© Graham Bishop