Breaking the common fate of banks and governments by Daniel Gros and Cinzia Alcidi


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Breaking the common fate of banks and governments by Daniel Gros and Cinzia Alcidi

  1. 1. /DANIEL GROS * / CINZIA ALCIDI**/ Breaking the common fate of banks and governments1. Introducción; 2. Recent eurozone history: From bad to worse; 2.1. Recallingthe building blocks of the EMU construction; 3. A false solution to the crisis: thefiscal compact; 4. Fiscal indiscipline versus financial regulation inconsistency;5. A proposal for a new regulatory treatment of sovereign debt securities in theeuro area; 6. Conclusions; Bibliography* Dr. Daniel Gros is the Director of the Centre for European Policy Studies (CEPS) since2000. Among other current activities, he serves as adviser to the European Parliamentand is a member of the Advisory Scientific Committee of the European Systemic RiskBoard (ESRB), the Bank Stakeholder Group (BSG) of the European Banking Authority(EBA) and the Euro 50 Group of eminent economists. He also acts as editor of EconomieInternationale and International Finance. In the past, Daniel Gros worked at the IMF(1984-86), at the European Commission (1989-91), has been a member of high-leveladvisory bodies and provided strategic advice to numerous governments and centralbanks. Gros holds a PhD. in economics from the University of Chicago, has taught atprestigious universities throughout Europe and is the author of several books and nume-rous contributions to scientific journals and newspapers. Since 2005, he has been Vice-President of Eurizon Capital Asset Management.** Dr. Cinzia Alcidi holds a Ph.D. degree in International Economics from the GraduateInstitute of International and Development Studies, Geneva (Switzerland). She is 197
  2. 2. Breaking the common fate of banks and governments 1. Introduction Since 2010 the news about Europe has gone from bad to worse. In early 2012, it still cannot be claimed that the eurozone crisis is solved, thought markets within the euro area seems to return (maybe only temporarily) to more normal conditions. Interestingly enough, the average of the fundamentals of the euro area looks actually relatively good: compared to the US, the eurozone as whole has a much lower fiscal deficit (4% of GDP in 2011 against almost 10% for the US) and unlike the US, it has no external deficit. Its current account is close to balance, which means that enough savings exist within the monetary union to finance the public deficits of all its member states. This implies, in turn, that potentially enough, domestic, euro zone’s resources exist to solve the debt problem, without recurring to external lenders. Whether these resources will be invested to finance eurozone governments is a different question.currently LUISS Research Fellow at Centre for European Policy Studies (CEPS) inBrussels where she is part of the Economic Policy Unit dealing mainly with issues rela-ted to monetary and fiscal policy in the European Union. Before joining CEPS in early2009, she taught undergraduate courses at University of Perugia (Italy) and worked atInternational Labour Office in Geneva. Her research interest focuses on internationaleconomics and economic policy. Since her arrival at CEPS, she has worked extensivelywith Daniel Gros on the macroeconomic and financial aspects of crisis in Europe andat global level, as well on the policy response to it. She has published several articles onthe topic and participates regularly in international conferences. 198
  3. 3. The Future of the Euro In spite of this relative strength, eurozone policy-makers seemincapable to solve the debt crisis. Meeting after meeting, heads ofstate and Government or finance ministers have failed to convincemarkets of the validity of their strategy, which has focused almostexclusively on fiscal discipline and has repeatedly advocated theneed of financial help from outside investors, e.g. IMF and Asianinvestors, regardless of whether resources exist within the eurozo-ne. This approach has been both misguided and unconvincing. Against this background, the paper emphasizes that while thepolitical agenda is almost obsessively focused on fiscal issues, theeuro zone crisis does not have a mere fiscal nature neither a simplefiscal solution. It involves different dimensions running fromcurrent account and external debt problems to the weak state of thebanking sector, which is still largely undercapitalized. This paperwill focus on the last element, the state of the banking system andattempts at highlighting how features of the existing financial mar-ket regulation framework which are inconsistent with main buil-ding blocks of the monetary union have affected the course of thecrisis. We will argue that this inconsistency has crucially contribu-ted to eurozone crisis and still remains unaddressed. The paper alsoexpresses concern about the misleading, prevailing view that thejust signed fiscal compact will work as crucial ingredient in the reci-pe to overcome the eurozone crisis, while the banking sectorremains highly leveraged and exposed to the fortune and misfortu-ne of sovereign governments. On this ground, the paper puts for-ward some ideas about how to break the tight linkage between 199
  4. 4. Breaking the common fate of banks and governmentsgovernments and banks. This is at the root of their common fateand represents a decisive obstacle to overcome the eurozone crisis.2. Recent eurozone history: From bad to worse To understand why the euro crisis has gone from bad to worse,one needs to develop a better understanding of the inconsistenciesin the setup of European Monetary Union (EMU) that caused theproblem in the first place. The official reading is that this is not acrisis of the euro, but of the public debt of some profligate euroarea member countries. Therefore, tackling the causes of this crisisand averting future ones requires only a new, tighter framework forfiscal policy – which will be delivered by the new ‘fiscal compact’. Yet, financial markets do not seem much impressed by a furtherstrengthening of fiscal rules: Portugal and other countries still haveto pay high risk premia while Greece has defaulted on its debt andstill teeters on the brink of a total collapse. This suggests that theofficial approach captures only part of the problem and still missesthe full picture. It is not only fiscal indiscipline in the periphery which turnedthe public debt problems of a small country like Greece into a cri-sis of the entire euro area banking system. The euro zone crisis isthe result of a constellation of vulnerabilities within the eurozone.They include balance of payments problems, foreign debt, sudden-200
  5. 5. The Future of the Eurostops of crosser-border financing running from North to Southcombined with a generalized undercapitalization of the bankingsystem. This financial fragility has been the result of inconsistencies inthe setup of the EMU as well as a fundamental inconsistency infinancial market regulation that has yet to be addressed.2.1. Recalling the building blocks of the EMU construction The original design of EMU, as established by the MaastrichtTreaty in 1992, contained three key elements:i) An independent central bank, the ECB, devoted only to price stability.ii) Limits on fiscal deficits enforced via the excessive deficit pro- cedure (Treaty based) and the Stability and Growth Pact (SGP, essentially an intergovernmental agreement, although still within the EU’s legal framework).iii) The ‘no bail-out’, or rather ‘no co-responsibility’ clause (art. 125 of the TFEU). The treaty also contained other elements of economic gover-nance,1 but this remained mostly declamatory as in reality1 For instance, Article 121 of the TFEU contains the provision that member statesshould regard economic policies as a matter of common concern and shall coordinatethem within the Council. 201
  6. 6. Breaking the common fate of banks and governments Member States did not see any need to coordinate economic poli- cies; at least, not before the crisis. The first key element of the Maastricht Treaty, i.e. the very strong independence of the ECB, was based on a large consensus among both economists and policy makers that the task of a cen- tral bank should mainly be to maintain price stability. The con- sensus was based on a common reading of the experience of the previous decades that higher inflation did not buy more growth and independent central banks (with the Bundesbank as the most prominent example) are best placed to achieve and maintain price stability.2 Some academic economists and some observers at international financial institutions worried already in the 1990s about financial instability and advocate a clear role of the EBC in safeguarding financial stability.3 Some also emphasized that a common currency area also requires a common system of supervision of financial markets.4 But the issue of financial stability did not attract the attention of policy makers mainly for two main reasons. The first one is theoretical: most prominent economic models before 2007 suggested that price stability delivers financial stability as by-pro-2 A prominent paper of the period when plans for EMU were taking shape encapsula-ted this insight in the title ‘The advantage of tying one’s hands’ (see Giavazzi andPagano (1988).3 See for instance Garber (1992).4 Among others Tommaso Padoa Schioppa (1994). 202
  7. 7. The Future of the Euroduct, with no need to add another tool to achieve it. The secondone is much less sophisticated and relates to the fact that the twokey member states driving EMU, France and Germany, had notexperienced a systemic financial crisis for decades. The second element of the Maastricht Treaty, namely the limitson fiscal policy, did not enjoy the same consensus in the academicprofession (nor among policy makers) as central bank indepen-dence. During the 1990s a wide ranging debate took place aboutthe sense or non-sense of the Maastricht ‘reference’ values of 3% ofGDP for the deficit and 60% for the debt level. Apparently theadvantage of tying one’s hands was much less recognized in the fieldof fiscal policy. However, this debate did not need to be resolved aslong as benign financial market conditions prevailed and even thecore countries conspired to weaken the limits on deficits set by theSGP in 2003. The third element was only in the background and remaineduntested until recently. Contrary to a widespread misconception,Article 125 of the TFEU does not prohibit bail outs. It merelyasserts that the EU does not guarantee the debt of its member sta-tes and that member states do not guarantee each other’s obliga-tions. Germany had insisted on the no bail-out clause when theMaastricht Treaty was negotiated about 20 years ago. Today, it isclear that this clause does not provide the kind of protection thatwas sought and widespread financial market turbulences threatento engulf Germany to agree to huge bail-out packages which would 203
  8. 8. Breaking the common fate of banks and governmentshave been unthinkable only recently. However, instead of workingon averting the repeat of this situation in the future, Germanpolicy makers are focusing exclusively on the need to ensure lowerfiscal deficits. This is the purpose of the Treaty on Stability, Coordinationand Governance in the Economic and Monetary Union also called the‘fiscal compact’ under which euro area member countries agree toadopt strict rules, ‘at the constitutional or equivalent level’, limi-ting the cyclically adjusted deficit of the government to less than0.5% of GDP. Will this fiscal compact work where the Stability Pactfailed? The ‘original’ SGP already contained the engagement by mem-ber states to balance their budget over the cycle. If implementedsince the onset of the monetary union, the rule would have led toa continuous reduction of the debt-to-GDP ratio towards the 60%target. But this did not happen. The promise or rather exhortationcontained in the SGP to balance budgets over the cycle was widelyignored, given that the rule was not binding and financial marketsremained in a ‘permissive’ mood. All of the larger euro area mem-bers ran budget deficits in excess of 3% of GDP threshold for thefirst 4-5 years of the euro’s existence. Even Germany ran deficitsabove 3% of GDP from 2001 to 2005. In 2003 a proposal put for-ward by the Commission to ratchet up the excessive deficit proce-dure to the point where fines might have been imposed on Franceand Germany was defeated in the Council (of finance ministers,ECOFIN). In the crucial vote the large countries (most of whichhad excessive deficits, except Spain) colluded to water down the204
  9. 9. The Future of the Europroposal and won the opposition of the smaller countries. The’band of three large sinners’ (Germany, France and Italy) evenmanaged to put together a qualified majority to ‘hold the proce-dure in abeyance’.5 This narrative is interesting in the light of the new ‘fiscal com-pact’ which is supposed to radically strengthen the enforcement ofthe fiscal rules by the application of the ‘reverse qualified majo-rity’. Under this principle, an excessive deficit procedure launchedby the Commission is taken to be approved unless it is opposed bya qualified majority. As past experience shows, despite the new sys-tem makes the opposition harder, it does not ensure enforcement. In 2005, following the 2003 episode, the SGP was changed. Theofficial justification was the need to improve its economic rationaland thus ownership,6 but it clear that it was necessary to avoid therepeat of the embarrassing situation in which a literal applicationof the rules would have led to sanctions for Germany and Franceamong others. The reaction in academia and among policy makerswas mixed: the SGP was ‘softened’ according to some, but ‘impro-ved’ according to others. The very fact that professional opinionon the merits of ’binding rules for fiscal policy’ was divided fromthe start certainly facilitated the change in the SGP when it beca-me politically opportune.5 See Gros et al. (2004). 3 See for instance Garber (1992).6 Annex to the 2005 Council conclusions( 205
  10. 10. Breaking the common fate of banks and governments As matter of facts, shortly after the SGP was made less stringent,the upturn of the business cycle allowed most governments toreduce their deficits to below 3% seemingly vindicating the officialposition that the ‘improved’ Stability Pact had led to a more res-ponsible fiscal policy. But structural deficits (i.e. adjusted for thecycle) actually improved very little even at time the boom reachedthe peak in 2006-7 and, when the crisis hit, any remaining cautionwas thrown overboard as deficits were allowed to increase again. The euro area countries thus never lived up to the rules they gavethemselves. But even so, on average they remained relatively con-servative in fiscal terms. In 2009, the average deficit peaked at 6.5%of GDP, its highest level, whereas both the UK and the US wentabove 11% during that year. Moreover, while the eurozone deficithas brought back to 4% of GDP in 2011, it has remained at doubledigits levels in both the UK and the US. In this limited sense, onecould argue that the Maastricht provisions against ‘excessive’ defi-cits did have some influence after all, at least on average. While the average deficits for the euro area appear today‘modest’ by the standard of other large developed countries, oneeuro area country, Greece, clearly violated all rules for years. Butmounting evidence that the Greek fiscal numbers did not add upwas never acted upon until it was too late. As long as financial mar-kets provided financing at favorable rates any action was politicallyinconvenient and was avoided.206
  11. 11. The Future of the Euro When the euro debt crisis started in early 2010 following thediscovery that Greece was running a deficit of 15% of GDP (andthat previous deficits had been misreported), some policymakers,German in particular, started to call for tighter fiscal rules as essen-tial to the survival of the euro.Despite Greece was an extreme case,the case of Italy is widely seen as providing another justificationfor tighter fiscal rules. However, the country seems to stand forcomplacency rather than fiscal profligacy. Over the last ten yearsthe deficits of Italy have on average been lower than those forFrance and even today its deficit is below the euro area average(and declining rapidly).Yet, the incapacity of the country to redu-ce its very high debt-to-GDP ratio has made it vulnerable to a lossof investor’s confidence.3. A false solution to the crisis: the fiscal compact The new Treaty that was agreed upon in March 2012 has a longtitle, Treaty on Stability, Coordination and Governance in the Economicand Monetary Union, but upon closer examination it is long ongood intentions and rather short on substance in terms of bindingprovisions. The core of the new ‘fiscal compact’ is an obligation to enshrine innational constitutions the commitment not to allow cyclically adjus-ted deficits to exceed about ½ of 1% of GDP, which is roughly equi-valent to balancing the budget over the cycle as in the original SGP. 207
  12. 12. Breaking the common fate of banks and governments This should be done ‘preferable at the constitutional level’. TheEuropean Court of Justice (of the EU) can be asked to pass a judg-ment on these national rules, but the maximum fine that could beassessed is capped at 0.1% of GDP – hardly a strong deterrent byitself. This Treaty concerns only the framework for fiscal policy, i.e.the rules setting up national ‘debt brakes’, not their implementa-tion. This Treaty thus does not give any new powers to the Courtof Justice (neither to the Commission) to interfere with the actualconduct of national fiscal policy. None of the provisions on eco-nomic policy coordination are binding. Essentially they reiteratethe already often repeated statements of good intentions on struc-tural reforms. Among the provisions, the specification on governance institu-tes regular meetings, at least twice a year, of the heads of state andgovernment of the euro area. However, since these meetings willremain informal, in truth, there was no need for an internationaltreaty to establish them. As far as the non-euro EU member states who signed the Treatyare concerned, there is no obligation for them to do anything, butthe signature constitutes a political statement which gives them apartial ‘seat at the table’ of the eurozone meetings, allowing themto participate in most of the euro area summits. From a purely legal point of view, this Treaty contains an inhe-rent contradiction: it implies that its signatory countries agree on208
  13. 13. The Future of the Eurobinding constraints for their constitutional order via an ordinaryinternational treaty. In most countries the national constitution isof a higher in legal hierarchy than international treaties. Thismeans that even the provisions on the ‘fiscal compact’ constituteessentially a political statement, unless the treaty is ratified with aconstitutional majority, as will be done in Germany. The main value of this political statement coming from all euroarea member states is of course that it provides political cover forthe German government in its efforts to sell the euro rescue ope-rations to a sceptical domestic audience. However, it is doubtfulthat the ‘fiscal compact’ was really needed for this purpose. Dataon German support of the euro show that public opinion remainsmuch more constructive on the euro than widely assumed (seeGros and Roth, 2011). Moreover even before the fiscal compactexisted, all votes in the Bundestag have resulted in very large majo-rities in favour of the euro area rescue operations, even when theycontained large fiscal risks for Germany. In judging the value of this Treaty one should also keep in mindthat, of the four large euro area countries, three have already natio-nal debt brakes at the constitutional level: in Germany it is alreadyoperational, in Spain has been adopted recently and in Italy is incourse of adoption. In the fourth country, France, it is already clearthat the Treaty will be implemented, if at all given the negativeattitude of the current opposition, via a so-called ‘loi organique’ andthat the French constitution will not be changed. 209
  14. 14. Breaking the common fate of banks and governments All in all, the fiscal compact is probably useful in the long runand may contribute to avert a future crisis. It forces Member Statesto adopt stronger national fiscal frameworks at home. Some, per-haps most, would have done so anyway under the pressure of themarkets, but it is unlikely that the new Treaty will make a signifi-cant difference. The main danger is that that it has been oversold. It is likely that the ratification process (e.g. the referendum inIreland) and then the implementation process in some difficultcountries (e.g. France) will receive a lot of attention and create adistorted impression of the importance of the Fiscal Compact. However, the initial excitement will be over once the nationalfiscal rules have been put into place and this Treaty will quietly beforgotten. Its only remaining impact will consist in the meetings ofthe euro area heads of state which are likely to produce the regularconclusions that ‘Member States commit’ to everything desirable(structural reforms, etc.). Conclusions which become irrelevantonce the heads of state return to their capitals and their domesticpolitical realities. The experience with the SGP suggests that how this new ‘fiscalcompact’ will be applied in future will depend on the degree of con-sensus on the need to balance the budget over the cycle. If anything,political will to follow this balanced budget rule will be even moreimportant for the new ‘fiscal compact’ since it will take the form ofan intergovernmental Treaty outside the legal framework of the EU.210
  15. 15. The Future of the Euro Today the consensus that only balancing budgets can solve thiscrisis and allow the euro to survive seems strong and the positionof the German government seems particularly tough. This is cer-tainly desirable to prevent future public debt problems but itneglects the crucial role financial market fragility has played in thiscrisis. The case of Greece is emblematic in this sense: despiteGreece accounts for less than 3% of the euro area’s GDP, the pros-pect of the Greek government becoming bankrupt caused Europe’sfinancial markets to go into a tailspin. The reason behind it wasthe fragility of banks due to their undercapitalization and theirlarge holdings of government debt. In this perspective, while for a creditor country like Germany itmight be important that other member states are forced to copy itsbalanced budget rules, it should be even more important to ensu-re that financial regulation helps to provide additional incentivesfor good fiscal policy and that financial markets become morerobust and able to withstand a sovereign insolvency. This is whatwould reduce the need for future bail outs by the German govern-ment. German savers have over the last decade of current accountsurpluses accumulated about one trillion euro worth of claims onother euro area countries. Safeguarding the value of these claims(which amount to about 50% of GDP) and ensuring the futureGerman savings surpluses are invested with minimal risk shouldthus be a key policy goal for German policy makers. 211
  16. 16. Breaking the common fate of banks and governments 4. Fiscal indiscipline versus financial regulation inconsistency The key insight that has been overlooked in the official circles dominating EU policy making today is that today’s crisis is largely due to an inconsistency in the original design of EMU, not in the area of fiscal policy, but in the area of financial market regulation. Even after the start of the EMU, financial regulation in general, and banking regulation in particular, continued to be based on the assumption that in the euro area all government debt is riskless. This was from the start logically incompatible with the no-bail out clause in the Maastricht Treaty, which implies that a euro area member country can become insolvent, and the institution of an independent central bank which cannot monetize government debt. But it was adopted anyway, maybe because of the perception, expressed recently in a spectacularly mis-timed paper from the IMF, which proclaimed: “Default in Todays Advanced Economies: Unnecessary, Undesirable, and Unlikely”.7 In the much more forgiving environment of the turn of the cen- tury, it was quite natural for policy makers to ignore the logical inconsistency between the no bail-out clause and maintaining the assumption that government was really risk less. Yet this contra- diction had two important consequences. First, banks did not (and still do not) have to hold any capital against their sovereign expo-7 Cottarelli, C., L. Forni, J. Gottschalk, and P. Mauro (2010) Staff Position Note No.2010/12. 212
  17. 17. The Future of the Eurosure. Second, it was also deemed unnecessary to impose any con-centration limit on the claims any bank can hold on any one sove-reign. This lack of a concentration limit for sovereign debt is inclear contrast to the general rule that banks must keep their expo-sure to any single name below 25% of their capital. This exceptionwould make sense only if government debt is really totally riskless. The main result of this special treatment reserved to govern-ment debt securities on banks’ balance sheets has been that aboutone third of all public debt of the eurozone is held by eurozonefinancial institutions, which also tend to privilege the financing oftheir own government. The fate of governments and banks is thustightly linked. To the inconsistency of financial market regulation it must beadded that the ECB failed to apply differentiated haircuts togovernment debt it accepted as collateral. Debt securities issued byeuro area governments ware accepted in indiscriminate fashionprovided that the country was rated at investment grade. This wasthe case for all euro area member countries, of Greece as Germany.When the Stability Pact was weakened by Germany and France in2005, the ECB took member countries to court, but it did notchange its collateral policy. By doing so it would have given a con-crete signal that it was worried about the long run sustainability offiscal policy and its consequences for the future of the singlecurrency. Alas, it did not do so, not even during the crisis, after itwas clear that it was changing its policy stance. Only now, the ECB 213
  18. 18. Breaking the common fate of banks and governmentsapplies a sliding scale of graduated haircuts which makes it lessattractive for banks to hold lower rated government debt. The idea that governments provide the only safe assets even ina monetary union where a no bail-out clause exists was also themain reason for another omission: a common euro area (or EU)deposit insurance scheme was never seriously considered. At EUlevel, deposit insurance is regulated by the 1994 Directive on depo-sit guarantee schemes, but the minimum harmonization approachadopted at that time has proven largely insufficient and the ulti-mate back up for all national schemes remains the national govern-ment. A common European deposit insurance modeled on the USapproach of a fund financed ex-ante by risk based contributionsfrom banks like the Federal Deposit Insurance Company – FDIC-would have had obvious advantages in terms of risk diversification.But the preference for national solutions (based on the fear that aEuropean equivalent to the FDIC would lead to large transfersacross countries) and the bureaucratic interests of the existingnational deposit guarantee schemes ensured that such ideas do notget a hearing even today. The experience with Greece should have served to rest the ideathat government debt in the euro area is riskless. But so far no cri-sis summit has drawn the conclusion from this experience for ban-king regulation. Of course, it is true that once the crisis has hit it isno longer possible to tighten the rules on government debt becau-se this is pro-cyclical as the mayhem which followed the only214
  19. 19. The Future of the Euroattempt to shore up the banking system in the context of therecent EBA stress tests on government debt has shown. However in order to illustrate the importance of thinking aboutthe larger benefits from a different kind of banking regulation it isstill worthwhile speculating what would have been different ifbanking regulation had been ‘Maastricht’ conform, i.e. if it hadrecognized that belonging to the European Monetary Unionimplies that national government debt is no longer riskless. One could thus consider how the crisis would have played outif the following rules had applied since 1999:i) Forcing banks to have capital against their holdings of euro area government debt.ii) Applying the normal concentration limits also to government exposure.iii) A different collateral policy of the ECB, for example with a sli- ding scale of increasing haircuts on government debt in func- tion of the country’s deficit and debt and its position in the excessive deficit procedure. One can only speculate what would have been different if thiskind of regulation had been in place during the boom years. But afew conclusions seem certain. 215
  20. 20. Breaking the common fate of banks and governments Greece would certainly have encountered much more difficul-ties selling its bonds to banks which would have had to hold capi-tal against it would be less able to use them to access ECB funds.The same applies to Italy, whose rating went already in 2006 belowthe threshold at which under normal banking rules higher capitalrequirements kick in. Both these countries would thus have seengradually increasing market signals, which would have most pro-bably led to a more prudent fiscal policy. Moreover, their problems would today have been much easierto deal with because banks would have more capital and the con-centration limit would have prevented Greek banks to accumulateGreek government debt worth several times their capital. Theresources necessary to prevent the collapse of the Greek bankingsystem has increased considerably (by about 40 to 50 billion euro)the size of the financial support Greece needed so far. The negative feedback loop between the drop in the value ofbanks and in the yields on government bonds which destabilized theentire European banking system so much during the summer and fallof 2011 would also have been very much mitigated if the concentra-tion limit had been observed. Italian banks would have accumulatedless Italian debt and would have been able to offset some of the markto market losses on the Italian debt with their gains on German debtholdings which they would have had to hold as well.216
  21. 21. The Future of the Euro Common euro area wide deposit insurance would have contri-buted in several ways to deal with the financial crisis from thebeginning. First of all, in 2008 it would have obviated the percei-ved need for the competitive rush to provide national guaranteesfor bank deposits. The Irish government would thus probably nothave had felt the need to provide the blanket guarantee for all lia-bilities of its local banks which proved fatal once the extent of thelosses was revealed. Ireland would still have suffered from a massive real estate bustwith all the consequences in terms of unemployment, but the Irishgovernment would not have been bankrupted by its own banks.Paul Krugman has drawn attention to the parallels in terms of eco-nomic fundamentals between Nevada and Ireland8 arguing thatexplicit fiscal transfers and higher labour mobility within the USconstitute the main differences. However, Ireland has actuallyexperienced a degree of labour mobility which is quite similar tothat among US states like Nevada. During the boom it had immi-gration running at over 1% of its population, which after the bustturned into emigration of a similar order of magnitude. The wides-pread held opinion that the euro could never work because there isnot enough labour mobility in Europe is not entirely correct. In the case of Ireland the key issue was not one of a lack of labormobility, but of the absence of a common safety net for banks. A8 See 217
  22. 22. Breaking the common fate of banks and governmentsEuropean deposit insurance would have provided stability to thedeposit base. It is also likely that the European Deposit insurancewould have been less complacent and less beholden to the inte-rests of Irish banks and would thus have started to increase its riskpremium when the signs of a local real estate bubble were clear toalmost everybody outside the country. Greece, where the national deposit guarantee scheme is nowpractically worthless because it is backed up only by the Greekgovernment, which has just defaulted on its debt, provides anot-her example of the potential importance of stabilizing the bankingsystem. With a European deposit guarantee scheme there wouldhave been no deposit flight, which has amounted so far to about50 billion, or over 25% of GDP. There would have thus been muchless need for the ECB to refinance the Greek banking system, lowe-ring again the cost of the Greek bail out. The next crisis will be different from the current crisis, but it isclear that different rules for the banking system could bring twoadvantages: they would provide graduated market based signalsagainst excessive deficits and debts. Moreover, a better capitalizedbanking system with less concentrated risks would be much betterable to absorb a sovereign insolvency, thus reducing the need forfuture bail outs. Acting on this front seems a much more promi-sing route to reduce the likelihood for future crises and minimizethe cost should they occur anyway.218
  23. 23. The Future of the Euro Perceptions matter. Europe’s policy makers seem to be driven bythe perception that this crisis was caused by excessively lax fiscalpolicy in some countries. In reality, however, the public debt pro-blems of some countries have become a systemic, area wide, finan-cial crisis because of the fragility of the European banking system.The ‘euro’ crisis is likely to fester until this fundamental problemhas been tackled decisively.5. A proposal for a new regulatory treatment of sovereigndebt securities in the euro area The purpose of this section is to sketch a simple proposal for anew regulatory treatment of sovereign debt securities in the euroarea which follows the arguments illustrated in the previous sec-tions.1. Any risk weights to be introduced after the crisis might better be based on ‘objective’ criteria, rather than ratings.2. Diversification of banks’ exposure; this is even more important than risk weighting for sovereign exposure. A simple way to attach a risk weight on government debt secu-rities of a given country would be to make the weight function ofobjective factors like the debt and deficit of the country. For exam-ple, one could imagine that the risk weight could remain at zero ifboth government debt and fiscal deficit relative to GDP remainbelow 60% and 3% respectively. If the deficit and/or the debt ratio 219
  24. 24. Breaking the common fate of banks and governmentsexceed the ‘reference’ values of the Treaty, the risk weight wouldincrease by certain percentage points in a proportional or progres-sive fashion. In addition the risk weights should be linked to thestages of the excessive deficit procedure (EDP). When the procedu-re is launched, the risk weight is increased and at each additionalstage of the EDP the risk weighting would be increased further. Thiswould provide the EDP with real incentives even without the needto impose fines. Introducing positive risk weights for government debt will notbe enough to prevent crisis because of the ‘lumpiness’ of sovereignrisk. Experience has shown that sovereign defaults are rare events;but the losses are typically very large (above 50%) when defaultdoes materialize. Even with a risk weight of 100% banks wouldhave capital only to cover losses of 8%. Risk weights would thushave to become extremely high before they could protect banksagainst realistic loss given default scenarios. This suggests that themore important aspect is diversification. All regulated investors, i.e. banks, insurance companies, invest-ment funds, pension funds, have rules which limit their exposurevis-à-vis a given counterpart to a fraction of their total investmentor capital (for banks). However, this limit does not apply to sove-reign debt, especially within the eurozone for banks. The result ofthis lack of exposure limits has been that, in the periphery, bankshave too much debt of their own government on their balancesheet which has led to the deadly feedback loop between sovereign220
  25. 25. The Future of the Euroand banks. In Northern Europe, investors, such as investmentfunds and life insurance companies, which typically cannot avoidgovernment debt have also concentrated their holdings nationally.This has led to a significant fall and in some cases even to negati-ve value of government bond yields, not only in Germany butthroughout Northern Europe. From the point of view of coreEurope investors, today this might appear as being a prudent stra-tegy, but this concentration increases the vulnerability of the sys-tem to any reversal of fortunes. Moreover, if Northern investorswere required to diversify their holdings there would be a naturaldemand for Southern European bonds, which would bring someoxygen to those governments which have experienced a dramaticsurge in their borrowing cost. Introducing exposure limits during a crisis period would bemuch less pro-cyclical than introducing capital requirements. Inpractical terms, the simplest approach would be to grandfather theexisting stocks, but apply exposure limits to new investments.6. Conclusions This paper has emphasized that while the political agenda hasbeen obsessively focusing on fiscal issues since the early onset ofthe euro zone crisis; this crisis has neither a mere fiscal nature noran exclusively fiscal solution. Despite the Greek episode seemed topoint only to fiscal indiscipline, the reasons why the crisis did not 221
  26. 26. Breaking the common fate of banks and governmentsconfined itself to Greece but spread out to the entire euro area assu-ming a systemic nature should be sought in the state of the euroarea banking sector. European banks were, and still are, largelyundercapitalized and too tightly linked to the fortune and the mis-fortune of governments. The paper spots three contradictory building blocks of the EMUconstruction: the no bail-out rule in the Stability and Growth Pact,the independence of the European central bank and the provisionin the financial market regulation framework that governmentbonds are considered as risk free assets. The combination of the no-bail clause with the institution of an independent central bankimplies that fiscally undisciplined countries may have to facedefault as no other country, nor the EU can take on its debt and thecentral bank cannot monetize it. This definitely collides with theprinciple that banks are not required to hold any capital againstgovernment debt securities as it assumed that they do not carryany default risk. In fact, Greece has proved this assumption wrong. This contradiction was completely overlooked during the goodyears in the turn of the new century and the politically more con-venient approach suggested by financial regulation became thedominant. The ‘risk free treatment’ of public debt securities has clearlyworked as incentive for banks to finance profitable governmentspending and accumulate large amounts of government bonds.222
  27. 27. The Future of the Euro This is at the root of the common fate of euro area banks andgovernments. Alas, the crisis has made that fate an evil one. Though these contradictory elements have now emerged clearly,the issue has not been addressed and the regulator treatment of thegovernment bonds has not changed yet. On this ground, the paper puts forward some concrete ideasabout how to break the tight linkage between governments andbanks, which represents a decisive obstacle to overcome of theeuro zone crisis. We argue that positive risk weights for government debt securi-ties must be introduced in the banks’ balance sheet, but alone thismeasure will not be enough to prevent a new crisis. A clear pres-cription to reduce concentration of the risk and impose diversifi-cation is at least equally important and complementary to the riskweighting. While developing the arguments for the regulatory changes, thepaper expresses skepticism about the official, widespread view thatthe just signed fiscal compact will have a crucial role in overco-ming the eurozone crisis. As far as the banking sector remains weakand highly exposed to governments, and the common fate ofgovernment and banks is not broken, the crisis will be hard to die. 223
  28. 28. Breaking the common fate of banks and governmentsBibliography- Cottarelli C., L. Forni, J. Gottschalk and P. Mauro (2010), “Defaultin Todays Advanced Economies: Unnecessary, Undesirable, andUnlikely”, IMF Staff Position Note No. 2010/12.- Graber M. And D. Folkerts-Landa (1992) The European CentralBank: A bank of a Monetary Policy Rule, NBER Working PaperN.4016.- Giavazzi, F. and M. Pagano (1988), “The advantage of tying oneshands: EMS discipline and Central Bank credibility”, EuropeanEconomic Review, Vol. 32, No. 5, June, pp 1055-1075( Gros, D., T. Mayer and A. Ubide (2004), The Nine Lives of theStability Pact, Special Report of the CEPS Macroeconomic PolicyGroup, CEPS, Brussels, February ( Gros D. and F. Roth (2011) Do Germans support the euro? CEPSWorking Paper Document No. 359, December 2011.- Gros D. (2012), The misdiagnosed debt crisis, Current History,Vol.111, Issue 773 p.83.224
  29. 29. The Future of the Euro- Gros D. (2012), The Treaty on Stability, Coordination andGovernance in the Economic and Monetary Union (aka FiscalCompact), CEPS Commentary, March 2012.- Padoa Schipppa T. (1994), The Road to the Monetary Union: TheEmperor, the King and Genies, Clarendon Press. Place ofPublication: Oxford. 225
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