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Can the EU respond adequately to the next crisis with its current instruments

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Can the EU respond adequately to the next crisis with its current instruments by Isabel Schnabel

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Can the EU respond adequately to the next crisis with its current instruments

  1. 1. Isabel Schnabel University of Bonn and German Council of Economic Experts Can the EU respond adequately to the next crisis with its current instruments? Workshop on advancing new tools for the EU budget to foster crisis management and economic convergence 5 February 2019, OECD, Paris
  2. 2. I. Financial sector in the euro area still fragile
  3. 3. Low share prices and price-to-book ratios Structural problems (overcapacities) Prolonged low-interest rate environment puts additional pressure on profits and may give rise to excessive risk-taking European banking sector remains weak Sources: EBA, ECB, Thomson Reuters © 8-229Sachverständigenrat | 1 1 January 2004 = 100 Bank share prices and price-to-book ratios 0 50 100 150 200 250 0 1 2 3 4 5 2004 06 08 10 12 14 16 2018 Stock price indices: Price-to-book ratio (right-hand scale): Euro area United States DE,FR,IT,ES United States
  4. 4. Bank capital still too low, NPLs still too high Sources: EBA, ECB, Thomson Reuters Risk-weighted and unweighted capital ratios in the euro area © 8-229Sachverständigenrat | 1 0 2 4 6 8 10 12 14 16 18 2007 08 09 10 11 12 13 14 15 16 2017 % Unweighted capital ratio Risk-weighted capital ratio Sources: EBA, ECB, Thomson Reuters % Euro area non-performing loans and risk provisions © 8-229Sachverständigenrat | 1 Coverage ratioNon-performing loans 0 10 20 30 40 50 60 70 2014 2015 2016 2017 Minimum Maximum Median
  5. 5. Strong home bias in banks’ sovereign exposures 0 20 40 60 80 100 PT DE IT FR ES IE GR Distribution of exposures to EU member states by rating category AAA AA+ to AA- A+ to A- BBB+ to BBB- BB+ to BB- B+ to B- Sources: EBA, Standard & Poor's, own calculations © Sachverständigenrat | 18-341 0 20 40 60 80 100 120 140 160 PT DE IT FR ES IE GR Ratio of exposures to its host country to own funds 31 December 2015 30 June 2016 31 December 2016 30 June 2017 Sources: EBA, own calculations © Sachverständigenrat | 18-341
  6. 6. Low financial integration in the euro area Euro area financial integration indicators Source: ECB © 8 305Sachverständigenrat | 1 - 0.2 0.4 0.6 0.8 1.0 0 1995 97 99 01 03 05 07 09 11 13 15 2017 Price-based Quantity-based Introduction of the euro Sources: ECB, own calculations MFI cross-border assets © 8 307Sachverständigenrat | 1 - € billion 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 2003 05 07 09 11 13 15 2017 Loans to non-financial corporations Non-MFI bonds Government bonds Loans to MFIs Stocks and shares in investment funds excluding money market funds MFI bonds
  7. 7. Segmentation of banking markets Sources: ECB, own calculations © 8 307Sachverständigenrat | 1 - MFI loans to non-MFIs % In the home country 0 20 40 60 80 100 2002 04 06 08 10 12 14 16 In other euro area member states In other EU member states 2017 In the rest of the world Sources: ECB, own calculations © 8 307Sachverständigenrat | 1 - 0 10 20 30 40 Share of foreign bank assets in the euro area % Median 2000 02 04 06 08 10 12 14 162017 Spread between 1 and 3 quartilest rd
  8. 8. (Too) little risk sharing in the euro area (ECB, 2018) Three fourths of shocks are not smoothed at all
  9. 9. A wake-up call from Italy Sources: Thomson Reuters, own calculations © 8 286Sachverständigenrat | 1 - 0 50 100 150 200 250 300 350 10-year government bond spreads Basis points France Ireland Italy Portugal Spain Jan Feb Mar Apr May Jun Jul Aug Sep Oct 2018 Sources: BankFocus, Thomson Reuters, own calculations Senior CDS spreads of banks 0 25 50 75 100 125 150 175 200 225 © 8 286Sachverständigenrat | 1 - Basis points Germany France Ireland Italy Portugal Spain Jan Feb Mar Apr May Jun Jul Aug Sep Oct 2018
  10. 10. Sovereign-bank nexus as a major source of vulnerability Source: own illustration based on Shambaugh (2012) and Schnabel and Véron (2018) © 8 303Sachverständigenrat | 1 - State Domestic banks Domestic economy Default risks for government debt Erosion of guarantees Implicit and explicit guarantees Economic policy measures Economic situation and framework conditions Lower tax revenues; increased expenditures Decline in lending; misallocations Capital Markets Union Removal of privileges for sovereign exposures EDISResolution regime Integrated banking market
  11. 11. II. Deepening Banking Union
  12. 12. How to strengthen the bank resolution framework Raise the credibility of the bank resolution framework Strengthen the role of the SRB Tighten conditions for state aid and precautionary recapitalization Harmonize national bank insolvency laws ESM as fiscal backstop to the Single Resolution Fund (SRF) Need for special liquidity facility for banks in resolution Calls for national or European champions are counterproductive − Modify merger control to include systemic relevance as a criterion?
  13. 13. How to complete Banking Union: European deposit insurance − National deposit insurance… − … fosters sovereign-bank nexus through implicit government guarantees − … promotes ring-fencing − Incentive-compatible design (Schnabel and Véron, 2018): − Reinsurance system: Mutualization only when the national compartment is depleted − Bank-specific premia containing a country component − System is “country-blind” from the depositors’ perspective but not from the funding perspective − Requires a regulation of sovereign exposures
  14. 14. How to regulate sovereign exposures: Concentration charges Sources: EBA, own calculations Difference: Basis points © 8 232Sachverständigenrat | 1 - Véron (2017) Variant 1 Variant 2 Variant 3 Variant 4 -450 -400 -350 -300 -250 -200 -150 -100 -50 0 BE DE SI PT IT ES FR IE CY GR MT AT LV LU NL Concentration charges should take the credit risk of sovereign debtors into account But: Diversified portfolios could be exempted, long transitions needed
  15. 15. Is there a need for a safe asset? Requirement for larger diversification would push some banks into riskier securities, which could make banks riskier Risks could be reduced by creating a „safe asset“ ESBies? E-Bonds?
  16. 16. III. Fostering Capital Markets Union
  17. 17. European financial system remains strongly bank-based Market-based financing plays a much smaller role in Europe than in the United States Strong focus on debt financing Capital Markets Union should especially foster resilient capital flows: − Equity, FDI, long-term debt, retail Sources: Eurostat, ECB, OECD, Klapper et al. (2015) United States © 8 025Sachverständigenrat | 1 - 0 1 2 3 4 5 6 7 8 2006 08 10 12 14 2017 United Kingdom Germany Euro area (excluding Germany) Ratio of capital market financing to bank financing: External financing of companies
  18. 18. How to foster Capital Markets Union Progress on CMU is slow Partly due to supervisory authorities‘ reluctance to give up power Limited willingness to put political capital into CMU, trends towards nationalization Strengthen capital supply by expanding capital-based pension systems Standardization and harmonization (e.g. insolvency law) Strengthen ESMA to harmonize implementation of rules Remove debt bias in taxation Foster financial literacy
  19. 19. IV. How to proceed
  20. 20. How to proceed? − Status quo is unstable − Stabilization of the euro area requires more market discipline and more risk sharing (Bénassy-Quéré et al., 2018) − Rather than rejecting reforms, policymakers should focus on how risk sharing instruments can be designed in an incentive-compatible way − Reforms are likely to come too late to deal with current issues but help to stabilize expectations regarding the future of the euro area

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