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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
I. Financial sector in the euro area still fragile
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
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
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
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
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
(Too) little risk sharing in the euro area (ECB, 2018)
Three fourths of
shocks are not
smoothed at all
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
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
II. Deepening Banking Union
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?
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
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
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?
III. Fostering Capital Markets Union
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
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
IV. How to proceed
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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Can the EU respond adequately to the next crisis with its current instruments

  • 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. I. Financial sector in the euro area still fragile
  • 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. 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. 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. 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. 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. (Too) little risk sharing in the euro area (ECB, 2018) Three fourths of shocks are not smoothed at all
  • 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. 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
  • 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. 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. 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. 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. III. Fostering Capital Markets Union
  • 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. 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. IV. How to proceed
  • 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