1) The European banking sector remains fragile with low bank capital and high non-performing loans. Financial integration in the euro area is still low. 2) Completing the Banking Union with a European deposit insurance and regulations on sovereign exposures can help address these issues. Introducing "safe assets" may also reduce bank risk. 3) Progress on Capital Markets Union has been slow. Expanding capital-based pension systems and standardizing rules can help foster capital markets. 4) Reforms are needed to stabilize the euro area through more market discipline and risk sharing, but they must be designed to maintain proper incentives.

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

11. II. Deepening Banking Union

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