the european debt crisis and the banking union proposal

1 1

The European Debt Crisis and the Banking Union Proposal

Claudia M. Buch (IWH Halle & University Magdeburg) Tobias Körner (German Council of Economic Experts)

Benjamin Weigert (German Council of Economic Experts)

Boston College/DIW Summer School June 11, 2013

1 1

2 2

A vicious circle of bank distress, sovereign risk, and macroeconomic crisis

Claudia M. Buch

Vicious circle of banking, debt and macroeconomic crises

© Sachverständigenrat

Bankingcrisis

Macro-economic

crisis

Debtcrisis

Economic downturn leading to debt default

Credit crunch decreases investment

Declining tax revenues andincreasing transfers adversely

affect public households

Default on government bondsimpairs banks' balance sheets

and capital levels

Banks bailed out bygovernment impairsgovernment budget

Unavoidablegovernment

consolidationweakens

domestic demand

3 3

The EU’s Banking Union Proposal

June 2012 summit: Policy measures that aim at breaking the “vicious circle between banks and sovereigns”. – Establishment of a Single Supervisory Mechanism involving the ECB by

January 1, 2013. – Afterwards, the ESM shall be allowed to recapitalize banks directly.

Establishment of a Single Supervisory Mechanism would be an important step towards a Banking Union consisting of pan-European supervision, restructuring and resolution, and deposit insurance. – Internal Market rests on the principles of home country control, mutual

recognition, and minimum harmonization.

So far, only the Single Supervisory Mechanism has been decided upon (March 2013).

Buch / Körner / Weigert

4 4

Why the Banking Union is Necessary

Weak supervision and weaknesses in the real economy have created a debt overhang.

Bank risks do not stop at national borders.

Formal risk-sharing mechanisms have been absent prior to the crisis.

Risks have been shifted to the European level through common monetary policy – without corresponding control rights at the European level.

The goal should be to align liability and control – without mutualizing legacy assets.


5 5

Designing the Banking Union


European supervisory authority European restructuring authority

National supervisory authorities

– Issuance of banking licences– Ongoing supervision– Early intervention

– Identification of systemic risks

Ongoing microprudentialat the request ofsupervision

the European supervisoryauthorityEarly intervention coordinationin

uropwith the E ean supervisoryauthority

Restructuring and resolutionif the stability of the Europeanfinancial system is at risk

Restructuring and resolutionat the request of the Europeanrestructuring authorityRestructuring and resolutionif the stability of the nationalfinancial system is at risk; incoordination with the Europeanrestructuring authority

Compensation of depositors in thecontext of– Resolution by European and/or

national restructuring authorities– Insolvency proceedings

European restructuring fund

National restructuringauthorities

National deposit guarantee schemes

Microprudential supervision

Macroprudential supervision

– Specification of additionalcapital buffers

Euro

pean

leve

lN

atio

nall

evel

Supervision FinancingRestructuring

Funded by harmonized, risk-basedinsurance premiums

Funded by European bank levyFiscal backstop, for examplethrough the ESM

Financing of bank restructuringand resolution measures

6 6

How can risk-sharing mechanisms be improved?

Contingent claims allow for ex ante risk sharing: Cross-border equity ownership improves risk-sharing.

Bank assets and liabilities are non-contingent claims and allow for ex post risk-sharing only: – Deposit insurance provides risk-sharing – but it requires risk-

adjusted premia and effective supervision to prevent moral hazard.

- Bail in of creditors as a risk-sharing device

The type of shocks matters: – Bank-specific or regional shocks can be insured at the national

level. Risks of banks and sovereigns need to be disentangled.

6 Buch / Körner / Weigert

7 7

Structure of the Talk

1. The present:

How are risks allocated in Europe’s banking markets?

2. The long-run:

How can the Banking Union contribute to improved risk-sharing?

3. The transition:

How to deal with existing risks on banks’ balance sheets?


8 8

The Present: How are risks allocated in Europe’s Banking Markets?


9

The increase in external liabilities in the Euro Area has been above-average …

E to GDPxternal liabilities

Euro Area average1)

1,0

2,0

3,0

4,0

5,0

6,0

7,0

8,0

0

1,0

2,0

3,0

4,0

5,0

6,0

7,0

8,0

01993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Non-Euro Area average2)

1) Euro Area: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Portugal, Spain.– 2) Non-Euro Area: Australia, Canada,Cyprus, Czech Republic, Denmark, Estonia, Hungary, Iceland, Israel, Japan, Korea, Latvia, Lithuania, Malta, Mexico, New Zealand, Norway, Poland,Singapore, Slovak Republic, Slovenia, Sweden, Switzerland, United Kingdom, United States. Dotted lines denote the average ±1 standard deviation.

10

… but the share of equity in total cross-border assets has been below-average.

0,1

0,2

0,3

0,4

0,5

0,6

0,7

093 94 95 96 97 98 99 00 01 02 03 04 05 06 07

Euro Area average1)

0,1

0,2

0,3

0,4

0,5

0,6

093 94 95 96 97 98 99 00 01 02 03 04 05 06 07

Equity to total liabilitiesEquity to total external assets

Non-Euro Area average2)

1) Euro Area: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Portugal, Spain.– 2) Non-Euro Area: Australia, Canada,Cyprus, Czech Republic, Denmark, Estonia, Hungary, Iceland, Israel, Japan, Korea, Latvia, Lithuania, Malta, Mexico, New Zealand, Norway, Poland,Singapore, Slovak Republic, Slovenia, Sweden, Switzerland, United Kingdom, United States. Dotted lines denote the average ±1 standard deviation.

11

European financial markets have become increasingly fragmented.

1) Excluding the Eurosystem.– 2) Share of cross-border intra-Euro-Area positions in sum of cross-border intra-Euro-Area and domestic positions.

Source: ECB

10

20

30

40

50

60

0

%

10

20

30

40

50

60

0

%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Share of cross-border holdings of assets of Euro Area MFIs1)2)

Corporate bonds

Loans to non-MFIsGovernment bonds

Loans to MFIs

12

Cross-border ownership of bank assets in Europe is very heterogeneous.

Foreign ownership of banking system assets1)

20

40

60

80

100

0

%

20

40

60

80

100

0

%

AT BE BG CH CY CZ DE DK EE ES FI FR GR HU IE IT LT LU LV MT NL PL PT RO SI SK UK

2001 2010

1) Percent of the banking system's assets in banks that were foreign-controlled (where foreigners owned 50 % or more equity) at the end of the year.AT-Austria, BE-Belgium, BG-Bulgaria, CH-Switzerland, CY-Cyprus, CZ-Czech Republic, DE-Germany, DK-Denmark, EE-Estonia, ES-Spain, FI-Finland, FR-France, GR-Greece, HU-Hungary, IE-Ireland, IT-Italy, LT-Lithuania, LU-Luxembourg, LV-Latvia, MT-Malta, NL-Netherlands, PL-Poland,PT-Portugal, RO-Romania, SI-Slovenia, SK-Slovakia, UK-United Kingdom.– 2) For 2001: As of 31 December 2002

Source: World Bank

2)

13

Banks in the crisis countries are in distress …

2

4

6

8

10

12

14

16

18

20

22

0

%

2

4

6

8

10

12

14

16

18

20

22

0

%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Banks' non-performing loans in selected countries1)

as a ratio of gross loans

1) The definition of non-performing loans differs from one country to the next. For this reason it is harder to compare figures between countries thanwithin a single country over time.– 2) .For the year 2011, status: as at Q2

Source: IMF

France2)Germany

Greece Italy

Ireland

Portugal

Spain

14 14

… and rely on central bank borrowing.

Euro billion

50100150200250300350400450

02006 2007 2008 2009 2010 2011 2012 2013


Germany Greece Italy Ireland Portugal Spain

Refinancing operations TARGET2 balances

-600

-400

-200

200

400

600

800

0

2006 2007 2008 2009 2010 2011 2012 2013

15

European banks are weakly capitalized.

Bank equity in selected countries1)

as a ratio of total assets

1

2

3

4

5

6

7

8

0

%

1

2

3

4

5

6

7

8

0

%

AT BE DE ES FR GR IE IT NL PT SE UK

12/2008 6/2012

1) The data are consolidated on a cross-border basis (data on branches and subsidiaries located outside the domestic market are consolidated in thedata reported by the parent institution) and a cross-sector-basis (branches and subsidiaries of banks that can be classified as „other financialinstitutions” are included). AT-Austria, BE-Belgium, DE-Germany, ES-Spain, FR-France, GR-Greece, IE-Ireland, IT-Italy, NL-Netherlands, PT-Portugal, SE-Sweden, UK-United Kingdom.– 2) banks with total assets of moreExcluding foreign (i.e. non-EU) banks.– 3) Large / medium / smallthan 0.5% / between 0.005% and 0.5% / less than 0.005% of the total consolidated assets of EU banks of the previous year.

Source: ECB

EU2)3)

Allbanks

Large Me-dium

Small

16 16

The Long-Run: How can the Banking Union contribute to improved risk-sharing?


17 17

How can the Banking Union contribute to improved risk-sharing?

Prevention of risk-taking and reduced regulatory forbearance through the Single Supervisory Mechanism.

Improved management of bank distress through rules for the restructuring and resolution of banks: – Equity owners need to bear risk. – Explicit rules for the bail in of creditors. – Fiscal backstops.

Strengthening of the lender-of-last-resort function of the ECB by closing insolvent banks.

Improved cross-border risk sharing to higher equity capital and more cross-border equity ownership.


18 18

Implications for the Single Supervisory Mechanism

Incentives to shift risks require comprehensive competence at the European level. – Liability and control need to be at the same level. – European supervisor needs clear regulatory competence for all

banks and – ideally – all countries in the Single Market.

Stricter banking regulations need to be enforced. - Leverage Ratio should become mandatory. - Privileges for government bonds should be abolished.

Supervision and monetary policy need to be clearly separated to prevent conflicts of interest. – Basing the Single Supervisory Mechanism on Article 127 (6) of

the European Treaty has severe shortcomings.


19

Governance Structure in the Single Supervisory Mechanism (SSM)

ECB Governing Council

MembersChair not member of the ECB Governing Council- ( )2)

- Vice-Chair (member of the ECB Executive Board)2)

- One representative from the supervisory authority ofeach participating member state3)

- 4 representatives of the ECB4)

- One representative of the European Commission mayparticipate in meetings as observer upon invitation

Decision making- Simple majority, with each member having one vote- In case of draw, the Chair has the casting vote

Supervisory Board

Mediation Panel

Draftdecision1)

Objects todraft decision

- One member per partici-pating state , chosen3)

among the members ofthe Supervisory Boardor the Governing Council

- Decisions by simple ma-jority, with each memberhaving one vote

Steering Committee

- Established by the Supervisory Board from among itsmembers

- Maximum 10 members, rotation- Chaired by the Chair of the Supervisory Board- No decision-making powers

Preparatory tasks

20 20

Implications for the Single Resolution Mechanism

European banking supervision is not sufficient but needs to be complemented by authority to restructure and resolve banks. – Covered by the Treaty?

Financing mechanisms are required – European bank resolution fund financed by a European bank

levy – Fiscal backstop through the ESM – Ex ante mechanism for fiscal burden sharing – But: National deposit insurance systems


21 21

Implications for Deposit Insurance

European deposit insurance is not necessary and would set the wrong incentives. – Deposit insurance and funding mechanism differ. – There are significant implicit guarantees for banks. – Banks are burdened with legacy assets, which should not be

mutualized.

Is FDIC a good role model? – Yes: FDIC has closed more banks after the crisis than European

authorities. – But: The Institutional structure differs: FDIC has resolution

powers, and it can borrow from the Ministy of Finance.

Deposit insurance first needs to be reformed at the national level.


22 22

The Design of the Banking Union


European supervisory authority European restructuring authority

National supervisory authorities

– Issuance of banking licences– Ongoing supervision– Early intervention

– Identification of systemic risks

Ongoing microprudentialat the request ofsupervision

the European supervisoryauthorityEarly intervention coordinationin

uropwith the E ean supervisoryauthority

Restructuring and resolutionif the stability of the Europeanfinancial system is at risk

Restructuring and resolutionat the request of the Europeanrestructuring authorityRestructuring and resolutionif the stability of the nationalfinancial system is at risk; incoordination with the Europeanrestructuring authority

Compensation of depositors in thecontext of– Resolution by European and/or

national restructuring authorities– Insolvency proceedings

European restructuring fund

National restructuringauthorities

National deposit guarantee schemes

Microprudential supervision

Macroprudential supervision

– Specification of additionalcapital buffers

Euro

pean

leve

lN

atio

nall

evel

Supervision FinancingRestructuring

Funded by harmonized, risk-basedinsurance premiums

Funded by European bank levyFiscal backstop, for examplethrough the ESM

Financing of bank restructuringand resolution measures

23 23

The Transition: How to deal with existing risks on banks’ balance sheets?


24 24

Two main obstacles block the road to full Banking Union

1. Incomplete institutional and legal framework. – Basing the Single Supervisory Mechanism on Article 127 (6) of

the European Treaty has severe shortcomings. – Both, competences for supervision and restructuring must be

transferred to the European level. – Sufficient separation between monetary policy and banking

supervision must be ensured. 2. Legacy assets.

– Exiting bad debts on banks‘ balance sheets should not be mutualized.

– Governments should be liable for bank recapitalization funds through the ESM.

Transition into the Banking Union should proceed in three steps.


25 25

Concept of the GCEE for the transition to a banking union

Time

Creation of thelegal and institutional

framework

Phase 2Qualifying phase

Phase 1

Supervision and liabilityat the national level

Phase 3Fully-fledged

Banking Union

Supervision and liabilityat the European

levelGroup 2

Group 3

Group 1

January 1, 20141) January 1, 2019

General framework

1) If the legal and institutional preconditions - including the modification of the EU treaties - are not fulfilled as of 1 January 2014, phases 2 and 3 will startlater, accordingly.

26 26

Summing up

ECB interventions have stabilized the situation but the debt crisis in Europe is not yet over.

Further steps towards a new institutional framework are required: – Pillar for fiscal stability („Maastricht 2.0“) – Crisis management – Enhanced financial stability and banking regulation

Crisis management is crucial – but without jeopardizing the

transition to a stable long-run framework. – The Banking Union is not a crisis management tool. – It can contribute to improved monitoring and management of risks. – Risk-sharing needs to be enhanced through higher equity capital and the

bail in option.


27 27

The European Debt Crisis and the Banking Union Proposal

Claudia M. Buch (IWH Halle & University Magdeburg) Tobias Körner (German Council of Economic Experts)

Benjamin Weigert (German Council of Economic Experts)

Boston College/DIW Summer School June 11, 2013

27 27

28 28

Backup

29 29 Claudia M. Buch

Long-run institutional framework for the euro area


Finanzierung

National responsibility

Strengthening ofmarket discipline

European responsibility

Reformed SGPPreventive anddissuasive arm

Fiscal policy

EuropeanStability Mechanism

(ESM)

Linkages:– Financial support in

case of state insolvencies

Crisis mechanism

– Ex-ante conditionalliquidity support (com-pliance with SGP)

– Financial back-upfor bank restructuring

EuropeanBanking Union

Financial market regulation

– Supervision– Restructuring

and resolution– Restructuring

fund

Accompanyingmeasure:

Abolition of regulatoryprivileges for sovereignbonds

Fiscal Compact

– But national:deposit guaranteeschemes

No-bailout clause

State insolvencyproceedings

Nationaldebt brakes

30 30

From the internal market to a banking union


Banking Supervision in the Internal Market and the Banking Union

Decentralized

DecentralizedLiabilityControl

Centralized

Centralized

IV.Banking Union

– centralized supervision– centralized restructuring competence and

financing mechanism (e.g. through the ESM)– national deposit insurance

I.Current concept of the Internal Market

– Minimum Harmonization– Home Country Control– Mutual Recognition

ESM with liability of single member states

III.

II.Financing illiquid and insolventbanks through the central bank

ESM with direct recapitalization of bankswithout sufficient transfer of control rights

31 31

Interest rate differentials reveal structural problems in the European banking sector.

Claudia M. Buch

Source: ECB

1

2

3

4

5

6

7

8

0

% p.a.

1

2

3

4

5

6

7

8

0

% p.a.

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Loans interest rates spreads in the Euro-Area:new loans to nonfinacial corporations


GermanyItaly

Euro areaNetherlands

FranceAustria

GreecePortugal

IrelandSpain

32 32

Interest rate spreads have narrowed but remain at a high level.

Claudia M. Buch

Source: Thomson Financial Datastream

150

300

450

600

750

0

Basispunkte

150

300

450

600

750

0

Basispunkte

2010 2011 2012

10 years bond yields spreads in Italy and Spain


SpainItaly

J F M A M J J A S O N D J F M A M J J A S O N D J F M A M J J A S O N D

Announcement SMP

Draghi speechLondon Announcement

OMT

Purchases of government bonds SMP

Reducing key ECB interest rate

3 year refinancing operations

33

20406080

100

0

%

02 03 04 05 06 07 08 09 10 11 12


Cumulated financial account balances for selected countries

as a percentage of GDP (2007)

Source of basic data: Thomson Financial Datastream

Total net finacial imports Private net financial imports

-80-60-40-20

2040

0

%

02 03 04 05 06 07 08 09 10 11 12

Greece Ireland

-5

51015202530

0

%

02 03 04 05 06 07 08 09 10 11 12

Italy

20

40

60

80

0

%

02 03 04 05 06 07 08 09 10 11 12

Portugal Spain

-70

-50

-30

-10

100

%

02 03 04 05 06 07 08 09 10 11 12

Germany

102030405060

0

%

02 03 04 05 06 07 08 09 10 11 12

34

500

1,000

1,500

2,000

2,500

3,000

0

500

1,000

1,500

2,000

2,500

3,000

02013 14 2015 16 17 18 19 2020 21 22 23 24 2025 26 27 28 29 2030 31 32 33 34 2035 36 37 2038

Debts in European Redemption Fund by countryEuro, billions


ItalyGermany FranceSpain Netherlands Austria

BelgiumMalta

35 35

The debt crisis affects both, public and private creditors.

20

40

60

80

100

120

0

%

US EU-17

DE UK Asia Latin-america

Sources: IMF, Thomson Financial Datastream

Public and private debt in selected countries


General government gross debt(in percent of GDP)

2009 2010 2011

Outstanding household debt(in percent of disposable income)

2008

30

40

50

60

80

120140

100

Log. Scale3. Quarter 2007 = 100

2000 2002 2004 2006 2008 2010 2012

Spain

Belgium

France

Ireland

Italy

Portugal

United States

Presenter

Presentation Notes

Öffentliche Schulden Anstieg der öffentlichen Verschuldung auf Grund von Fiskalprogrammen und Bankenrettung, aber z.T. auch bereits hohe Niveaus vor der Krise. Weiterer Anstieg in der Krise auf Grund der nachlassenden wirtschaftlichen Dynamik. Private Schulden In USA, Irland, Spanien auf Grund der Immobilienblase Umkehr bisher nur in den USA und Irland Belastung der Bankbilanzen

the european debt crisis and the banking union proposal

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