Keynote lecture by Athanasios Orphanides, Governor of the Central Bank of Cyprus, at the conference on "The Euro Area and the Financial Crisis" organised by the National Bank of Slovakia
Bratislava, 6 September 2010
As crises often do, the global financial crisis we have been experiencing has highlighted key policy challenges that were insufficiently attended to in the past and has focused minds on needed improvements. In Europe, the crisis has exposed fault lines in governance, and deficiencies in the architecture of the financial supervisory and regulatory framework. The need for more effective micro and macro-prudential regulation and supervision, but also for better coordination between the two as well as amongst regulators, was underscored. The crisis has also confirmed that central banks can play an important role in safeguarding financial stability, but also demonstrated that a mandate to maintain price stability in not sufficient to ensure financial stability, strengthening the case that central banks need to be armed with the appropriate policy tools to enhance their contribution to financial stability.
The crisis has prompted critical thinking about the EU economic and financial policy frameworks and the need for a new supervisory architecture. The severe economic cost suffered as a result of the crisis, and acknowledgment of the need to limit the likelihood of future costly occurrences, has provided an important opportunity for the development of an improved financial stability framework for Europe and highlighted the urgency of the need for a comprehensive crisis management regime. Not that this was not understood earlier. The lack of harmonisation in the European legal and supervisory framework and its potential cost in managing crises were known. Nevertheless, perhaps due to the complications and political sensitivities involved in addressing crisis management, and perhaps owing to other policy priorities, undue reliance was arguably given to the role of crisis prevention, avoiding prickly issues such as how potential losses associated with the efficient resolution of a cross-border financial institution are allocated.
In the European context the financial crisis has illustrated not only the deficiencies of the current EU-cross-border arrangements, but also that a fragmented approach towards crisis management and resolution is insufficient to deal with these shortcomings. I take for granted the desirability of further integration of our economy across member states, and further enhancement and cross-border development of the financial industry in Europe. This is imperative to raise efficiency and more fully exploit the benefits of a common market. Even more so in the euro area, where member states have tied their fortunes together more closely by adopting the common European currency. The economic benefits of integration are unquestionable, but realising the great potential presented by our union also makes it necessary to place greater emphasis on comprehensive EU-wide solutions towards enhancing financial stability in Europe.
Against this background, I would like to thank Narodna Banka Slovenska (the National Bank of Slovakia) for the invitation to address this conference on "The Euro Area and the Financial Crisis". I focus on a few issues related to the question of how the financial supervision architecture in Europe could be strengthened for securing financial stability. Namely, I discuss elements of micro and macro-prudential policy tools towards enhancing regulation and supervision, and also the development of a crisis management framework in Europe. I also present some pertinent thoughts on governance. Before proceeding, however, I should note that the views I express are my own and do not necessarily reflect those of my colleagues on the Governing Council of the European Central Bank (ECB).
Financial stability is a multifaceted concept. It involves the stability of the whole financial system, comprising financial institutions, financial intermediaries and financial markets. The latest international financial crisis has been associated with a serious weakening and, in some cases, failure of financial institutions together with stress in credit markets and in the funding of financial institutions. These inflicted heavy costs on real economies and their taxpayers in many countries, including in the European Union.
In light of the cost associated with financial instability to the real economy as well as the threat to public finances, the desirability of policies that reduce the occurrence of future crises as well as policies that contain the damaging effects of actual crises is clearly evident. This entails two main elements. First, prudential regulation and supervision policies and second, a crisis management and resolution framework. The two elements are interrelated because the effectiveness of prudential supervision crucially depends on the incentives of financial institutions and thus on the likely costs incurred by the management and other stakeholders of a financial institution in case it needs to be resolved during a crisis. This is the notion that endgames matter(1). For cross-border institutions, EU governance issues may need to take a central role.
As already mentioned, the crisis has highlighted weakness in prudential regulation and supervision. It has demonstrated a general underappreciation of systemic risks in micro-prudential supervision and highlighted the need for a more system-wide macro-prudential approach towards supervisory oversight to ensure overall stability in the financial system. But what further prudential tools should be developed or how should existing tools be enhanced? A number of sometimes competing proposals have been put forward by policymakers, regulators, academics and the financial services industry to be included in preventive policies(2). These proposals entail specific prudential policy instruments aimed at mitigating the build-up of systemic risk. Systemic risk – that is the risk of serious disruption in the provision of financial services to the economy – arises both from linkages within the financial system and through its interaction with the real economy across the cycle. Macro-prudential policies are needed to address the cyclical aspect of systemic risk, noting that in "good times" financial imbalances tend to build up as leverage increases and financial institutions become overexposed to risks, ultimately raising the probability of triggering system-wide instability. Prudential tools can be used to counter an excessive build-up of these risks in the financial system as a whole.
Higher prudential requirements regarding capital and liquidity would enhance the resilience of credit institutions to shocks and adverse market developments. A leading role towards a harmonised global framework for the achievement of this objective rests with the Basel Committee on Banking Supervision (BCBS). In December 2009, the BCBS approved for consultation a package of proposals to strengthen global capital and liquidity regulations (Basel Committee on Banking Supervision, 2009b). These proposals are aimed at raising the quality, consistency and transparency of bank capital (predominance of common equity, phasing out of hybrid Tier I, and abolishing Tier III); introducing a simple capital-to-asset ratio (leverage ratio); introducing measures to promote the build-up of capital buffers in good times (countercyclical capital buffers); restrictions on dissipating capital when buffers are depleted (capital conservation measures); and strengthening the risk coverage of the capital framework (by increasing capital requirements for counterparty credit risk arising from derivatives, repos and securities financing activities).
Prudential regulation could also limit the build-up of liquidity risk, which proved neglected in various supervisory frameworks before the crisis. Quantitative liquidity ratios or standards that limit reliance on volatile non-core funding and prevent excessive build-up of maturity mismatches could be introduced, while other potentially volatile liability components such as foreign currency deposits should have adequate liquidity coverage and maturity matches.
Improving liquidity and capital standards should discourage excessive leverage and enhance the resilience of financial institutions during all phases of the business cycle. Adjusting regulation according to business cycle considerations may also better smooth risks across time. One approach towards that end is that of expected loss provisioning as against the current incurred loss approach, in line with the dynamic provisioning practiced by banks in Spain. Indeed, last year the European Commission started consultations with a view to adopting dynamic provisioning across the EU.
Additional macro-prudential tools could limit the build-up of more structural vulnerabilities that contribute to systemic risk. Such policies and monitoring could aim inter alia at addressing the build-up of financial imbalances in the economy relating to the raising of leverage in specific sectors. Early detection of signs of overheating of particular financial or property markets would be a case in point. Efforts aimed at affecting imbalances could include measures to attempt to directly reduce mortgage or credit demand from specific economic sectors. Prudent collateral policies could be used, for example by setting minimum margins on collateral and/or capping loan-to-value ratios. There is some uncertainty regarding the effectiveness of loan-to-value ratios and margin requirements in reducing risk taking as financial institutions may attempt to evade, in part, such regulations. Nonetheless, there are examples where these tools appeared to have an effect towards dampening risk taking. A recent example I am personally familiar with is the reduction in the loan-to-value ratios in the real estate sector in Cyprus in July 2007, near the peak of a rapid run-up in real-estate prices and fast credit growth in that sector. Raising the shock absorbing capacity of lending in real estate with a stricter loan-to-value regulation before the crisis erupted, was one of the factors that contributed to the maintenance of stability on the island in 2008 and 2009, years that proved quite difficult for other banking systems in Europe.
Shortcomings in regulation and supervision reflected in inadequate macro and micro-prudential policies have been identified as major factors contributing to the international financial crisis. In Europe rules and regulations for the financial sector are made at the country level and are not fully aligned across the euro area, despite the existence of some common directives. And even when rules and regulations are similar, national differences in interpretation and rigour of application have resulted in a fragmented and highly decentralised supervisory structure across Europe that is much too micro and institutionally focused.
The crisis has revealed not only the need for more effective micro and macro-prudential regulation and supervision, but also the need for better coordination between the micro and macro parts, especially in providing timely information. Considering the important informational synergies between micro-prudential supervision and systemic risk analysis, bringing micro-supervision under the same roof as other central bank functions seems very appropriate. Central banks can benefit from, and rely on, extended access to supervisory information and intelligence, especially on systemically relevant intermediaries, in order to better assess risks and vulnerabilities of the financial system as a whole Overall, a lesson of the crisis is that greater central bank involvement in regulation and supervision pertaining to credit and finance should contribute to better management of overall economic stability(3).
In Europe the need for strengthening the macro-prudential orientation of financial supervision has led to an important new initiative at the EU level. It was decided by the European Council in June 2009, in line with the de Larosiere (2009) report, to entrust macro-prudential supervision to a new body, the European Systemic Risk Board, with the objective of increasing the focus on systemic risk within the framework of financial supervision. Institutionally and at the EU level, the ESRB should be in a favourable position to undertake system-wide risk assessments with policy to detect areas of emerging financial imbalances and related structural vulnerabilities. The ESRB can provide policy recommendations based on its risk assessments that can be converted into effective policy actions via the use of macro-prudential tools and measures outlined above.
To enhance micro-prudential supervision in Europe, new EU supervisory authorities (ESAs) are currently being set up which, among other things, will help coordination and converge the content and implementation of regulatory standards. The ESAs that are being created include the European Banking Authority that combines advantages of a European wide framework for financial supervision with the expertise of micro-prudential supervision bodies at the national level that are closest to the institutions operating in their jurisdictions. However, in certain cross-border emergency situations, the tools for coordinated effective action by national supervisors may be insufficient, and this, consequently, points to the need for building a comprehensive cross-border framework to strengthen the European Union’s financial crisis management(4).
It is recognised that close cooperation between the ESRB and the new European Supervisory Authorities in establishing the link between macro and micro-prudential supervision would be useful for strengthening financial stability in Europe. For example, the ESRB together with the newly established European Banking Authority could conduct EU-wide stress tests on a regular basis to assess the resilience of financial institutions to adverse shocks.
Apart from the requirement of integrating macro with micro-prudential supervision and regulation, an urgently needed convergence of supervisory standards across Europe is required with supervisors addressing problems through European rather than national approaches. While the creation of a supranational financial supervisory authority for Europe does not currently appear to enjoy strong support, efforts should be made at helping the existing highly decentralised system of supervision become sufficiently effective so that it can act as one in dealing with crisis prevention and management.
Effective prudential supervision can help prevent the occurrence of a crisis. But to contain the economic and budgetary cost of a crisis once it materialises and swiftly restore financial stability, requires effective crisis management mechanisms. A transparent pre-agreed crisis management framework also reduces the moral hazard for banks, therefore contributing to reducing the risk of a financial crisis. The presence of a legal authority for prompt action and clear rules about how potential losses are allocated affects incentives and actual behaviour long before difficulties arise, and indeed might effectively discourage excessive risk taking. These are serious weaknesses in policies and procedures relating to crisis management in Europe. Indeed, the de Larosiere report called for "a coherent and workable framework for crisis management in the EU". But little progress has been made towards a comprehensive European crisis framework focusing on early intervention by supervisors, bank resolution and more formal procedures for the rapid winding-up of insolvent financial institutions. European Union bodies have been working on developing a crisis management framework and the European Commission has indicated to the G20 that it will set out its "orientations" for a crisis management framework in October 2010. At the same time the EU states that it looks forward to the Financial Stability Board, in cooperation with the BCBS, providing concrete policy recommendations for reducing moral hazard posed by systemically important financial institutions at the G-20 November 2010 Seoul Summit.
The crisis has provided a fresh opportunity for the EU to build a crisis management framework consistent with the regulatory and supervisory frameworks improving coordination between policymakers and taking account of the potential problems of moral hazard, burden sharing and allocation of costs. The development of a comprehensive crisis management framework would also appear in line with EU citizens support for stronger supervision by the EU of the activities of the most important international financial groups. According to the latest Eurobarometer public opinion poll, 75% of Europeans agreed that stronger coordination of economic and financial policies among EU member states would be effective as a means for combating the crisis (Council of the European Union, 2010a). I note that the strongest support, 89%, was registered in Slovakia, while Cyprus, at 87%, tied for second place with Belgium.
In the euro area stability framework, liquidity matters clearly lie within the ECB’s mandate which exercises a rigorous European approach. As a result, there is already in place a mechanism for dealing with liquidity crises, and indeed, the experience since the beginning of the turbulences in August 2007, which were originally manifested in the money markets, serves as evidence of the effectiveness of the ECB in alleviating liquidity issues. In contrast, solvency matters are addressed exclusively by national institutions, which may have differences on what constitutes a systemic threat, in identifying potential insolvency, and about how and when public resources should be employed. As numerous observers have pointed out, and experience during the crisis painfully confirmed, crisis management involving cross-border institutions in such a decentralized system is a highly inefficient and difficult task. The failure of Fortis in September 2008, highlighted conflicting national interests and the inability of governments in the Benelux region - arguably the most integrated region in the euro area - to find an efficient way to resolve a cross-border concern.
Accordingly, the greatest difficulty, perhaps, is associated with developing a framework for crisis management for dealing with problems involving cross-border financial groups that should have procedures for early intervention, bank resolution and insolvency. At present, there is no common approach in Europe for early public intervention in the case of a troubled financial institution. The absence of such a mechanism increases moral hazard on the part of the management of institutions that may find themselves in trouble. There is a need for supervisory authorities to have a stronger set of tools so that they can use and intervene at an early stage to avoid the failure of an institution or at least limit its problems. While many stakeholders are in favour of minimum rather than maximum harmonisation, a credible threat of early intervention provides incentives for financial institutions to guard their capital and thereby reduce systemic risks and moral hazard problems. The absence of such mechanisms leaves policymakers with only bad choices during a crisis and often proves very costly to taxpayers.
Where early intervention fails to deal with the problems of a distressed bank the second pillar "bank resolution" involves reorganising the troubled bank in the most cost-efficient manner for the economy and society, before it becomes insolvent. Resolution measures that might be taken by the competent authorities include, for example, transfer of assets/liabilities, a bridge bank, good bank/bad bank split, so as to preserve the value of remaining assets and facilitate, if possible, a quick return to their productive use. An appropriate legal framework is needed for resolution, especially since resolution measures may impinge on shareholder rights (under company or other laws). Moreover, resolution measures entail costs, which need to be financed, ideally by the financial industry itself. However, controversy surrounds the concrete means of financing and burden sharing as well as the level of authority (EU or national) to be responsible for bank resolution. A global consensus is emerging that shareholders and uninsured creditors of a bank should be the first to bear the costs of its distress, in line with the principle "the polluter pays". A key issue is how to credibly implement this attractive idea.
A European resolution authority, as argued for example by Fonteyne et al (2010), could be created and be given the mandate and tools to resolve large cross-border bank problems, particularly in a cost-effective manner. To deal with the financing of bank resolution measures and, ultimately, the use of public money to support ailing banks, the Commission has suggested the establishment of bank resolution funds by member states to be funded ex ante by a levy on banks. Together with the G20, they have asked specifically for the IMF to study this funding proposal. (G20 Pittsburg Summit, 2009). However, the resolution funds could be used as insurance against failure or to bail out failing banks thus creating a moral hazard problem.
Fonteyne et al (2010) contend that a resolution framework needs to include a European Deposit Insurance and Resolution Fund that is pre-funded by the financial industry through deposit insurance premiums and systemic levies, so as to minimise costs of crisis management to government budgets. The authors argue further that the crisis management and resolution framework for European banking system should be designed to implement and achieve commonly agreed principles and objectives. There should be ex ante agreement on these objectives and principles to allow rapid decision-making in crisis situations with countries agreeing to a third party, such as a European resolution authority, largely managing financial crises for them.
In this context it may be recalled that on 9 October 2007, the EU’s Economic and Financial Affairs Council (ECOFIN) adopted a set of common principles for the management of any cross-border financial crisis (Council of the European Union, 2007), which were later endorsed by the financial supervisory authorities and central banks as part of the 1 June 2008 Crisis Management Memorandum of Understanding (Council of the European Union, 2008). Key elements of these principles are that:
the objective of crisis management is to protect the stability of the financial system in all countries involved and in the EU as a whole, and is not to prevent bank failures,
crisis management should minimise potential harmful economic impacts at the lowest overall collective cost, and
direct budgetary net costs should be shared among affected member states on the basis of equitable and balanced criteria.
While these principles are sound, the crisis has demonstrated that non-binding commitments or understandings insufficiently guarantee their consistent implementation, to the detriment of mutual trust and cooperation and, consequently, crisis outcomes. In this context, it is noted that in April 2010 the EU and euro-area member states together with the IMF agreed on a loan to Greece, with participation of euro-area members, to be ratified by their respective parliaments. However, last month the parliament of one euro area member state voted overwhelmingly against contributing to the agreed loan. This decision highlighted the challenge of successfully achieving cohesiveness and solidarity of member states within the EU, despite the public support for stronger coordination of economic and financial policies reflected in the Spring 2010 Eurobarometer survey I mentioned earlier.
This underscores the need for strong binding and institutionalised arrangements for EU crisis management, putting the principles agreed upon on an operational basis. Cost minimisation needs to be defined more precisely, with cost-effectiveness representing a major challenge, as avoiding or minimising costs is the best way to preclude disagreements about their distribution or burden sharing between EU members states: cost-effectiveness is also essential to deal with moral hazard and "too-big-to-fail" or "too-big-to-save" financial institutions. Indeed, it is argued that only a cost-effective resolution offers a credible threat of failure and exit (Cihak and Nier, 2009). And cost-effectiveness in arranging a deal with a failing cross-border bank should comprise no losses to insured depositors, minimal losses to deposit guarantee systems, minimal collateral damage to the economy, and minimal or no costs to government budgets.
In the case of insolvency proceedings, where resolution measures cannot return the distressed bank or part of it to viability, these proceedings should ensure an orderly wind down. However, insolvency regimes differ substantially across the 27 EU countries and initiatives to promote their harmonisation are required. In particular, there are major differences between EU members in bankruptcy legislation and procedures. The European Commission’s initiative to establish a group of experts on insolvency law is commendable, but harmonisation of insolvency regimes, while certainly feasible, will be difficult.
Alternatively, the Basel Committee on Banking Supervision (2009a) argues that contingent resolution plans ("living wills") could be an effective tool for crisis contingency preparedness for large and complex financial groups. These institutions would be required to devise detailed and regularly updated plans for dissolution that need to be approved by the supervisory authority. In principle, these plans would also "specify formulas for loss sharing among international subsidiaries of the bank (such loss-sharing arrangements would be preapproved by regulators in countries where subsidiaries are located)" (Calomiris, 2009, p.10). It is important also that supervisors should have the power to require a banking group to formulate an acceptable winding-down plan, so that the living will puts in place all the conditions, ex ante, that would allow a wider range of options beyond having the whole bank rescued.
For the euro area the crisis demonstrated the need for greater cooperation and coordination between member states and, moreover, raised questions about euro area governance. Which European institutions are ultimately in charge of surveillance and collective action in times of stress, and how can member states be disciplined to adhere to agreed policies? Is it sufficient for the Van Rompuy task force on euro area governance (Council of the European Union, 2010b) to concentrate on enforcement and strengthening of existing EMU provisions? Or are there more macro- surveillance problems that go beyond weak enforcement in the fiscal area? In this respect, the European Commission has proposed that macro surveillance go "beyond the budgetary dimension to address other macro economic imbalances" (European Commission, 2010).
Some commentators contend that euro area governance has been characterised by a lack of policy coherence, with most member states not gearing domestic policies, particularly wage setting, to euro area policy management(5). Even under the Stability and Growth Pact (SGP) member states have demonstrated little ownership of fiscal targets to which they were committed. Certainly, the crisis has exposed fault lines in the governance of the euro area, and much is expected of the Van Rompuy task force on multiple fronts including strengthening surveillance of budgetary policies and more effective corrective measures; and improving surveillance of competitiveness developments and the correction of imbalances. In particular, there are three pillars on which stronger governance may rely in order to reinforce compliance of national authorities with the rules of the Treaty and the SGP. First, reinforcing the SGP through, for example, more effective fiscal surveillance, wider spectrum of sanctions, strengthening of the independence of fiscal surveillance, etc. Second, addressing imbalances in competitiveness through, for example, less strict surveillance of countries which perform well and stricter oversight for member states with excessive vulnerabilities. Third, establishing a permanent framework for crisis management that will minimise moral hazard problems and at the same time provide a credible establishment for countries in true need. Within this framework a euro area crisis management institution could be developed.
The crisis has provided an opportunity to construct a comprehensive crisis-management regime that can replace the current patchwork of limited financial stability arrangements based largely on national interests. And as outlined earlier, it is recommended that institutional arrangements for resolving problems of large cross-border banks should give authority to a pan-European institution backed by ex ante largely private funding arrangements. Furthermore, in extending financial assistance to member states - such as under the European Financial Stability Facility (EFSF) created in May 2010 to address tensions in the euro area sovereign debt markets and from unsustainable financial imbalances - there is a need for a strengthening of institutional arrangements and legal obligations so that member states can show greater cohesiveness in fully honouring their commitments and providing funding and loan guarantees for assistance to financially distressed members.
At this stage of the crisis, and while efforts are still in progress to strengthen the framework for surveillance, corrective measures and mutual support, it is critical for all governments in the EU, and in particular in the euro area, to show their support for a European approach. It would be especially unfortunate, in light of the strong support exhibited by the citizens of Europe for stronger European economic governance, if this strengthening is not achieved within a reasonable time-frame.
The crisis has brought to the forefront the need to build a European financial supervisory architecture. There has been progress in developing the institutional framework for micro and macro-prudential supervision, including the recent process of creating pan-EU financial supervisory authorities. Progress in establishing prudential tools, especially more appropriate capital and liquidity requirements, for contributing to crisis prevention, has been more limited. But it is in the construction of a comprehensive European crisis management and resolution framework where there is a real deficiency and where much work needs to be undertaken.
In my remarks I have provided some thoughts on the way forward for building a crisis management framework, which needs to address problems of moral hazard, burden-sharing and cost-effectiveness and, moreover, problems of policy coordination between the various financial authorities in Europe. Inevitably, such discussion leads to issues of economic governance in Europe on which I have posed some questions and furnished some further considerations. An extended discussion on the most effective ways to improve regulation and monitoring as well as facing potential future crisis has been going on for some time in European and international fora. It is also apparent that an integrated approach to prevention management and conflict resolution is crucial to ensure financial stability.
In closing, I note that is virtually impossible to avert future crises without an unwelcome change in the core elements of the philosophy of our economic system based on the free market ideology and the fundamental principles of free movement of labour, capital, goods and services. It is, however, feasible to work towards a framework that supports economic efficiency and growth while it reduces the frequency and the cost of future crises. Building this framework should be one of our main present tasks.
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ENDNOTES:
(1) This is discussed in detail in Claessens et al (2010).
(2) See e.g. International Monetary Fund (2010a).
(3) See e.g. Orphanides (2009 and 2010).
(4) See e.g. European Commission (2009).
(5) See the discussion in Bini Smaghi (2010), Gaspar (2010), International Monetary Fund (2010b) and Pisani-Ferry (2010).
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