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Financial stability in Europe: a European public good


Speech by Panicos Demetriades, Governor of the Central Bank of Cyprus, at the Fiduciary Future Cyprus 2012 Conference

Nicosia, 1 November 2012

 

Ladies and gentlemen,

I am very pleased to be part of this event today. Let me first extend my thanks to the organisers of this conference for their invitation and the opportunity to discuss broadly the importance of financial stability from an international and, more particularly, a European perspective.

Introduction

One of the causes of the financial crisis was the failure of national governments to properly rein in some of the volatile and unstable aspects of market forces, which were fast becoming global in nature. Policymaking remained almost exclusively concentrated at the level of the nation-state, hence leaving unmanaged the rapid emerging reality of global finance (Padoa-Schioppa, 2010). The increase in cross-border financial activities required a corresponding increase in the provision of basic facilities or services – supporting or facilitating those activities – including prudent regulation and supervision from a cross-border perspective. Nevertheless, the supply of such facilities or services was deficient or lacking because national governments inherently could not provide for them.

Financial stability is, therefore, a global public good transcending national objectives and interests. A public good is a good that is both non-rivalrous and non-excludable: that is, one's use of a public good does not reduce the availability to others and one cannot effectively prevent the use by others (Shirakawa, 2012). Non-rivalry in consumption means that the marginal cost of providing the benefit to an additional consumer is zero. Non-excludability in supply means that no one would be willing voluntarily to help supply the good or pay for using it. Consequently, two important features of public goods are that they will not be provided if left solely to the market, and that they tend to be consumed excessively when they are provided at all.

Everyone would like to see financial stability preserved because there are both private and public costs associated with bank failures, market disfunctions and systemic financial problems. However, no one individual or small group of individuals can do much to prevent problems from arising beyond engaging in prudent portfolio and risk management. Moreover, because the private cost of doing something about systemic risk is too high, and the private rewards too low, on balance everyone has the incentive to let someone else worry about it (Schinasi, 2006). Safeguarding financial stability provides benefits to all individuals, and the fact that one person incurs these benefits does not prevent others from doing so. Thus, the principles of non-excludability and non-rivalry apply to financial stability just as they do to other public goods such as national defence and the maintenance of law and order.

EU financial intermediation and integration

Turning to Europe, in order to understand better the importance of financial stability and why it should be viewed as a European public good, let me talk briefly about developments regarding financial intermediation and integration in the EU, by focusing on the banking sector.

Financial intermediation in the EU increased considerably in the years leading up to the financial crisis. This is evident, for example, from the growth in the (relative) size of the European banking sector during the above period. Total asset growth significantly outpaced GDP growth, with total non-consolidated banking assets in the EU reaching €43 trillion by 2008 (€32 trillion in the euro area) or about 350% of EU GDP (High-level Expert Group on Reforming the Structure of the EU Banking Sector, 2012). The EU banking sector is large by international comparisons and this partly reflects the greater dependence of the European economy on bank intermediation, with bank credit being the main source of finance for the EU private sector. There is, however, significant variation in the size of the industry between European countries. The largest banking sectors are in the UK, Germany and France, while in Luxembourg, Ireland, Malta and Cyprus, all international financial centres, banking assets relative to GDP appear to be the largest.

The years preceding the financial crisis were characterised by growing cross-border financial and banking activity in the EU. Financial integration, as measured by several statistics (e.g. cross-country interest spreads, their volatility, cross-border investment and portfolio flows) increased steadily but, in some cases, strongly and rapidly. This progress, taking place in the context of the competitive EU market for capital and financial services prevailing since the early 1990s, was further boosted after 1999 by the introduction of the single currency, which increased asset substitutability across frontiers by eliminating currency risks (European Central Bank, 2012).

The growth in the banking sector was accompanied by an increased internationalisation of activities, both within the EU and globally. However, the degree of cross-border bank penetration differs significantly between member states. In some member states, in particular the larger economies, the share of assets of non-domestic banks is more limited – these member states tend to export banking services to other member states and are home to large banking groups. By comparison, in other member states, the banking sector is dominated by non-domestic banks, which in some cases have a share of more than 80% or 90% of total banking sector assets.

The crisis has shown that, while there are clear benefits to financial integration, it also carries financial stability risks. It is evident that some banks domiciled in one member state that operate on a cross-border basis have been adversely affected by negative developments in other member states where they have a presence. A good example is Cypriot banks that operate in a number of other EU member states (e.g. Greece, UK, Romania, Malta), with particularly strong presence in the Greek market. Specifically, around 34% and 47% of the operations of the two largest Cypriot banks, respectively, that have requested state aid are in Greece. The Cyprus banking sector has indeed suffered from contagion from Greece, especially with regard to the heavy losses imposed by the Greek PSI, which cost banks an amount equivalent to around 25% of Cyprus’s GDP. It should not be forgotten that the Cyprus government willingly provided its agreement to the Greek PSI, despite the very serious negative impact on the domestic banking sector, in order to contribute to the solution of a European problem together with its EU partners. The two banks have also been adversely affected as a result of the significant asset quality deterioration of the banks’ Greek loan portfolio and, therefore, recapitalisation will need to cover for the significant losses arising from the banks’ Greek operations too.

Impact of the financial crisis on the wider EU economy

The costs of financial instability and banking crises go beyond the costs of explicit or implicit fiscal support and central bank liquidity provision. While not all of the adverse economic consequences since the onset of the crisis can be attributed to failures in the banking sector, the system had a key role to play, not only in terms of the costs of bailing out the banks, but also the costs related to the misallocation of resources and boom-bust cycles experienced in a number of member states.

The financial crisis has triggered a recession and significant job losses in the EU. The unemployment rate in the euro area increased from a pre-crisis low of 7,3% to 11,4% in August 2012 (10,5% at EU level). This average conceals sharp differences across member states with the lowest rate in Austria (4,5%) and the highest rate in Spain (25,1%). Eurostat estimates that in August 2012 25,7 million people were unemployed in the EU, of whom 18,2 million were in the euro area. Average youth unemployment in the EU reached 22,7% in August 2012, with unemployment rates exceeding 55% and 52% in Greece and Spain, respectively, and over 30% in several other member states.

There has been a significant increase in public debt levels, which will imply higher debt servicing costs for future generations and which can at least partly be attributed to the direct and indirect costs of bailing out the banks. Laeven and Valencia (2012) estimate that for the period 1970-2011 the increase in public debt due to banking crises in advanced economies amounts to, on average, 21% of GDP. The euro area currently stands at 20%, whereas the US does worse with 24% of GDP.

Output has fallen particularly sharply since the onset of the crisis and the weak growth is expected to persist in 2012 and possibly beyond. The final costs associated with output losses are yet to be determined. But experience from previous systemic banking crises suggests that these are significant. Laeven and Valencia (2012) estimate that the cumulative output loss of banking crises in advanced economies in the period 1970-2011 amounts to, on average, 33% of GDP (measured cumulatively in net present value terms and as the deviation from trend GDP). For the euro area, the current output loss stands at 23%, whereas the US again does worse with 31%; but the final outcome is hard to predict given the ongoing bank-sovereign feedback loop that puts a further burden on several EU member states.

The financial crisis also had a significant impact on the financial position of European households, reflecting a combination of a rise in unemployment, low or stagnant wage growth, higher inflation, rises in indirect taxes, and austerity measures restricting governments' room for manoeuvre. The number of people running into debt has risen, and there are signs of rising poverty in many member states. The crisis affected households' capacity to service existing loans and their ability to continue or increase such borrowing. There has been a sharp rise in mortgage arrears in some member states, such as Spain and the UK, as well as house repossessions in several EU markets. While the actual detriment to households was greater in some member states than in others, there has been a general erosion of consumer confidence and trust in the financial sector.

Reforms in EU financial stability arrangements

Broadly speaking, the pre-crisis financial stability arrangements in the EU were characterised by a dichotomy between the increasingly globalised nature of finance and the national nature of supervision and regulation, which remained a prerogative of member states, with only a modest degree of supranational coordination. This asymmetry was more relevant in the euro area, because of the tensions generated by the existence of a common currency and central bank, while substantial supervisory, fiscal and economic policy powers remained in national hands without sufficient discipline being exercised by the coordination mechanisms. This dichotomy prevented the full integration of the EU financial sector and the detection of the build-up of vulnerabilities before the crisis. Once these risks materialised, it also proved to be an obstacle to the efficient management of the crisis.

A number of initiatives have been taken or are currently underway at the EU level to enhance the stability and resilience of the financial system. These include the reform of the supervisory, regulatory and crisis management and resolution frameworks as well as the creation of a banking union.

Financial supervisory framework

Following the crisis, the EU supervisory framework underwent a comprehensive reform, aimed at ensuring a stable, reliable and robust single market for financial services. The new EU supervisory architecture consists of two mutually reinforcing European pillars: (a) a macro-prudential pillar, with the creation of the European Systemic Risk Board (ESRB) and (b) a micro-prudential pillar, with the establishment of three European Supervisory Authorities (ESAs) for banking (EBA), securities (ESMA) and insurance and occupational pension funds (EIOPA).

It is widely accepted that insufficient regulation and supervision of the financial system as a whole was a very serious shortcoming of public financial policy prior to the financial crisis. The supervisors did not see the forest for the trees. Hence, there is now widespread recognition that it is essential to enhance the macro-prudential orientation of supervision by having an authority monitoring the entire financial system, spotting vulnerabilities and systemic risks that are not apparent when attention is concentrated on individual financial institutions and implementing policies to prevent or mitigate the build-up of systemic risks. Recognition of these risks is without doubt one of the most important lessons learned from the financial crisis (Bingham, G., Sigurðsson, J. and Jännäri, K., 2012).

Financial regulatory framework

The crisis has highlighted the urgency of overhauling the regulatory capital framework in the EU. The European Commission has issued a proposal for a Capital Requirements Directive (CRD IV) and a Capital Requirements Regulation (CRR) to implement the Basel III framework, which is aimed at strengthening the quality and quantity of capital. Beyond the micro-prudential dimension of capital, the new capital framework also introduces key macro-prudential elements, such as a capital conservation buffer and a counter-cyclical capital buffer. These requirements ensure, respectively, that banks build up capital buffers outside periods of stress and provide for a safeguard for periods of excessive growth. In order to prevent the build-up of leverage, a leverage ratio has been included in the framework. Furthermore, the CRD IV incorporates new liquidity standards, which should ensure that banks hold sufficient high quality liquid assets to withstand acute stress. In the longer term, they will increase banks’ incentives to use more stable sources of funding on a structural basis.

Crisis management and resolution framework

The crisis also revealed severe deficiencies in the crisis management framework. Member states were forced to resort to a government funded bailout to prevent a potentially disorderly failure of financial institutions, but burdened taxpayers with deteriorating public finances. The reasons were manifold. First, the absence of a bank resolution regime often precluded the option of an orderly closure of financial institutions. Second, even if a well-designed bank resolution regime had been in place in an individual country, this did not guarantee that the resolution of a cross-border bank could also be dealt with effectively, as there was no adequate resolution framework for such banks. Third, given the lack of a clear legal framework, rescue strategies were surrounded by a high degree of uncertainty. One of the main obstacles to group resolution lay in the fact that procedural and substantive insolvency rules are a matter of domestic law. Another relates to asset transferability within groups. While supervisory ring-fencing measures served to protect domestic creditors and shareholders from unfavourable transfers, they sometimes made the survival of a group more difficult. Fourth, and closely linked to the previous two points, the inadequacy of private financing arrangements and the lack of ex ante burden sharing arrangements also posed a significant barrier to effective resolution. In their absence, strong interlinkages existed between supervisory and crisis management policies and national fiscal policies. In this context, more effective cooperation and exchange of information among national authorities would have been helpful.

In light of the above, in June of this year the European Commission adopted proposals for EU-wide rules for bank recovery and resolution (European Commission, 2012a), which ensure that in the future authorities will have the means to intervene decisively both before problems occur and early on in the process if they do. Furthermore, if the financial situation of a bank deteriorates beyond repair, the proposal ensures that a bank's critical functions can be rescued while the costs of restructuring and resolving failing banks fall upon the bank's owners and creditors and not on taxpayers. To be effective, the resolution tools will require a certain amount of funding. If market funding is not available and in order to avoid resolution actions from being funded by the state, supplementary funding will be provided by resolution funds, which will raise contributions from banks proportionate to their liabilities and risk profiles. The funds will be used exclusively for supporting orderly reorganisation and resolution, and never to bail out a bank.

Sovereign debt crisis management instruments

New crisis management instruments have been created over the past two years to guarantee the financial stability of the euro area. The European Financial Stability Facility (EFSF) was established in June 2010, while the European Stability Mechanism (ESM) entered into force in September 2012. The main rationale for the EFSF and ESM’s core activities is to relieve a euro area country from market pressure for a limited period of time to allow it to adjust in times of severe economic stress. The ESM will function as a permanent firewall for the eurozone with a maximum lending capacity of €500 billion.

The foreseen use of ESM loans for the direct recapitalisation of banks will allow negative feedback loops between sovereigns and the banking sector, such as those seen during the crisis, to be weakened. By ensuring the capacity of the government concerned to finance bank recapitalisation at sustainable borrowing costs, it should help to preserve financial stability in the euro area as a whole and within euro area countries and limit the contagion of financial stress. In this respect, when taking the example of Cyprus, by the direct recapitalisation of Cypriot banks via the ESM, not only is the stability of the domestic financial system safeguarded but financial stability in the EU is enhanced as well.

European banking union

Finally, the European banking union is envisaged to be one of the main drivers towards strengthening the Economic and Monetary Union and fostering deeper financial integration. It will also help break the link between sovereigns and banks. In the future, bank losses should no longer become the taxpayers' debt, putting into doubt the financial stability of whole countries.

The banking union rests on the completion of the single rulebook, i.e. a set of common standards applicable to all financial institutions across the whole EU. Such rules should help to reduce regulatory arbitrage and advance progress towards more sustainable financial integration in the EU.

The banking union should have three crucial elements: a single supervisory mechanism (SSM), a common resolution framework and a unified deposit guarantee scheme. The Commission proposals for a SSM for banks in the euro area published in June of this year (European Commission, 2012b) are an important first step in creating a banking union that will help restore confidence in the supervision of all banks in the euro area, while reinforced supervision within the new system will help improve the robustness of banks. If a crisis does occur it is necessary to ensure that institutions can be resolved in an orderly manner and that depositors are assured their savings are safe. Against this background, a banking union should also include a more centralised management of banking crises. Therefore, a single resolution mechanism, which would govern the resolution of banks and coordinate the application of resolution tools to banks within the banking union, is needed. In addition, a unified deposit insurance scheme should also be established.

Concluding remarks

Financial stability plays a crucial role in the economy and society as a whole, as the financial crisis has shown. And with an increasing number of financial institutions now active in one or more countries or continents, global financial stability has become even more important.

In Europe, establishing adequate arrangements for safeguarding the stability of the financial system is of vital importance. Financial stability is a European public good and as such it should be preserved. In this regard, recent decisions and actions at the EU level are in the right direction. A prime example is the significant progress made in creating a European banking union. This is particularly important, especially for countries like Cyprus with large banking systems relative to the size of the economy since it will help decouple sovereigns from banks. The direct recapitalisation of Cypriot banks via the ESM would also help enhance financial stability not only on the island but also in Europe.

Continuing with the issue of Cyprus, there has been substantial progress with the Troika. I anticipate that the Troika will be in a position to come to Cyprus soon for the purpose of finalising the financial assistance programme. It needs to be emphasised that there has been substantial goodwill on all sides, i.e. government, political parties and other stakeholders. Everyone has shown understanding, willingness and flexibility for the purpose of adopting a programme of fiscal and structural adjustment appropriate for the needs of our country. The reforms will help restore confidence and sustainable growth.

While to outsiders the time it has taken for all the stakeholders in Cyprus to agree on a common understanding for the programme may appear long, one has to bear in mind that these are perhaps the most significant reforms in the life of the Republic since its independence in 1960.

I am optimistic that, with appropriate national policies and EU financial assistance, the Cyprus banking sector and the economy as a whole will recover and emerge stronger from the current crisis.

Thank you.

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REFERENCES:

Bingham, G., Sigurðsson, J. and Jännäri, K. (2012) "Framework for financial stability in Iceland", Recommendations of the Group of Three to the Ministries of Industries and Innovation and the Minister of Finance and Economic Affairs, October.

European Central Bank (2012), Financial integration in Europe, April.

European Commission (2012a) Proposal for a Directive of the European Parliament and of the Council establishing a framework for the recovery and resolution of credit institutions and investment firms and amending Council Directives 77/91/EEC and 82/891/EC, Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC and 2011/35/EC and Regulation (EU) No 1093/2010, June.

European Commission (2012b) Proposal for a Council Regulation conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions, September.

High-level Expert Group on Reforming the Structure of the EU Banking Sector (2012) Final report, October.

Laeven, L. and Valencia, F. (2012) "Systemic banking crisis database: an update", IMF Working Paper 12/163.

Padoa-Schioppa, Tommaso (2010) "Markets and government before, during, and after the 2007-20XX crisis", The Per Jacobsson Lecture in Basel, Switzerland, 27 June.

Schinasi, G.J. (2006) Safeguarding financial stability: theory and practice, International Monetary Fund.

Shirakawa, M. (2012) "International financial stability as a public good", Keynote address at a High-Level Seminar co-hosted by the Bank of Japan and the International Monetary Fund in Tokyo, Japan, 14 October.