This column is a lead commentary in the VoxEU Debate "Euro Area Reform"
The discussion on feasible reform of euro area governance entered into high gear following the publication in January of an important paper by seven French and seven German high-powered economists (Bénassy-Quéré et al. 2018). Two Italian economists (Messori and the author of this column) criticised those proposals (Messori and Micossi 2018), mainly claiming that in their quest to eradicate moral hazard, the authors weren’t paying sufficient attention to the liquidity dimension of financial market stability and that, as a result, euro area defences against idiosyncratic shocks could be weakened, rather than strengthened, by that governance framework. On behalf of the 7+7 economists, Pisani-Ferry and Zettelmeyer argued in a pointed response that their proposals had been factually misrepresented, and that many of the recommendations in Bénassy-Quéré et al. (2018) were in fact designed in light of the Italian situation and the imperative to reconcile the need for bold reforms with the necessity to avoid triggering turmoil (Pisani-Ferry and Zettelmeyer 2018).
Subsequent discussions with some authors of Bénassy-Quéré et al. (2018) have clarified certain critical aspects where in my view there is room to strengthen the 7+7 economists’ recommendations in view of the paramount need to make the euro area more resilient to idiosyncratic liquidity shocks. In this column I first discuss some specific recommendations by the 7+7 economists, and then comment on the overall implications of those proposals for the euro area financial stability.
On debt restructuring
A key pillar in the 7+7 recommendations is that the euro area governance needs a fallback position for the case of insolvency of a member state, and that fallback is the no-bailout rule; that the no-bailout rule is not credible unless the system includes a sovereign debt restructuring mechanism (SDRM); and that this requires a financial architecture where restructuring is possible without major disruptions in the financial system. Accordingly, they want to introduce sovereign concentration charges to disincentivise own-sovereign debt holdings by banks, and to go ahead with supranational deposit insurance (EDIS). These proposals are reasonable.
The hard question is how to avoid falling again into the ‘Deauville trap’ whereby the new SDRM is read by financial investors as the promise that debt restructuring for some highly indebted countries is inevitable, triggering financial instability.1 The line separating temporary liquidity problems in the sovereign debt markets from insolvency of the debtor is fickle and depends on investors’ expectations that there is a lender of last resort willing to intervene to stabilise markets unsettled by a liquidity shock. Thus, ESM policies on debt restructuring must dispel beyond any doubt the notion that financial distress, possibly including loss of access by the sovereign to capital markets, will likely lead to debt restructuring.
On sovereign concentration charges and the ‘safe’ asset
I have myself advocated the introduction of sovereign concentration charges to encourage banks to reduce the exposure to their sovereign in a recent CEPS Policy Insight (Misossi 2017), albeit with softer calibration of key parameters. However, I remain uneasy at the 7+7 stated goal that the reduction in sovereign charges “should be viewed as a structural change” whereby national banking sectors would lose the specific role of default absorbers of domestic sovereign debt (Bénassy-Quéré et al. 2018: 7). Whether this would happen ‘naturally’ as a result of the new disincentives to own-sovereigns holdings by the banks or following new regulations is not specified. This is consistent with another stated goal of the 7+7 economists, which is to accelerate the day of reckoning for insolvent sovereign debtors by narrowing the room to postpone hard decisions.
It seems to me that this is unnecessary and indeed counterproductive since it would have the distinct effect of reducing liquidity in some sovereign debt markets, especially as long as financial fragmentation and adverse risk spreads on high-debt sovereigns persist. To push (gently) for low concentration of own-sovereigns in banks’ assets in steady state is one thing; it is an entirely different thing to try to exclude banks from cushioning a temporary shock in national sovereign markets in conditions of distress, precisely when foreign investors might run for the door. This is a concept that in my view would weaken the resilience of the euro area and its ability to cope with idiosyncratic liquidity shocks.
Let me also note that the provision of a safe asset to accompany the diversification of banks’ portfolios – the so-called ESBies – would not change this conclusion, unless asset substitution between ESBies and national sovereigns were to be undertaken on a truly massive scale. Otherwise, the provision of the safe assets would broaden the menu of asset available to banks but would not necessarily make national sovereign markets more liquid.
On tightening the screws on state aid for banks and bail-in rules
The 7+7 economists advocate the tightening of the rules governing resolution, state aid to banks, and precautionary recapitalisations to strengthen the change in policy regime from bailout (taxpayers pay) to bail-in (shareholders and creditors pay) (Bénassy-Quéré et al. 2018: 6). These proposals make sense; however, care is needed to avoid that these changes go beyond their purpose and end up limiting the financial stability exception provided for by the 2013 Guidelines on state aid to banks (point 45) and the resolution directive (Article 31.4.d in the BRRD).2
On the European Deposit Insurance Scheme (EDIS)
The 7+7 recommendations on EDIS depart from the original Commission proposal in two important respects. First, full loss-sharing through the deposit insurance fund is excluded even in the final stage of the system (and the mutualised compartment could not be tapped until the national compartment had been fully utilised to cover ‘first losses’). Second, deposit insurance fees would include a component based on country risk, where the latter is related to certain national features like creditors’ rights and the effectiveness of insolvency and foreclosure procedures (but not sovereign debt levels). This approach clearly is a concession to German concerns on sharing national banking losses; however, it is likely to perpetuate an adverse risk premium on banks from certain countries, and therefore maintain an element of financial fragmentation even in steady state – as long as certain weaknesses in national banking systems were not eliminated – despite the uniformity across the euro area of depositors’ rights of reimbursement in case of bank failure.
On the overall impact on euro area financial stability
In the final equilibrium, the 7+7 economists recommendations entail, on one hand, stricter discipline on sovereign indebtedness, adjustment programmes for crisis lending, and the room for state aid; on the other hand, they offer improved risk sharing thanks to the introduction of EDIS, an ESM backstop for the Single Resolution Fund and the new deposit insurance system, a new ESM credit line for countries in compliance with common policies, and a ‘rainy day’ fund granting one-off transfers in case of a large unemployment shock. There is thus a need to assess the likely impact on investors’ confidence, and hence on financial fragmentation, of the resulting balance of measures designed on one hand to mitigate moral hazard and strengthen market discipline, and on the other hand to provide countries with financial assistance in meeting idiosyncratic liquidity shocks – in an environment in which the ability of the ECB to intervene as lender of last resort after the end of QE may be diminished.
The critical measures to consider in seeking an answer are the specificities of the SDRM, on one hand, and the liquidity impact of the new ESM credit line for ‘pre-qualified’ countries respecting country specific recommendations and not at risk of losing market access on the other. Clearly, there is a need to dispel the notion that financial distress conditions are a likely harbinger of debt restructuring; and there is a need to ensure that the size and access conditions to the new ESM credit line meet strict requirements of certainty and speed. Moreover, the ESM already has powers to intervene in the primary and secondary markets of sovereigns which have never been used but could be added explicitly to the tool box to combat financial instability.
Bénassy-Quéré, A, M Brunnermeier, H Enderlein, E Farhi, M Fratzscher, C Fuest, P-O Gourinchas, P Martin, J Pisani- Ferry, H Rey, I Schnabel, N Véron, B Weder di Mauro, and J Zettelmeyer (2018), “Reconciling risk sharing with market discipline: A constructive approach to euro area reform”, CEPR Policy Insight No. 91.
Messori, M and S Micossi (2018), “Counterproductive proposals on euro area reform by French and German economists”, CEPS Policy Insight No. 4.
Misossi, S (2017), “A blueprint for completing the banking union”, CEPS Policy Insight No. 42.
Micossi, S, G Bruzzone and M Cassella (2016), Fine-tuning the use of bail-in to promote a stronger EU financial system, CEPS Special Report no. 132.
Pisani-Ferry, J and J Zettelmeyer (2018), “Messori and Micossi’s reading of the Franco-German 7+7 paper is a misrepresentation”, CEPS Commentary, 19 February.
 Following their promenade on the beach of Deauville on the eve of a European Council meeting, in October 2010, Chancellor Merkel and President Sarkozy announced that henceforth sovereign bailouts from the European Stability Mechanism would require that losses be imposed on private creditors. That announcement and the subsequent application in the Greek rescue package triggered turmoil in financial markets, with contagion spreading to Ireland, Portugal, Spain and Italy.
 Footnote 4 in Bénassy-Quéré et al. (2018) specifies that that the possibility to use state aid to remedy a “serious disturbance” in the economy “should no longer be generally presumed but be assessed on a case by case basis”, and that “in cases where there is no ‘serious disturbance’, all relevant instruments would be bailed in”. This language raises the possibility that such assessment be left in the hands of the competition authorities, which of course have little taste for recognising the possible presence of a systemic stability issue; it would be useful to clarify that the proper institution to make such assessment should be the ECB, which has all the instruments and capabilities required to evaluate the presence of a systemic shock. On this, see Micossi et al. (2016).