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Legacy problems in transition to a banking union

As a banking union within the Eurozone seems ever more likely, this column looks at banking union as a way of responding to the crisis, but also as a way of preventing the next one.

1. Background

At their June 2012 summit, the heads of state of the Eurozone have decided upon policy measures that aim at breaking the “vicious circle between banks and sovereigns”. Most importantly, the summit declaration envisages the establishment of a single supervisory mechanism involving the ECB. Given that the supervisory mechanism has been established, the ESM shall be allowed to recapitalise 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. Hence, a banking union is a long-term project which is part of a new institutional structure for Europe.

Such a new long-run institutional framework should rest on three pillars (GCEF 2010, 2011): A substantially enhanced Stability and Growth Pact including strict fiscal rules and an insolvency regime for sovereigns, a unified pan-European financial regulation and supervision with a wide range of effective instruments and, finally, a European Crisis Mechanism which is directly linked to the insolvency regime for sovereigns.

Just as many other elements of this new institutional structure, steps towards a banking union are blocked by legacy problems. As a result of an overexpansion of private and public sector debt in the run-up to the crisis, the Eurozone faces three severe and closely interrelated crises: a sovereign debt crisis, a banking crisis, and a macroeconomic crisis. These crises are mutually reinforcing, thus culminating in a crisis of confidence. 

Legacy problems obstruct the transition to a new long-run institutional structure in many ways. For example, enforcing the Fiscal Compact would require significant improvements in fiscal indicators in some countries. In addition, as long as banks carry non-performing assets on their balance sheets and as long as losses on these assets have not fully been acknowledged, introducing pan-European deposit insurance would amount to the introduction of an insurance system after the insured event has already happened. This would entail severe moral hazard problems. Hence, a consistent and credible framework for bank resolution and restructuring must be a core element of a banking union. Yet, progress towards financial sector reform to date has been slow, and key elements of the reform package are unlikely to be introduced in the near future. In this sense, ‘legacy’ problems not only refer to debt overhang but also to delayed financial sector reforms.

The German Council of Economic Experts (2011, 2012), has recently outlined steps towards dealing with legacy problems in the banking system and with excess debt burdens of the public sector. In the following, we summarise the main conclusions. For a full version see GCEE (2012).

2. Dealing with distressed banks

Many banks in the crisis countries are in distress and carry a high share of non-performing assets on their balance sheets. The resulting banking sector distress can have severe negative implications for the real sector and for financial stability. Banks carrying non-performing assets on their balance sheets have incentives to gamble for resurrection, which can prevent an efficient reallocation of assets from shrinking to growing sectors of the economy. Japan’s experience in the 1990s and 2000s constitutes a prime example of the wrong incentives that delayed recapitalisation and restructuring of banks can have for the real economy (Caballero et al. 2008).

These developments do not only affect individual countries. Due to foreign trade and financial linkages, banking distress can have negative spillover effects for the entire Eurozone. Low confidence in banks in the distressed countries has caused private capital inflows to dry up or even to reverse. Many banks in these countries are no longer able to refinance themselves through the private capital market and are strongly reliant on financing through the ECB. The ECB has lowered standards for central bank-eligible collateral and has provided liquidity assistance. All this is reflected in a sharp rise in TARGET2 balances within the Eurosystem. All EMU member states are liable for the risks that are shifted onto the central bank’s balance sheet.

In short, the European banking and financial sector is in an acute crisis that calls for swift action by policymakers. At the same time, delayed financial sector reforms are hampering crisis management. Essentially, the statement of the June 2012 summit rightly focuses on the links between banks and sovereigns. What will be decisive are the concrete measures to be taken and the speed with which the necessary reforms are implemented.

2.1. Acute crisis management

Currently, banking sector problems are most pressing in Spain. Spain has already applied for funding to recapitalise its banks from the EFSF, and it has signed a corresponding Memorandum of Understanding. A solution to problems in the Spanish banking sector cannot wait until a fully-fledged long-term regulatory framework for the European banking system has been established. At the same time, clear conditions under which funds for bank recapitalisation in Spain will be used need to be specified. Experience with banking sector restructuring in the past can provide useful guidance how to proceed – and which mistakes to avoid. Generally, recapitalisation of banks through public funds should not lead to government ownership of banks in the long term. On the contrary, recapitalisation through the government should enable the banks to regain health as quickly as possible, to reduce costs for taxpayers and to restore a functioning banking system by re-privatising the banks.

To achieve these goals, recapitalisation and restructuring must follow clear criteria. First, on the basis of a thorough audit of banks’ balance sheets with the assistance of outside experts, banks’ capital requirements must be defined. Second, only if these capital requirements cannot be covered from private or from national sources could EFSF or ESM loans be granted to the government. The government should be liable for funds used for bank recapitalisation. Clear conditionality needs to be imposed. Third, the government should provide additional equity capital, and it should assume the associated control functions. The goal must be to restructure banks in such a way that they have sustainable business models in the future. It will be necessary to closely involve European institutions and specifically the European competition authorities in the process.

Should it be necessary to resort to the EFSF or the ESM to recapitalise banks, the government should be liable for these funds. The conditions stipulated in the June 2012 statement by the EMU heads of state and government allow for direct recapitalisation to banks only if a European supervisory mechanism has been established. In the meantime, the EU Commission has outlined the concept of such a Single Supervisory Mechanism. The timeline foresees a sequence, starting with supervision of banks applying for funding from the EFSF/ESM by the ECB in January 2013. Given the scope and scale of the required regulatory changes, this time line seems overly ambitious. Hence, the conditions for funding to be granted directly to the banks without the government assuming liability will not be met in the foreseeable future. Moreover, supervision at the European level does not in itself suffice. Instead, powers of restructuring and resolution must be transferred to a European-level body as well.

2.2. Make up for lost time

In the longer term, an effective supervisor at the European level should ensure that the probability and the scale of crises decline. Higher bank capital will play a key role in this context because this will enhance the banks’ ability to bear risk. Parallel to this, effective mechanisms for restructuring and winding up banks need to be established. The implementation of common supervisory and resolution mechanisms should be a precondition for using common financial resources to restructure banks.

In the past four years since the outbreak of the financial crisis, key financial market reforms have been discussed in Europe. However, only a few have been initiated. Coherent implementation is still missing. At present, finding a comprehensive solution to the European debt crisis is complicated by the absence of an effective and European-wide procedure for restructuring and winding up banks. This affects, in particular, large and systemically important credit institutions with significant cross-border activities. Priority should therefore be given to reforms in these areas.

2.3. No hasty moves towards a banking union

Establishing a banking union will take a considerable amount of time. Key issues to be clarified include the questions of how to involve the central bank into the supervisory process while clearly separating monetary policy functions, how to define the exact tasks of the European and the national banking supervisors, how to introduce uniform processes for winding up and restructuring banks, and not least how to solve the attendant financing questions. A long-term system in which liability and control are closely linked requires not least that national sovereignty is partly given up. This will invariably take some time. It is therefore all the more important that progress is made now on introducing the regulatory changes required.

3. Dealing with distressed sovereigns

Legacy problems do not only affect the banking system. Recurring instabilities on markets for government debt also show the need to deal with distressed sovereigns. The Fiscal Compact, which has been agreed upon by 25 EU member countries in February 2012, is the right and necessary step towards fiscal consolidation and debt reduction. It is, therefore, an indispensable element of the long-term stability framework in the Eurozone. But to make the Fiscal Compact a credible framework in the short and medium run, countries need both strong economic growth and sustainable levels of interest rates. Yet risk premia even on long-term Italian and Spanish government bonds have risen considerably compared with German bonds. Hence, contagion has spread to countries that were previously regarded by financial markets as fiscally solid and undoubtedly solvent. Because (short-term) interest rates can be influenced by the ECB, the ECB is under immense pressure to support fiscal policy of indebted countries, which is in conflict with its mandate of delivering price stability to the Eurozone.

3.1. ECB trapped in the fiscal realm

Unconventional monetary policy measures taken by the ECB have helped to stabilise the situation. The ECB has provided banks in the Eurozone with extensive liquidity for the next three years at very favourable conditions, it has expanded its collateral framework of eligible assets for refinancing operations, and it has recently introduced the Outright Monetary Transaction program with conditionality attached to an EFSF/ESM program. While these measures aim at breaking the link between banks and sovereigns, transactions in secondary sovereign bond markets are dangerously close to the monetisation of sovereign debt. Stabilisation thus comes at a very high price. The politically well-established division between fiscal policy and monetary policy has been successively blurred. Phasing out unconventional measures in the near future will be very difficult. If changing market sentiments or inactivity of European fiscal authorities will lead to a renewed intensification of the crisis, there will be immense pressure on the ECB to step in once more. Hence, the key issue is to find a fiscal solution to a stabilisation of sovereign bond markets.

3.2. The European Redemption Pact proposal

With the introduction of the EFSF and the ESM, fiscal policymakers have implemented a firewall. However, in the current crisis, the shortcoming of the ESM is that it acts ex post, that it cannot and should not be used as a preventive measure, and that it is not designed to deal with fiscal legacy problems (Buch 2012). The Fiscal Compact that addresses fiscal consolidation and debt reduction lacks credibility because, in the current economic environment, the consolidation path is highly unrealistic for many countries. Therefore, in November 2011, the German Council of Economic Experts proposed the European Redemption Pact (ERP) as a crisis resolution mechanism that provides a viable bridge to the long-term stability framework (GCEE 2011; Doluca et al. 2012).

The ERP consists of three contiguous elements: a tightened Fiscal Compact together with its prescribed fiscal consolidation paths, a European Redemption Fund (ERF) for sovereign debt in excess of 60% of GDP providing limited and temporary joint and several liability, and a sovereign insolvency regime which becomes effective after all excessive debt has been redeemed. The main objective of the proposal is to restore national responsibility for fiscal policy in line with the revised and tightened SGP and the no-bail-out clause of the Lisbon treaty.

Strict safeguards against moral hazard are the backbone of the ERP. As a prerequisite for joining the ERP, countries need to ratify the Fiscal Compact and to introduce national debt brakes. Compliance with national debt brakes should be monitored by an independent European body that would also impose penalty payments to the ERF in case of any violations. Participation is restricted to countries that are not already on under an adjustment program of the EFSF/ESM (i.e., Greece, Portugal, Ireland, and Cyprus would not participate). These countries are allowed to outsource that part of their sovereign debt to the ERF that exceeds, at a pre-specified date, the threshold of 60% debt-to-GDP ratio being set out in line with the Maastricht Treaty. The outsourcing of sovereign debt to the ERF is stretched over a multi-year time horizon until the predefined volume of debt is reached (roll-in phase) (Figure 1). During this period, the ERF will buy a country’s long-term bonds (with maturity over two years) on the primary market while any short term debt is still issued on the financial market.

The ERF interest rates for any debt transferred are expected to be significantly lower than what markets currently demand from countries like Italy or Spain. In return, participating countries would enter into payment obligations towards the ERF that are calculated such that each country would repay its transferred debt within 25 years. After this period, the ERF would dissolve itself. All participating countries are jointly and severally liable for any debt transferred to the ERF. Therefore, the ERP has a lot of strings attached, and it entails a sanctioning mechanism to ensure a successful transition to sound public finances.

Figure 1. Debts in European Redemption Fund by country (€ billion)

Notes: 1) Authors' calculations as of June 2012. Assumed starting date of the ERP: 1.1.2013; basic data: European Commission, AMECO database, 26.7.2012.

3.3. Preventive measures with strict conditionality

Outsourcing of debt is tied to strict conditionality. Countries need to comply with consolidation plans that are agreed upon by participating countries at the time of joining the ERP. In case of non-compliance, various sanctions can be imposed on the country that range from interest rate mark-ups for debt already transferred to the fund to complete suspension of the roll-in phase.

To limit moral hazard and to limit the joint and several liability borne by participating countries, each country has to pledge collateral – currency or gold reserves or covered bonds – totalling 20% of the debt outsourced to the ERF. The collateral would automatically accrue to the fund if a country does not meet its payment obligations. Additionally, countries have to politically earmark certain (new) taxes that are used to meet the payment obligations.

One of the decisive features of the ERF is that it does not completely substitute the markets’ disciplining effects. During the roll-in phase, governments still have to rely on financial markets to refinance their short-term debt. After the roll-in phase, a country has to refinance the remaining debt of up to 60% of GDP and is, therefore, fully exposed to market discipline.

The goal of the ERP is to address the systemic crisis of confidence by a credible political commitment to the Euro. But the ERP is certainly no panacea, and it entails risks. Therefore, the proposal must be assessed against the alternatives. Dealing with legacy problems is, by no means, a trivial task, and it involves decisions with redistributive implications to be taken. Advantages of the ERP are that it makes the true scale of the risks assumed by creditor countries transparent, that any assistance provided is subject to strict conditionality, and that redistributive decisions are democratically legitimated. This is a crucial feature which distinguishes the ERP from de facto debt mutualisation through the ECB. The ERP also restores the separation of monetary and fiscal policy, and it provides breathing space so that country-specific structural problems can be overcome.


Buch, C M (2012), "From the Stability Pact to ESM - What next?", in A Dombret and O Lucius (eds) Stability of the Financial System - Illusion or Feasible Concept? (forthcoming) and IAW Discussion Papers 85, Institut für Angewandte Wirtschaftsforschung (IAW). Tuebingen.

Caballero, R J T Hoshi und Anil K Kashyap (2008), ‘Zombie Lending and Depressed Restructuring in Japan’, American Economic Review 98(5): 1943–77.

Doluca, H, M Hübner, D Rumpf, and B Weigert (2012), ‘The European Redemption Pact: Implementation and macroeconomic effects’, Intereconomics: Review of European Economic Policy, 230-239, vol. 47(4).

German Council of Economic Experts (GCEF) (2010), Annual Report 2011/2012 "Chances for a stable upturn". Wiesbaden.

German Council of Economic Experts (GCEF) (2011), Annual Report 2011/2012 “Assume responsibility for Europe”, Wiesbaden.

German Council of Economic Experts (GCEF) (2012), Special Report "After the Euro Area Summit: Time to Implement Long-term Solutions", Wiesbaden.

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