Beblavy et al (eds ) the euro area and the financial crisis (2011)

190zden ˇek t ˚uma and david v ´avra Part III The future of the euro area 11 Why the current account may matter in a monetary union: lessons from the financial crisis in the francesco g

The financial crisis of 2007–10 has presented a number of key policychallenges for those concerned with the long-term stability of the euroarea It has shown that price stability as provided by the EuropeanCentral Bank is not enough to guarantee financial stability, and exposedfault lines in governance and deficiencies in the architecture of thefinancial supervisory and regulatory framework This book addressesthese and other issues, including why the crisis affected some countriesmore than others, whether the euro is still attractive for new EU statesand what policy changes and structural reforms, both macro and micro,should be undertaken to ensure its future viability Written by a team ofleading academic and central bank economists, the book also includeschapters on the cross-country incidence of the crisis, the Irish crisisand ECB monetary policy during the crisis, and studies on Spain, theBaltics, Slovakia and Slovenia.

miroslav beblav ´y has an unusual blend of academic and politicalexperience He is a Senior Research Fellow at the Brussels think tank,Centre for European Policy Studies and, at the same time, Member ofthe Slovak Parliament He is also Associate Professor of Public Policy atthe Comenius University in Bratislava, Slovakia In the past, he served

as a junior minister in his country’s government, created an influentialthink tank and worked for a range of multilateral development institu-tions as a consultant in Europe, Africa and the Caucasus

david cobham is Professor of Economics at Heriot–Watt University

He is a specialist in monetary policy who has worked on the UK, onFrench and Italian monetary policy, on European monetary integrationand on monetary policy and exchange rate regimes in the Middle Eastand North Africa He is the editor or co-editor of a number of books

on European monetary integration and monetary policy, including The Travails of the Eurozone (2007) and Twenty Years of Inflation Targeting: Lessons Learned and Future Prospects (2010).

l’udov´it ´odor is an advisor to the Prime Minister and Minister ofFinance in Slovakia In the past, he served as a member of the BankBoard at the National Bank of Slovakia and Executive Director respon-sible for research He also worked as a Chief Economist at the Ministry

of Finance of the Slovak Republic He played an important role in tutional and structural reforms in Slovakia including the euro adoption

insti-in 2009

The Euro Area and the Financial Crisis

Edited by

Miroslav Beblav´y, David Cobham and L’udov´ıt ´ Odor

Cambridge, New York, Melbourne, Madrid, Cape Town,

Singapore, S˜ao Paulo, Delhi, Tokyo, Mexico City

Cambridge University Press

The Edinburgh Building, Cambridge CB2 8RU, UK

Published in the United States of America by

Cambridge University Press, New York

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 Cambridge University Press 2011

This publication is in copyright Subject to statutory exception

and to the provisions of relevant collective licensing agreements,

no reproduction of any part may take place without the written

permission of Cambridge University Press.

First published 2011

Printed in the United Kingdom at the University Press, Cambridge

A catalogue record for this publication is available from the British Library Library of Congress Cataloguing in Publication data

The Euro area and the financial crisis / edited by Miroslav Beblav´y, David Cobham, and L’udov´ıt ´ Odor.

p cm.

“This volume brings together the papers and panel contributions presented at the conference on ‘The Euro Area and the Financial Crisis’, held in Bratislava from 6 to 8 September 2010” – Introd.

Includes bibliographical references and index.

ISBN 978-1-107-01474-9

1 Monetary policy – European Union countries 2 Euro.

3 Global Financial Crisis, 2008–2009 I Beblav´y, Miroslav.

II Cobham, David P III ´ Odor, Ludov´ıt IV Title.

in this publication, and does not guarantee that any content on such

websites is, or will remain, accurate or appropriate.

List of figures pageviii

Part I The experience of the crisis

3 Weathering the financial storm: the importance of

fundamentals and flexibility 23thor vardur tj ¨or vi ´olafsson and th ´orar inn

juan f jimeno and juan a rojas

6 The financial crisis and the Baltic countries 97aurelijus dabu ˇsinskas and mar tti randveer

v

Part II Accession to the euro area

7 The road to euro adoption: a comparison of Slovakia

biswajit banerjee, damjan kozamer nik and

l’udov´it ´odor

8 Is the euro really a ‘teuro’? The effects of introducing

the euro on prices of everyday non-tradables in

miroslav beblav ´y

9 The euro’s contribution to economic stability in Central,Eastern and Southeastern Europe: is euro adoption still

ewald nowotny

10 Is the euro still attractive for CEE countries? 190zden ˇek t ˚uma and david v ´avra

Part III The future of the euro area

11 Why the current account may matter in a monetary

union: lessons from the financial crisis in the

francesco g iavazzi and luig i spaventa

12 National fiscal rules within the EU framework 222daniele franco and stef ania zotter i

13 The road to better resolution: from bail-out to bail-in 243thomas f huer tas

14 Financial stability and monetary policy: lessons from the

laurent clerc and benoˆıt mojon

15 Is there a case for price-level targeting? 292bor is cour n `ede and diego moccero

16 Heterogeneity in the euro area and why it matters for thefuture of the currency union 320wendy carlin

17 The euro area: how to regain confidence? 329v´itor gaspar

18 How to regain confidence in the euro area? 335stef an gerlach

19 How to save the euro? Lessons from the US 340jacques m ´elitz

4.1 Ratio of private credit to GDP, 1984–2008 page624.2 Net foreign liabilities of the Irish banking

4.4 Spread between ten-year bonds: Ireland over

5.8 Demographic and interest rate changes: data vs

6.4 Merchandise export and REER indexes: Baltic

6.5 Output gaps: Baltic States, July 2010

7.1 Twelve-month HICP inflation and the Maastricht

7.3 Output gap estimates for Slovakia by alternative

8.1 HICP inflation: euro area, the Czech Republic and

viii

8.2 HICP inflation for passenger transport: Eurozone, Czech

8.3 HICP inflation in restaurants, caf´es and similar

establishments: Eurozone, Czech Republic and

8.4 HICP inflation in hairdressing salons and personal

grooming establishments: Eurozone, Czech Republic and

8.5 Perceived inflation: Eurozone, Czech Republic and

8.6 Correlation of twelve-month moving sample of the Slovak

9.1 (a) Output growth, 2006–10 and (b) output differential,

14.1 Indebtedness of non-financial sectors: US and in the euro

14.2 Short-term interest rates and Taylor benchmarks: (a) euro

14.4 Effects of shocks to credit standards and stance of

14.5 Contribution of credit standards shocks and monetary

policy shocks to variance of variables of interest: euro area

14.6 Counterfactuals without monetary policy

14.9 Spread between three-month interbank and overnight

14.10 Provision and liquidity absorption by

14.11 Covered bond spreads against five-year

15.1 Prices over long periods: price-level targeting vs IT in

3.1 Country sample page 26

3.3 Regression results for the depth of the consumption

3.8 Probit estimates of the likelihood of a banking, currency,

5.2 Role of interest rates and demographic changes,

6.1 Correlation between output gap and financial variables:

6.2 Structure of foreign capital inflows: the Baltic countries,

6.3 Changes in credit portfolios: selected Nordic banks on

6.4 Cyclically adjusted fiscal balance of general government,

6.5 Impact of EU funds on the cyclically adjusted fiscal

6.6 Decline in imports among the ten main trading partners

6.A1 Number of recessions covered by different variables and

xi

7.1 Selected indicators at landmark dates, 1998–2007 1327.2 Contribution of administered price and indirect taxes to

8.1 Answers by Eurozone respondents to the question: ‘For

each of the following, do you personally have the feeling

8.2 Inflation in selected areas: July after euro adoption vs the

8.3 Nominal appreciation/depreciation in the run-up to the

8.4 Perceived and actual HICP inflation in the six months

8.5 Actual and perceived inflation in period of euro adoption:

8.6 Summary statistics for datasets measuring changes in the

prices of selected services: Bratislava and Brno, July 2008

8.7 Distribution of price changes for schnitzel and boiled

8.8 Distribution of price changes for a woman’s haircut:

8.9 Frequency distribution of all price changes in the micro

8.10 Comparison of enterprise-level inflation data: Bratislava

and Brno, with national inflation data, July 2008–July

8.A1 Inflation in selected areas, comparing prices eighteen

8.A2 Inflation in selected areas, comparing prices thirty months

8.A3 Inflation in selected areas, comparing prices forty-two

11.3 Per capita income and labour productivity, 1998, 2000

11.8 Portfolio investment of the four cohesion countries’ share

12.1 Most common features of national fiscal frameworks in

13.3 Bail-in via conversion of back-up capital to common

13.4 Bail-in via conversion: timing and decision-maker for

Box table 15.1 Compared simulated effects of IT and price-level

15.1 Price-level targeting vs higher inflation targets as

15.2 Redistributive effects under inflation and price-level

xiv

biswajit banerjee, Haverford College

miroslav beblav ´y, Comenius University

wendy carlin, UCL and CEPR

laurent clerc, Banque de France

david cobham, Heriot–Watt University

bor is cour n `ede, OECD

aurelijus dabu ˇsinskas, Bank of Estonia

daniele franco, Banca d’Italia

v´itor gaspar, Banco de Portugal

angel gavil ´an, Banco de Espa˜na

stef an gerlach, Goethe University and CEPR

francesco g iavazzi, Bocconi University, CEPR and NBERpablo her n ´andez de cos, Banco de Espa˜na

thomas f huer tas, EBA and FSA

juan f jimeno, Banco de Espa˜na

damjan kozamer nik, Bank of Slovenia

philip r lane, Trinity College Dublin and CEPR

jacques m ´elitz, Heriot–Watt University, CREST–INSEE and CEPRdiego moccero, OECD

benoˆıt mojon, Banque de France

ewald nowotny, ¨Osterreichische Nationalbank

xv

l’udov´it ´odor, Ministry of Finance, Slovakia (formerly NationalBank of Slovakia)

thor vardur tj ¨or vi ´olafsson, Central Bank of Iceland and versity of Aarhus

Uni-athanasios or phanides, Central Bank of Cyprus and CEPR

th ´orar inn g p ´etur sson, Central Bank of Iceland

mar tti randveer, Bank of Estonia

juan a rojas, Banco de Espa˜na

luig i spaventa, University of Rome and CEPR

zden ˇek t ˚uma, Charles University

david v ´avra, OGResearch

stef ania zotter i, Banca d’Italia

ABS Asset Backed Securities

Affairs (EU)

xvii

EMS European Monetary System

Union)

Act (US)

IFS International Financial Statistics (IMF)

OECD Organisation for Economic Cooperation and

Development

Miroslav Beblav´y, David Cobham and L’udov´ıt ´ Odor∗

This volume brings together the papers and panel contributions sented at the conference on ‘The Euro Area and the Financial Crisis’,held in Bratislava from 6 to 8 September 2010 The conference washosted by the National Bank of Slovakia and jointly organised by theNational Bank of Slovakia, Heriot–Watt University in Edinburgh andComenius University in Bratislava The event was characterised by inten-sive discussions between central bankers, academics and policy-makersfrom all over Europe, which contributed directly and indirectly to theauthors’ revisions of their papers The basic question was: What are theimplications of the financial crisis and the great recession for the future

pre-of the euro area?

Gover-nor Athanasios Orphanides on the issues surrounding financial stability

´

fac-tors that caused the depth and duration of the crisis to be larger in

Angel Gavil´an, Pablo Hern´andez de Cos, Juan F Jimeno and Juan A

by countries in Central, Eastern and Southeastern Europe (CESEE)

analyse the different strategies for entry to the euro used by Slovakia and

was associated with significant rises in prices (especially for non-tradablegoods and services) in Slovakia And in the first panel contributions Gov-

∗ We would like to express our thanks to the discussants and all the other participants in the

conference, and to Martin ˇ Suster of the National Bank of Slovakia, for their contributions

to the conference and to the book.

1

David V´avra, discuss inChapter 10whether and how CESEE countries

more attention needs to be paid to current account deficits within theEuropean Monetary Union (EMU) Daniele Franco and Stefania Zot-

mechanisms for ‘bail-in’ as an alternative to future bail-outs of financial

conduct of monetary policy in the euro area since the inception of theeuro and the challenges that the Eurosystem has faced since the financial

con-tribution that a price-level (as opposed to an inflation) target could make

to the operation and performance of monetary policy This is followed

by contributions by Wendy Carlin, V´ıtor Gaspar, Stefan Gerlach and

confidence in the euro project

Despite the different backgrounds of the contributors, there was a nificant measure of convergence, and five important observations emerge.The first is the need to reshape and strengthen EU governance Gover-

topic of better prudential regulation and supervision attention should

be paid to governance issues, notably crisis resolution The financialcrisis found the member states and their financial frameworks largelyunprepared, which led to chaotic resolution mechanisms and huge costsfor taxpayers Orphanides calls for a unified EU resolution mechanismbased on three principles: limited moral hazard, fair burden-sharing andcost-effectiveness

The crisis also showed that one of the pillars of the monetary union –the ‘no bail-out’ principle – was more wishful thinking than crediblethreat for financial institutions and member states Several participantsargue that this problem needed to be fixed, but there is no clear consensus

continue to support large financial institutions, and advocates ‘bail-in’rather than bail-out: he explores the creation of buffers at systemicallyimportant financial institutions in the form of subordinated debt which

in case of emergency would be automatically converted into capital Thiswould place the primary burden not on taxpayers but on the creditors

1 Dr T ˚ uma was unable to attend the conference but kindly submitted his views shortly afterwards.

argues there is no need for no bail-out rules in EMU Instead, as withthe states of the US, a national government could simply be allowed todefault, while policy should be limited to the construction and operation

of EMU-wide prudential rules for banks backed up by ECB powers to act

takes the failure of no bail-out rules as given and proposes a nism that credibly promises a rescue, but at unattractive terms Such amechanism would replace the temporary European Financial StabilityFacility (EFSF) and would contain significant automatic write-downs(of 20–30 per cent) and strict conditionality, including pre-approval ofbudgets

mecha-The second key observation to emerge was a challenge to the modelsscholars have traditionally used to think about monetary unions, with themost heated debates concentrated on the issue of fiscal policy coordina-tion Several contributors put much more emphasis than the traditionalmodel on the issue of countries’ current account deficits In particular,

was made in the downgrading of the problem of current account deficits:although monetary union eliminates the threat of currency devaluation,high current account deficits can cause substantial problems if the pro-ceeds of external borrowing are not used for ‘productive purposes’ Inother words, using external resources to finance investments in non-tradables or domestic consumption can lead to problems in meeting theintertemporal budget constraint The high level of the former (invest-ment in construction and housing) made economic success fragile inIreland and Spain, while the latter (borrowing for consumption) resulted

in increasing stress in Greece and Portugal

This general argument, with its emphasis on country-specific tions, is broadly consistent with the individual country studies by Lane(Chapter 4) and Gavil´an et al (Chapter 5) Lane argues that the longIrish expansion actually involved two distinct periods: a ‘Celtic Tiger’output boom fuelled by high productivity increases in the second half ofthe 1990s, and then a property-driven boom period concentrated mainly

condi-in the non-tradable sector condi-in the 2000s He considers the argumentsthat EMU membership may have contributed to the Irish boom–bustcycle, but emphasises instead the lack of appropriate policies in bank-ing regulation and fiscal stabilisation, and the positive contributions of

EMU membership Gavil´an et al use a small open-economy model to

discuss the reasons for the emergence of a large current account deficitduring the period of strong Spanish growth before the crisis Their anal-ysis highlights the decline in interest rates due to Spain’s participation inEMU, and the demographic changes resulting from the large inflow of

immigrants Given these factors, in their model alternative fiscal policieswould have made little difference, while structural reform in labour andproduct markets would have improved the growth rate but intensified theexternal deterioration in the short run.

There is also some common ground here in the more general chapter

cross-country variation in post-crisis experience using a wide variety ofpre-crisis explanatory variables They find that high preceding domes-tic inflation and macroeconomic imbalances, including large currentaccount deficits, are crucial in determining the incidence and severity

of the crisis, while larger banking systems were associated with longerand deeper cuts in consumption and with a higher risk of banking orcurrency crisis Exchange rate flexibility tended to make the contractionshorter and shallower, but it also increased the risk of crisis EMU mem-bership, on the other hand, did not entail the negative effects associatedwith unilateral exchange rate pegs In addition, Carlin’s panel contribu-

the different countries of the euro area: because nominal exchange ratescannot be adjusted such differentials (which would show up in currentaccount imbalances) have to be reversed and eliminated (not just con-tained)

The third observation concerns fiscal policy Bringing the problem ofcurrent account deficits to the forefront does not mean that fiscal policyproblems are less relevant than before On the contrary, several con-tributors highlighted the need to strengthen the Stability and GrowthPact (SGP) and increase the effectiveness of national fiscal frameworks

challenges posed by demographic trends in the EU, argues that both ket discipline (operating through interest rate differentials) and the SGPhave failed to ensure appropriate behaviour by national fiscal authori-ties Major adjustments in the governance of the euro area are thereforecalled for; these will include higher financial penalties and stronger con-ditionality on financial support to countries in difficulty Gerlach in his

incorporat-ing more automaticity in the SGP and replacincorporat-ing the existincorporat-ing inadequatemarket discipline by incentives for governments to act with restraint: he

Chap-ter 12) discuss the fiscal policy reforms which have been introduced orare under consideration in different EU countries, with particular refer-ence to current and ongoing German and French reforms and to fiscalrules Such national reforms need to be complementary to any changes atthe EU or euro area level, but they can contribute to fiscal discipline and

facilitate stabilisation However, they need to be supported by public

fur-ther task for fiscal policy: she proposes the use of fiscal policy not just to

stabilise the price level but to ensure optimal relative prices vis- `a-vis the

rest of the monetary union

The fourth observation is that the crisis has uncovered some of theweaknesses of the conventional monetary policy framework Policy-makers on both sides of the Atlantic found themselves in a difficultsituation after hitting the effective lower bound for nominal interest rates.They had to chart unknown waters using non-standard monetary policymeasures, including quantitative and credit easing Some of the contribu-tors tried to identify gaps in the conduct of monetary policy and analysedthe costs and benefits of changes in the standard flexible inflation target-

build-up of financial fragility was a consequence of monetary policy andwhether it would be worth incorporating financial stability issues into theconduct of such policy Although their modelling suggests that higherinterest rates in the run-up to the crisis would have had relatively smalleffects on house prices, they suggest that the ECB should widen its mon-itoring of asset prices as well as money and credit and should stand ready

to take decisions based on that monitoring even when consumer pricesseem securely stable They also discuss the potential conflict betweenthe ECB’s price stability target and its liquidity management operations

Chap-ter 15) ask whether there is a case for price-level targeting (PLT) instead

of inflation targeting If bygones are not bygones the risk of hitting a zerolower bound is reduced Moreover, when an economy is near that boundPLT is preferable to, for example, raising the inflation target There is agrowing body of literature that finds some other aspects of PLT appeal-ing, including lower volatility of inflation and hence nominal policy rates,lower inflation risk premia in long-term rates and higher capital accumu-lation On the other hand moving to PLT is not without costs The mainconcerns are that there is little practical experience of PLT, there arequestion marks over the transition from inflation targeting (credibilityissues) and agents might not be sufficiently forward-looking

The final observation is that there is no optimal one-size-fits-all euroadoption strategy and much depends on the set-up of the foreign capi-tal inflow-based catching-up growth model Banerjee, Kozamernik and

´

Slovenia joined the euro area The starting positions of these two tries were very distinct and there were also substantial differences in the

coun-conduct of monetary policy before euro adoption While Slovenia ferred stable exchange rates and more administrative control over theprocess, Slovakia allowed for significant exchange rate appreciation anddeep structural reforms which resulted in a high productivity growth

pre-differential vis- `a-vis the euro area This also confirms the importance

of investments in productive uses if one relies on external financing

finan-cial crisis on the Baltic countries, which were hit particularly hard Theyhad experienced a prolonged boom period but then suffered falls of one-fifth in consumption According to Dabuˇsinskas and Randveer the highcyclical volatility of these countries can be explained mainly by the strongprocyclical developments in the financial sector Foreign capital inflowsvia the financial sector were significantly higher in the Baltic countriesthan in most other new EU member states In addition, the choice ofexchange rate regime (currency board or fixed exchange rate regime)could have created overconfidence

All this illustrates that the catching-up model based on foreign ing is not without risks and the policy options need to be selected withcare The crisis brought mixed feelings about the attractiveness of euro

shelter against the excessive volatility of financial markets On the otherhand, the problems in Greece illustrate that membership of the elite club

is not a panacea and if the internal problems of the union are not solvedthe future of the euro is uncertain This brings additional arguments foropponents of euro adoption in many new member states and lowers the

of long-term nominal stability is the only tangible economic benefit ofthe euro project’ This may be enough to justify adoption by the fixedexchange rate economies of Southeastern Europe, but not enough for theindependent monetary policy countries of Central and Eastern Europe(though these countries may have sufficient political reasons for joining

Chap-ter 9) argues that the euro will remain an attractive option for potentialentrants, but he emphasises that participation implies a commitment tostructural reforms which will enable the economy to function withoutrecourse to competitiveness-improving devaluations

Chap-ter 8) provides an analysis of whether in the Slovakian case there werefaster or exceptional price rises associated with the introduction of euronotes and coin (of the kind typical of popular beliefs about the euro in

many existing member countries) The answer turns out to be ‘no’, in thesense that Slovakian entry to the euro occurred at a time of actual andperceived disinflation However, there is some evidence of faster infla-tion in certain non-tradables around the time of entry More generally,Beblav´y emphasises that countries are likely to experience euro adoption

in quite different ways, which implies that Slovakia’s experience herecannot be generalised

In the four months between the conference itself and the submission

of this book to Cambridge University Press, the European Union, theECB and the euro area countries have taken – often after much debate –

a number of measures to strengthen the coordination and credibility ofmonetary, fiscal and financial policies, in a process which is still contin-uing We have not attempted to cover these innovations here, and most

of the chapters were finalised in October or November 2010 (the only

the end of December) At this stage it is clear that some important issuesremain unresolved Moreover, as conference participants broadly agreed,while better policies can reduce the probability or magnitude of futurecrises, it will not be possible to completely prevent them We believe thatthe way in which events and policy changes work out will be consistentwith the analyses and propositions put forward in this book But therewill, of course, be plenty of scope for further critical work in this area

financial stability in Europe

as among regulators, has been underlined The crisis has confirmed thatcentral banks can play an important role in safeguarding financial stabil-ity, but also demonstrated that a mandate to maintain price stability is notsufficient to ensure financial stability, strengthening the case that centralbanks need to be armed with the appropriate policy tools to enhancetheir contribution to financial stability

The crisis has prompted critical thinking about the EU economic andfinancial policy frameworks and the need for a new supervisory archi-tecture The severe economic cost suffered as a result of the crisis, andthe acknowledgement of the need to limit the likelihood of future costlyoccurrences, has provided an important opportunity for the development

of an improved financial stability framework for Europe and highlightedthe urgency of the need for a comprehensive crisis management regime.Not that this was not understood earlier The lack of harmonisation inthe European legal and supervisory framework and its potential cost inmanaging crises were known Nevertheless, perhaps due to the complica-tions and political sensitivities involved in addressing crisis management,and perhaps owing to other policy priorities, undue reliance was arguablygiven to the role of crisis prevention, avoiding prickly issues such as howpotential losses associated with the efficient resolution of a cross-borderfinancial institution were allocated

In the European context the financial crisis has illustrated not onlythe deficiencies of the current EU cross-border arrangements, but alsothat a fragmented approach towards crisis management and resolution

8

is insufficient to deal with these shortcomings I take for granted thedesirability of further integration of our economy across member states,and further enhancement and cross-border development of the finan-cial industry in Europe This is imperative to raise efficiency and morefully exploit the benefits of a common market, even more so in the euroarea, 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 sented by our union also makes it necessary to place greater emphasis oncomprehensive EU-wide solutions towards enhancing financial stability

pre-in Europe

Against this background, I would like to thank Narodna Banka ska (the National Bank of Slovakia) for the invitation to address this con-ference on ‘The Euro Area and the Financial Crisis’ I focus on a fewissues related to the question of how the financial supervision architec-ture in Europe could be strengthened in order to secure financial stability.Namely, I discuss elements of micro- and macro-prudential policy toolsfor enhancing regulation and supervision, and also the development of acrisis management framework in Europe I also present some pertinentthoughts on governance Before proceeding, however, I should note thatthe views I express are my own and do not necessarily reflect those of

Sloven-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, financialintermediaries and financial markets The latest international financialcrisis has been associated with a serious weakening and, in some cases,failure of financial institutions, together with stress in credit marketsand in the funding of financial institutions These inflicted heavy costs

on real economies and their taxpayers in many countries, including inthe EU

In light of the cost to the real economy associated with financial bility as well as the threat to public finances, the desirability of policiesthat reduce the occurrence of future crises as well as policies that con-tain the damaging effects of actual crises is clearly evident This entailstwo main elements: first, prudential regulation and supervision policiesand, second, a crisis management and resolution framework The twoelements are interrelated because the effectiveness of prudential supervi-sion crucially depends on the incentives of financial institutions and thus

insta-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.1For cross-border institutions,

EU governance issues may need to take a central role

As already mentioned, the crisis has highlighted weaknesses in tial regulation and supervision It has demonstrated a general underap-preciation of systemic risks in micro-prudential supervision and high-lighted the need for a more system-wide macro-prudential approachtowards supervisory oversight to ensure overall stability in the financialsystem But what further prudential tools should be developed, or howshould existing tools be enhanced? A number of sometimes competingproposals have been put forward by policy-makers, regulators, academics

These proposals entail specific prudential policy instruments aimed atmitigating the build-up of systemic risk Systemic risk – that is, the risk ofserious disruption in the provision of financial services to the economy –arises from linkages both within the financial system and through its inter-action with the real economy across the cycle Macro-prudential policiesare needed to address the cyclical aspect of systemic risk, noting that in

‘good times’ financial imbalances tend to build up as leverage increasesand financial institutions become overexposed to risks, ultimately raisingthe probability of triggering system-wide instability Prudential tools can

be used to counter an excessive build-up of these risks in the financialsystem as a whole

Higher prudential requirements regarding capital and liquidity wouldenhance the resilience of credit institutions to shocks and adverse mar-ket developments A leading role in the construction of a harmonisedglobal framework for the achievement of this objective rests with theBasel Committee on Banking Supervision (BCBS) In December 2009,the BCBS approved for consultation a package of proposals to strengthenglobal capital and liquidity regulations (Basel Committee on Banking

consistency and transparency of bank capital (predominance of commonequity, phasing out of hybrid Tier 1 and abolishing Tier 3); introducing asimple capital-to-asset ratio (leverage ratio); introducing measures to pro-mote the build-up of capital buffers in good times (countercyclical capi-tal buffers); restrictions on dissipating capital when buffers are depleted(capital conservation measures); and strengthening the risk coverage ofthe capital framework (by increasing capital requirements for counter-party credit risk arising from derivatives, repos and securities financingactivities)

1 This is discussed in detail in Claessens, Herring and Schoenmaker (2010).

2 See, e.g., International Monetary Fund (2010a).

Prudential regulation could also limit the build-up of liquidity risk,which proved neglected in various supervisory frameworks before thecrisis Quantitative liquidity ratios or standards that limit reliance onvolatile non-core funding and prevent excessive build-up of maturitymismatches could be introduced, while other potentially volatile liabilitycomponents such as foreign currency deposits should have adequateliquidity coverage and maturity matches.

Improving liquidity and capital standards should discourage sive leverage and enhance the resilience of financial institutions duringall phases of the business cycle Adjusting regulation according to busi-ness cycle considerations may also better smooth risks across time Oneapproach towards that end is that of expected loss provisioning as againstthe current incurred loss approach, in line with the dynamic provisioningpractised by banks in Spain Indeed, in 2009 the European Commis-sion started consultations with a view to adopting dynamic provisioningacross the EU

exces-Additional macro-prudential tools could limit the build-up of morestructural vulnerabilities that contribute to systemic risk Such policies

and monitoring could aim inter alia to address the build-up of financial

imbalances in the economy relating to the raising of leverage in specificsectors Early detection of signs of overheating of particular financial orproperty markets would be a case in point Efforts aimed at affectingimbalances could include measures to attempt to directly reduce mort-gage or credit demand from specific economic sectors Prudent collateralpolicies could be used – for example, by setting minimum margins oncollateral and/or capping loan-to-value ratios There is some uncertaintyregarding the effectiveness of loan-to-value ratios and margin require-ments in reducing risk-taking, as financial institutions may attempt toevade, in part, such regulations Nonetheless, there are examples wherethese tools appear to have had an effect in dampening risk-taking Arecent 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 thepeak of a rapid run-up in real estate prices and fast credit growth in thatsector Raising the shock-absorbing capacity of lending in real estate with

a stricter loan-to-value regulation before the crisis erupted was one of thefactors 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 inadequatemacro- and micro-prudential policies have been identified as major fac-tors contributing to the international financial crisis In Europe, rulesand regulations for the financial sector are made at the country level

and are not fully aligned across the euro area, despite the existence ofsome common directives And even when rules and regulations are sim-ilar, national differences in interpretation and rigour of application haveresulted in a fragmented and highly decentralised supervisory structureacross 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 forbetter coordination between the micro and macro parts, especially inproviding timely information Considering the important informationalsynergies between micro-prudential supervision and systemic risk anal-ysis, bringing micro-supervision under the same roof as other centralbank 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 assessthe risks and vulnerabilities of the financial system as a whole Overall, alesson of the crisis is that greater central bank involvement in regulationand supervision pertaining to credit and finance should contribute to

In Europe, the need to strengthen 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

supervision to a new body, the European Systemic Risk Board (ESRB),with the objective of increasing the focus on systemic risk within theframework of financial supervision Institutionally and at the EU level, theESRB should be in a favourable position to undertake system-wide riskassessments with a policy designed to detect areas of emerging financialimbalances and related structural vulnerabilities The ESRB can providepolicy recommendations based on its risk assessments, which can beconverted into effective policy actions via the use of the macro-prudentialtools and measures outlined above

To enhance micro-prudential supervision in Europe, new EuropeanSupervisory Authorities (ESAs) are currently being set up which, amongother things, will help coordination and convergence of the content andimplementation of regulatory standards The ESAs that are being cre-ated include the European Banking Authority (EBA), which combinesthe advantages of a European-wide framework for financial supervisionwith the expertise of micro-prudential supervision bodies at the nationallevel that are closest to the institutions operating in their jurisdictions.However, in certain cross-border emergency situations, the tools for

3 See, e.g., Orphanides (2009 and 2010).

coordinated effective action by national supervisors may be insufficient,and this points to the need to build a comprehensive cross-border frame-

It is recognised that close cooperation between the ESRB and thenew ESAs in establishing the link between macro- and micro-prudentialsupervision would be useful for strengthening financial stability inEurope For example, the ESRB together with the newly establishedEBA could conduct EU-wide stress tests on a regular basis to assess theresilience of financial institutions to adverse shocks

Apart from the task of integrating macro- with micro-prudential vision and regulation, an urgently needed convergence of supervisorystandards across Europe is required, with supervisors addressing prob-lems through European rather than national approaches While the cre-ation of a supranational financial supervisory authority for Europe doesnot currently appear to enjoy strong support, efforts should be made tohelp the existing highly decentralised system of supervision to becomesufficiently effective that it can act as one in dealing with crisis preventionand management

super-Effective prudential supervision can help prevent the occurrence of acrisis But to contain the economic and budgetary cost of a crisis once

it materialises and swiftly restore financial stability requires effectivecrisis management mechanisms A transparent pre-agreed crisis man-agement framework also reduces the moral hazard for banks, therebycontributing to reducing the risk of a financial crisis The presence of

a legal authority for prompt action and clear rules about how tial losses are allocated affects incentives and actual behaviour longbefore difficulties arise, and indeed might effectively discourage exces-sive risk-taking There are serious weaknesses in policies and proce-dures relating to crisis management in Europe Indeed, the de Larosi`erereport called for ‘a coherent and workable framework for crisis man-agement in the EU’ But little progress has been made towards a com-prehensive European crisis framework focusing on early intervention bysupervisors, bank resolution and more formal procedures for the rapidwinding-up of insolvent financial institutions EU bodies have been work-ing on developing a crisis management framework and the EuropeanCommission has indicated to the G20 that it will set out its ‘orien-tations’ for a crisis management framework in October 2010 At thesame time the EU has called for the Financial Stability Board (FSB),

poten-in cooperation with the BCBS, to provide concrete policy dations to reduce the moral hazard posed by systemically important

recommen-4 See, e.g., European Commission (2009).

financial institutions by the time of the G20 November 2010 SeoulSummit.

The crisis has provided a fresh opportunity for the EU to build a crisismanagement framework consistent with the regulatory and supervisoryframeworks improving coordination between policy-makers and takingaccount of the potential problems of moral hazard, burden-sharing andallocation of costs The development of a comprehensive crisis man-agement framework would also appear to be in line with EU citizens’support for stronger supervision by the EU of the activities of the mostimportant international financial groups According to the Spring 2010Eurobarometer public opinion poll, 75 per cent of Europeans agreedthat stronger coordination of economic and financial policies among EUmember states would be effective as a means of combating the crisis

sup-port, 89 per cent, was registered in Slovakia, while Cyprus, at 87 per cent,tied for second place with Belgium

In the euro area stability framework, liquidity matters clearly lie withinthe mandate of the ECB, which exercises a rigorous European approach

As a result, there is already in place a mechanism for dealing with liquiditycrises 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 liquidityissues In contrast, solvency matters are addressed exclusively by nationalinstitutions, which may have differences on what constitutes a systemicthreat, in identifying potential insolvency and about how and when publicresources should be employed As numerous observers have pointed out,and experience during the crisis has painfully confirmed, crisis manage-ment involving cross-border institutions in such a decentralised system is

a highly inefficient and difficult task The failure of Fortis in September

2008 highlighted conflicting national interests and the inability of ernments in the Benelux region – arguably the most integrated region inthe euro area – to find an efficient way to resolve a cross-border concern.Accordingly, the greatest difficulty, perhaps, is associated with develop-ing a framework for crisis management for dealing with problems involv-ing cross-border financial groups that should have procedures for earlyintervention, bank resolution and insolvency At present, there is no com-mon approach in Europe for early public intervention in the case of atroubled financial institution The absence of such a mechanism increasesmoral hazard on the part of the management of institutions that may findthemselves in trouble There is a need for supervisory authorities to have

gov-a stronger set of tools which they cgov-an use in intervening gov-at gov-an egov-arly stgov-age

to avoid the failure of an institution, or at least limit its problems While

many stakeholders are in favour of minimum rather than maximum monisation, a credible threat of early intervention provides incentives forfinancial institutions to guard their capital and thereby reduces systemicrisks and moral hazard problems The absence of such mechanisms leavespolicy-makers with only bad choices during a crisis and often proves verycostly to taxpayers.

har-Where early intervention fails to deal with the problems of a tressed bank the second pillar, ‘bank resolution’, involves reorganisingthe troubled bank in the most cost-efficient manner for the economyand society, before it becomes insolvent Resolution measures that might

dis-be taken by the competent authorities include, for example, transfer ofassets/liabilities, a bridge bank, or a good bank/bad bank split designed

to preserve the value of remaining assets and facilitate, if possible, theirquick return to productive use An appropriate legal framework is neededfor resolution, especially since resolution measures may impinge onshareholder rights (under company or other laws) Moreover, resolutionmeasures entail costs, which need to be financed, ideally by the financialindustry itself However, controversy surrounds the concrete means offinancing and burden-sharing as well as the level of authority (EU ornational) to be responsible for bank resolution A global consensus isemerging that shareholders and uninsured creditors of a bank should bethe first to bear the costs of its distress, in line with the principle ‘thepolluter pays’ A key issue is how to credibly implement this attractiveidea

A European resolution authority, as argued for example by Fonteyne

et al (2010), could be created and be given the mandate and tools toresolve large cross-border bank problems, particularly in a cost-effectivemanner To deal with the financing of bank resolution measures and,ultimately, the use of public money to support ailing banks, the Com-mission 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 International Monetary Fund(IMF) to study this funding proposal (G20 Pittsburgh 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

include a European Deposit Insurance and Resolution Fund (EDIRF)that is pre-funded by the financial industry through deposit insurancepremiums and systemic levies, so as to minimise the costs of crisis man-agement to government budgets The authors argue further that thecrisis management and resolution framework for the European bankingsystem 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 uations with countries agreeing to a third party, such as a Europeanresolution authority, largely managing financial crises for them

sit-In this context it may be recalled that on 9 October 2007, the EU’sEconomic and Financial Affairs Council (ECOFIN) adopted a set ofcommon principles for the management of any cross-border financial

by the financial supervisory authorities and central banks as part of the

1 June 2008 Crisis Management Memorandum of Understanding

prin-ciples are that:

r The objective of crisis management is to protect the stability of thefinancial system in all countries involved and in the EU as a whole, and

is not to prevent bank failures

r Crisis management should minimise potential harmful economicimpacts at the lowest overall collective cost

r Direct budgetary net costs should be shared among affected memberstates on the basis of equitable and balanced criteria

While these principles are sound, the crisis has demonstrated that binding commitments or understandings insufficiently guarantee theirconsistent implementation, to the detriment of mutual trust and cooper-ation and, consequently, crisis outcomes In this context, it is noted that

non-in April 2010 the EU and euro area member states, together with theIMF, agreed on a loan to Greece, with participation of euro area mem-bers, to be ratified by their respective parliaments However, last monththe parliament of one euro area member state voted overwhelminglyagainst contributing to the agreed loan This decision highlighted thechallenge of successfully achieving cohesiveness and solidarity betweenthe member states within the EU, despite the public support for strongercoordination of economic and financial policies reflected in the Spring

2010 Eurobarometer survey mentioned earlier

This underlines the need for strong, binding and institutionalisedarrangements for EU crisis management, putting the principles agreedupon on an operational basis Cost-minimisation needs to be definedmore precisely, with cost-effectiveness representing a major challenge, asavoiding or minimising costs is the best way to preclude disagreementsabout their distribution or burden-sharing between EU member 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 arguedthat only a cost-effective resolution offers a credible threat of failure and

with a failing cross-border bank should comprise no losses to insureddepositors, minimal losses to deposit guarantee systems, minimal col-lateral damage to the economy and minimal or no costs to governmentbudgets.

In the case of insolvency proceedings, where resolution measures not return the distressed bank or part of it to viability, these proceedingsshould ensure an orderly wind down However, insolvency regimes dif-fer substantially across the twenty-seven EU countries and initiatives topromote their harmonisation are required In particular, there are majordifferences between EU members in bankruptcy legislation and proce-dures The European Commission’s initiative to establish a group ofexperts on insolvency law is commendable, but harmonisation of insol-vency regimes, while certainly feasible, will be difficult

argues that contingent resolution plans (‘living wills’) could be an tive tool in crisis contingency preparedness for large and complex finan-cial groups These institutions would be required to devise detailed andregularly updated plans for dissolution that need to be approved by thesupervisory authority In principle, these plans would also ‘specify for-mulas for loss-sharing among international subsidiaries of the bank (suchloss-sharing arrangements would be preapproved by regulators in coun-

impor-tant also that supervisors should have the power to require a bankinggroup 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 eration and coordination between member states and, moreover, raisedquestions about euro area governance Which European institutions areultimately in charge of surveillance and collective action in times ofstress, and how can member states be disciplined to adhere to agreedpolicies? Is it sufficient for the Van Rompuy task force on euro area

on enforcement and strengthening of existing EMU provisions? Or arethere more macro-surveillance problems that go beyond weak enforce-ment in the fiscal area? In this respect, the European Commission hasproposed 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 acterised by a lack of policy coherence, with most member states notgearing domestic policies, particularly wage-setting, to euro area policy

char-management.5 Even under the SGP, member states have demonstratedlittle ownership of fiscal targets to which they were committed Cer-tainly, the crisis has exposed fault lines in the governance of the euroarea, and much is expected of the Van Rompuy task force on multi-ple fronts, including strengthening surveillance of budgetary policies andmore effective corrective measures, improving surveillance of competi-tiveness developments and the correction of imbalances In particular,there are three pillars on which stronger governance may rely in order toreinforce compliance of national authorities with the rules of the Treatyand the SGP First, reinforcing the SGP through, for example, moreeffective fiscal surveillance, a wider spectrum of sanctions, strengtheningthe independence of fiscal surveillance, etc Second, addressing imbal-ances in competitiveness through, for example, less strict surveillance ofcountries which perform well and stricter oversight for member stateswith excessive vulnerabilities Third, establishing a permanent frame-work for crisis management that will minimise moral hazard problemsand at the same time provide a credible arrangement for countries in trueneed Within this framework a euro area crisis management institutioncould be developed.

The crisis has provided an opportunity to construct a comprehensivecrisis management regime that can replace the current patchwork of lim-ited financial stability arrangements based largely on national interests.And, as outlined earlier, it is recommended that institutional arrange-ments for resolving the problems of large cross-border banks should give

authority to a pan-European institution backed by largely private ex ante

funding arrangements Furthermore, in extending financial assistance tomember states – such as under the European Financial Stability Facil-ity (EFSF) created in May 2010 to address tensions in the euro areasovereign debt markets and from unsustainable financial imbalances –there is a need to strengthen institutional arrangements and legal obliga-tions so that member states can show greater cohesiveness in fully hon-ouring their commitments and providing funding and loan guaranteesfor 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 andmutual support, it is critical for all governments in the EU, and inparticular in the euro area, to show their support for a Europeanapproach It would be especially unfortunate, in light of the strong sup-port exhibited by the citizens of Europe for stronger European economic

5 See the discussion in Bini Smaghi (2010), Gaspar (2010), International Monetary Fund (2010b) and Pisani-Ferry (2010).

governance, if this strengthening is not achieved within a reasonabletime-frame.

The crisis has brought to the forefront the need to build a Europeanfinancial supervisory architecture There has been progress in develop-ing the institutional framework for micro- and macro-prudential super-vision, including the recent process of creating pan-EU financial super-visory authorities Progress in establishing prudential tools, especiallymore appropriate capital and liquidity requirements, for contributing tocrisis prevention, has been more limited But it is in the construction

of a comprehensive European crisis management and resolution work where there is a real deficiency, and where much work needs to beundertaken

frame-In my remarks I have provided some thoughts on the way forwardfor building a crisis management framework, which needs to addressproblems of moral hazard, burden-sharing and cost-effectiveness and,moreover, problems of policy coordination between the various financialauthorities in Europe Inevitably, such discussion leads to issues of eco-nomic governance in Europe on which I have posed some questions andfurnished some further considerations An extended discussion on themost effective ways to improve regulation and monitoring as well as fac-ing potential future crises has been going on for some time in Europeanand international fora It is also apparent that an integrated approach

to prevention management and conflict resolution is crucial to ensurefinancial stability

In closing, I note that it is virtually impossible to avert future criseswithout an unwelcome change in the core elements of the philosophy ofour economic system based on the free market ideology and the funda-mental principles of free movement of labour, capital, goods and services

It is, however, feasible to work towards a framework that supports nomic efficiency and growth while it reduces the frequency and the cost offuture crises Building this framework should be one of our main presenttasks