Finance: Research, Policy and Anecdotes

The topic of bank resolution in the Eurozone is again in the headlines, with possible controversial actions in two countries that often find themselves at opposite sides of the argument – Italy and Germany. Both threaten to undermine the progress that the Eurozone has made over the past years to a Single Market in banking and thus a more sustainable currency union.


In Italy, there are – not surprisingly -  more bank failures. On January 2, the ECB appointed temporary administrators at Banca Carige, based in Genoa, after shareholders were unable to secure additional equity. The problems in Banca Carige are not new, but the can had been kicked down the road until late last year.  The Italian government seems to stand ready to pour money into Banca Carige via the instrument of  precautionary recapitalization (as also applied to Monte dei Paschi in Siena in 2017) even though this bank cannot really be considered a systemically important financial institution. Also, guarantees of Carige’s bondholders go through the Italian deposit insurance scheme, thus transferring contingent liabilities to the rest of the Italian banking system. However, the bail-out goes beyond this specific case. According to news reports, Italy’s government has set up a 1.6 billion euro fund to compensate investors who have lost their money in a string of recent bank liquidations. This will pay junior bondholders up to 95 percent of the original value of the investment and shareholders up to 30 percent. While this arrangement is almost exclusively for retail investors, it certainly extends the financial safety net far beyond what has been agreed under the new European bail-in rules. And even if one can make the case for compensation for retail investors that were mis-sold junior securities in banks, there is no case to be made to compensate equity holders!


Ultimately, the Italian-style bank resolution over the past two/three years is a big step backwards to the era of bail-outs. It is also a reflection of the failed politics of kicking the can down the road when it comes to bank resolution – the Italian government had ample opportunities to clean up its banking system before the BRRD came into force; however, it is also a failure on the European level that new rules come into place for a continuously weak banking system whose structural deficiencies have not been addressed yet.  


While Italy thus undermines the bail-in principle of the banking union, the German government is going even a step further, trying to “renationalise” banking sector policies, thus actively undermining the Single Market in Banking.  In the spirit of industrial policy and creating national champions, there seem to be government efforts under way to facilitate a possible merger of Deutsche Bank and Commerzbank, the two largest privately-owned banks in the fragmented German market. While the argument of consolidation and reducing overbanking might make sense, the creation of a national champion as explicitly aimed at by the Minister of Finance seems mistaken if not dangerous. Such a bank would be considered German and with active political involvement in its creation would immediately raise further bail-out expectations in case things do not work out as planned. It also undermines level playing field within the Eurozone - fiscally strong countries such as Germany can support their banking systems, while others cannot. This also shows the hypocrisy of German commentators when criticising bail-outs in Italy (as politely pointed out by Isabel Schnabel in this German commentary).


Both the Italian and the German actions counter the enormous progress made over the past years towards a single regulatory framework for the Eurozone. Let’s remind ourselves – the most immediate reason for the banking union was to cut the link between sovereign and bank fragility (a target which has not really been achieved, but this is for another day); however, the broader objective is that of creating a Single Market in Banking without which the Eurozone would not be a sustainable currency union. However, this implies a move away from national champions and purely national actions.


The Eurozone has made big strides towards a Single Market in Banking with the establishment of the Single Supervisory Mechanism and the Single Resolution Mechanism. Important elements (most notably a European Deposit Insurance Scheme) are still missing. However, a Single Market in Banking is not only about the legal framework but political actions. Both the Italian and the German governments have shown over the past weeks that they are not willing to “walk the talk”. Not only have the lessons of the Global Financial Crisis been forgotten, but also the lesson of the Eurozone crisis that national financial safety net and national banking sector policies undermine the Eurozone!


If Brexit were a soap opera, yesterday’s historic defeat of Theresa May would have been the season finale. But the new season is starting almost immediately and – maybe, just maybe – might become quite innovative and original. Two quick observations.


First, on popular (populist) vs. representative democracy. The referendum of 2016 was odd in many aspects, as not really in line with the parliamentary tradition of the UK. And unlike many previous referenda on EU issues across Europe, it did not offer a choice between status quo and further integration but between status quo and something unknown (aka unicorns) – where the unknown won. The Prime Minister took it on herself to interpret the findings without any consultation or consensus-seeking within government, party or country – so not really surprising that she failed!  Step by step, over the past two years parliamentary democracy has fought back, first gaining the right to a meaningful vote (which took place yesterday) and by forcing the government to show its cards (and thus calling its bluff). Now, that the referendum politics has failed and Theresa May is in the weakest position of any prime minister over the past generations, it might be the moment when parliament finally takes back power and does what it is supposed to do in a representative democracy like the UK: legislate – in this case, legislate the future relationship between the UK and the EU. It would be ironic if after two years of everyone being fixated by the referendum result, parliament comes out stronger than before!


Second, Brexit has been mainly and predominantly an intra-Tory discussion. David Cameron triggered the referendum to settle an intra-Tory conflict; Theresa May initially tried to mollify hard-line Brexiteers in her own party, and even now the tendency is to first look for a consensus on Brexit within the party rather than within the House of Commons and the country. This “party before country” approach has brought the Prime Minister and the Tories to the brink of complete failure (and has allowed Jeremy Corbyn a home run by not forcing him to take any realistic position). Maybe, just maybe, it is time to put country first!  This relates directly to my first point – maybe it is time for some sensible people in the House of Commons from all sides of the political spectrum to take charge of the process and come to a solution! Make the whole political class and the whole country own its future, not the kitchen cabinet in 10 Downing Street!

What a year it has been! In terms of politics, 2016 was the year of shocks (Brexit vote and Trump election) and 2017 the year of hope (Macron election). 2018 can be referred to as the year of the new normal, with populists-authoritarian parties now firmly in charge in several European countries, Macron running into trouble in France and Trump continuing his attacks on international trade. On a personal level, it has been an exciting and intellectually stimulating year, working with my outstanding PhD students Andre and Mikael, continuing as Economic Policy editor and helping to push forward the long-term finance agenda in Africa.


2019 will bring new challenges for me, including on the professional level. It will be my last year as managing co-editor of Economic Policy and my first year as managing co-editor of the Journal of Banking and Finance.  I have joined the Advisory Scientific Committee of the ESRB and have been working as academic advisor for the FSB on the evaluation of the effects of Basel III on SME finance.  And as important background noise, the comedy show “Brexit” has been just renewed for another season (my bet is that it will be extended for several more seasons).  In any case, if anyone thought 2018 was a crazy year in British politics, wait for 2019 you ain’t seen nothing yet! 


Happy holidays!

Meghana Ayyagari, Sole Martinez Peria and I have finally published a working paper version of our study on the effect of macroprudential policies on firms’ funding and investment/sales growth. An early version of this paper was supported by the Hong Kong office of the BIS and presented at the BNM-BIS conference on financial systems and the real economy in Kuala Lumpur two years ago. The new version, however, has added quite some additional results. Here is in a nutshell what we find: the implementation of macroprudential tools aimed at borrowers (such as loan-value and income-debt limits) have a statistically and economically significant association with small and young firms’ funding growth, especially those firms that are financially less healthy. These relationships are statistically and economically stronger for long-term (more than one year) funding growth. There is a similar relationships for firms’ sales and investment growth, suggesting that macroprudential tools have implications not just for the financial but also the real economy. The results do not seem that surprising as smaller and younger firms are also more affected by other types of macro policies, such as monetary policy and  capital controls.  On the other hand, the results are reassuring as it is the financially weakest firms that are affected, thus mitigating concerns on financial inclusion.


For a short, non-technical version of the paper, see the Vox column here.

This week, the Eurogroup (Ministers of Finance of all Eurozone countries) agreed on some reforms for the banking union and Eurozone governance.  As always, it is two steps forward and one step back.  There has been an important step towards creating a backstop for the Single Resolution Fund (in the form of a revolving credit line from the ESM), which will strengthen the resolution component of the banking union. Having access to the necessary funding (even if only for transitional needs) provides supervisory and resolution authorities more options and stronger incentives to intervene in time.  Moving towards a Eurozone-level deposit insurance, on the other hand, has been referred to yet another High-level Working Group, which is supposed to report back by June 2019 – typical can kicking.  While one might see backstop and Eurozone deposit insurance as substitutes, creating a common backstop specifically for depositors in the form of a Eurozone deposit insurance can help create stronger confidence in the banking system in some periphery countries where the national backstop to the deposit insurance is not trusted and might also help to move the Eurozone towards a Single Market in banking.  


Beyond the rather slow progress towards a complete banking union, one major gap is the refusal to address the stock problems in the Eurozone, most notably the large share of NPLs in Italy and other countries.   I know I sound like a broken record (here, here and here), but the refusal to address these stock problems will also prevent further progress towards a full-fledged banking union that allows for full risk-sharing and is the regulatory fundament for a Single Banking market in the Eurozone.  As long as creditor countries in the North of Europe are afraid of having to foot an open bill for legacy problems in the South, they will be reluctant to move to complete risk sharing.  Simply waiting for these problems to disappear (also known as flow solution) or national governments to address them (after they have dragged their feet for the past ten years), however, seems somewhat disingenuous.


This constraint is also reflected in the discussion on sovereign restructuring mechanisms and the role of the ESM, given the sovereign fragility of Italy.  The idea of allowing for a restructuring mechanism for sovereign debt (similar to the bail-in regime for banks) has not been adopted and the aim is now to rather introduce single limb collective action clauses (allowing for one resolution decision to cover all bonds) by 2022 and enable the ESM to facilitate a dialogue between debtholders and Eurozone governments in times of crises. In addition, precautionary credit lines from ESM for countries are planned, with conditionality imposed and monitored by the European Commission. While this might strengthen market discipline to a certain extent, the introduction of risk sharing mechanisms in the form of common fiscal policy has been left for future discussions.


As always, the question is whether the glass is half full or half empty. Maybe a different question is whether the glass will break with the next earthquake – will the necessary reforms only be undertaken when there is an acute need or will the Eurozone and its banking system enter the next crisis better prepared?


On a somewhat different, but related note, the appointment of Jakob of Weizsaecker as chief economist in the German Ministry of Finance is an incredibly good and important signal that the German government might finally move away from an exclusive focus on market discipline to a more holistic view on the Eurozone governance structure. Jakob has actively participated on the discussion on Eurozone reforms over the past ten years, with innovative proposals, so we might see a shift in the role of the German government in these discussions (where his appointment already signals a possible shift in thinking).