Finance: Research, Policy and Anecdotes

Credit guarantees for (small) businesses have been one popular policy tool in government’s fight against the COVID-recession. At a time when revenues fall away, but many businesses still have to cover at least part of their costs, cash can run out quickly. Further, the changed economic environment and high degree of uncertainty increases the riskiness of these borrowers in the eyes of the banks, which might result in reductions of credit lines or non-renewal of loans at a time when external funding is most needed; where funding is not cut, higher risk could be reflected in higher interest rates or demands for additional collateral. Credit guarantees are supposed to counter these effects and help small businesses through these hard times, in line with the idea that the economy is to go into the freezer for some weeks or months but should roar back to life quickly once it is possible. Maintaining the productive capacity is key in this context.  

 

Before discussing their effects, it is important to note that credit guarantees have been used for a long time by governments in the developed and developing world alike. Though their purpose has been traditionally a different one – trying to expand access to external finance among small businesses without sufficient access to bank finance. With this purposes, policy makers typically face the trade-off between additionality and sustainability, i.e., reaching firms that previously did not have access to external funding while at the same time minimising losses that arise from banks calling in guarantees. The track record is a mixed one, with problems ranging from limited take-up over administrative barriers to lack of limited additionality and unsustainable losses. However, there have also been quite some successful cases, as a growing literature has shown.

 

Back to credit guarantee as crisis management tool.  The issue here is not additionality or sustainability, but survival. Guarantees are targeted at existing borrowers with the objective of guaranteeing their survival during the Great Lockdown and incentivising banks to extend as much financing as necessary. The challenge is one of speed – how to get cash as quickly as possible to firms affected by COVID-19.  However, there are clearly still design issues and trade-offs to be considered. Underlying these trade-offs is the deeper issue whether liquidity support is really the ideal way to address what increasingly seems more like a solvency problem.

 

First, what should be the coverage? 100% (as in Switzerland) or rather 80% (as in the UK)? On the one hand, incentive theory tells us that banks should maintain skin in the game so that they keep monitoring borrowers. On the other hand, anything less than 100% loss coverage might make banks reluctant to lend in these uncertain times and might make them also slower in their lending decisions. The recent decision of the UK government to shift towards 100% guarantees clearly shows these problems.

 

Second, for how long will such guarantees last? As with containment policies, there is the question of an exit strategy. As our economies will slowly emerge from the Great Lockdown, it will become very clear that there are winners and losers (at least in relative terms). Capital reallocation to winning sectors will be important as will be to NOT keep zombie firms alive. Borrowing firms might not be able to repay loans quickly and might need additional funding during the recovery phase. There will be thus pressure to extend the guarantee scheme further. Converting many of these guaranteed loans into grants ex-post might be one way to address this challenge, which would be the ultimate recognition that the Great Lockdown implies solvency and not liquidity problems. There will be losses from these guarantee schemes, with government bearing all or large parts of them (which will bring some governments in the euro area into potential trouble).

 

While the ultimate reckoning can be delayed, it cannot be avoided. If we want to avoid the banking system turning into a utility channelling government funds to the private sector, it has to eventually recover its function as screener and monitor, deciding on credit allocation across sectors and firms according to expected risk-adjusted returns. There will be a clear trade-off between a quick recovery, with government continuing to be the ultimate guarantor and with an increasing contingent debt burden vs. a slower recovery with more pain but possibly returning eventually to a more sustainable growth part. Corporate restructuring programmes for small businesses, as used previously in emerging market crises, might be one valid policy option.  Challenges that still seem far away but it is important to start thinking about them now.

Governments around the world have responded with unprecedented measures to the spread of the COVID-19. Borders are now closed for travel among most major economies. Drastic policies have been introduced to curtail economic and social activity. The early evidence so far suggests that they have indeed helped to limit the spread of the virus, but at the same time there are likely to be dire economic consequences

 

While COVID-19 is a global pandemic, the policy responses so far have been almost exclusively national. Across Europe, one country after the other closed its border and introduces increasingly stringent domestic containment policies, culminating in lockdowns in most countries. Similarly, in the US, most of the public health response has been on the local or state level, with little coordination or policy action on the federal level. It takes little if any academic or scientific knowledge to realise that non-coordinated responses are not optimal.

 

Wolf Wagner and I analyze the optimality of national containment policies in an integrated world in a paper that has just been published in COVID Economics by CEPR (papers receive a 48 hour review with up-down decisions). Specifically, we consider a theoretical model with two countries that independently choose their containment policies. We show that while during the containment phase countries might implement policies that are too stringent or too loose, during the phase of loosening these restrictions, countries will tend to adopt policies that are too loose.

 

In the short-term, during the lockdown stage, governments face a trade-off between maintaining economic activity and the costs of a rapidly spreading virus. Critically, there are also cross-border externalities to this decision. Specifically, a lockdown and the shutdown of manufacturing companies will affect supply chains and cause disruption in the production in other countries. We have seen evidence of this when China shut down large parts of its economy, with negative repercussions on many companies in the US and Europe that depended on Chinese suppliers.  There are also demand externalities from these containment policies as well as negative earnings effects through foreign direct investment channels. These externalities would imply that national policies in this first stage might be too stringent, as individual governments will ignore these cross-border ramifications of their actions.

 

There are off-setting effects, though. Countries that rely a lot on tourism, for example, might be less willing to adopt stringent containment policies and might rather be on the side of waiting rather than acting too quickly. We provide suggestive empirical evidence for that, relating containment policies across 27 European countries to death rates and their reliance on merchandise trade and tourism. We show that countries relying more on merchandise trade “produce” externalities for other countries and thus opt for rather more stringent lockdown policies, while countries relying more on tourism will delay lockdown as much as possible.

 

The more successful the suppression of the virus has been, the lower the costs of the virus during the new-normal stage of our model. In the new-normal phase, externalities will be predominantly coming through the cross-border spreading of the virus rather than economic channels. We assume that at this stage, borders are open, allowing people to travel internationally. Direct disruptions in the production process from curtailing production in the other country are thought to be of less relevance then, because production processes will have adjusted; firms will have modified their supply chain and countries will have become more autarkic.    This implies that during the new normal, containment policies may be excessively lenient, and in particular so in countries that have a high mobility (inward and outward), such as popular tourist destinations.

 

These externalities call for urgent international cooperation, to internalize the externalities discussed above and help flatten both the medical and the economic curves.

One might not like the name and the politics that comes with it, but there is a clear economic, political and moral case to push for a joint fiscal policy effort in the EU and/or Eurozone to mitigate the impact of the COVID shock.  Here is my Vox column that was published today, detailing the diferent arguments and explaining the clear downsides of other approaches:

 

The economic, political and moral case for a European fiscal policy response to COVID-19

 

 

There has been a lot of discussion in recent weeks on whether or not an EU-wide fiscal policy response should include common liability for the additional debt that such a response would imply. Some observers see a replay of similar discussions from a few years ago on Eurobonds, even though the circumstances are very different. Others observe that it would not be the first time such community bonds were issued after a major economic disruption (Horn, Meyer and Trebesch, 2020).  In the following, I will lay out the arguments in favour of such an approach – arguments that go beyond economic ones.  

 

Principle of subsidiarity

The principle of subsidiarity, as defined in Article 5 of the Treaty on European Union, is a basic tenet of European decision-making. It aims to ensure that decisions are taken as closely as possible to the citizen and actions on EU level have to be justified in light of the possibilities available at national, regional or local level. Responsibilities for specific policy areas should only be transferred to the EU level if objectives can be better reached at Union level.

 

One can easily apply this principle to policy actions in the context of the Coronavirus. Neighbourhood-based Whats App groups have mushroomed across London (I am sure they have so in other cities around the world) to offer help to vulnerable residents.  Given differences in the organisational structure of health systems across EU countries, the primary public health response has happened on regional or national levels.  Other actions, however, clearly benefit from being undertaken at the union-level, such as the case of procurement of ventilators and other medical equipment, which is cheaper for the EU than for individual countries given a larger market share on the demand-side if countries act together.  Incentives to find reliable tests and a vaccine can benefit from more generous funding on the supra-national level. These public health actions benefit from being taken on the European rather than national level, given scale benefits, strong externalities and the character of a vaccine as public good.

 

This argument for policy action on the European (or even global) level also applies to the economic policy reaction to the COVID-recession. The socio-economic lockdown made necessary by the COVID-19 virus will damage economies. A quick recovery and limitation of further damage will require fiscal policy actions. While many such actions have been taken already to help firms and households during the lockdown phase, more might be needed in the recovery phase.   Given the close interconnectedness of European economies (in the form of supply chains, good and service market integration and labour mobility) it is in every country’s interest that such recovery happens quickly and across all countries in Europe. There are thus strong externalities of national fiscal policy actions, which – without coordination - can result in too little fiscal policy. As important, however, is that some countries have less fiscal space available than others. This is clearly reflected in the fiscal policy measures to-date, which have been much more expansive in Germany than, for example, in Italy or Spain.  So, what role can European institutions play in these circumstances?

 

 

Why not the ECB?

As has become tradition over the past 12 years, the ECB was the first European institution to step up to its responsibility. The pandemic emergency purchase programme (PEPP) and its flexibility is an aggressive monetary policy step, more effective than pushing interest rates further into negative territory. The PEPP as well as the “no limits” policy announcement (the equivalent to Draghi’s “whatever it takes”) has helped reduce panic on financial markets, including on the sovereign bond markets. There is the suggestion that the use of the OMT programme (announced after Draghi’s “whatever it takes” speech in summer 2012 but never actually used so far) can help reduce pressure on eurozone governments that have reached the limit of its fiscal space.

 

While the ECB is clearly the first line of policy defence in this recession when it comes to financial markets, there are several reasons why it should not bear the main burden of the necessary public support programmes for the recovery. First, the COVID and the consequent government expenditures are clearly fiscal policy tasks; the losses incurred during this crisis will have to be funded and distributed.  There are different (non-exclusive) ways of doing so – one is through higher taxes on, for example, income or wealth, another is through higher government debt over the next decades, thus spreading the costs to future generations. In either case, the most transparent way is to do so openly and sanctioned by democratically elected parliaments and governments.  

 

The alternative of using ECB monetary policy tools to keep interest rates and spreads (and thus the cost of such debt) low would also imply that a normalisation of interest rates and reduction of quantitative easing would be even further away.  I would not expect any tightening of monetary policy any time soon during the next few years but having the additional task of avoiding runs in the sovereign bond markets would push such a return even more into the future.   

 

A further consideration when burdening the ECB with what is effectively a role for fiscal policies is that it would undermine the standing of the ECB as independent monetary policy institution even further. The ECB has been criticised for keeping interest rates at zero or in negative territory for too long, as often as this argument has been proven wrong; it has also been accused of overstepping its mandate and entering effectively fiscal policy. Forcing the recovery of COVID-losses through long-term financial repression is certainly counter to its mandate. While this is what was partly done in many European countries post-World War II (Reinhart and Kirkegaard, 2012), central banks were not independent during these times but rather seen as part of democratically elected governments.  

 

 

Why not the ESM?

The ESM has been established for situations where individual governments are hit by shocks and cannot finance themselves any longer on the market. Similar to the IMF on global level, such a programme comes with conditionality.

 

There have been suggestions that the easiest way (partly because of existing structures) is for countries at risk of not having sufficient access to market funding to tap ESM funding (e.g, Erce et al., 2020).  There are several problems with this. First, ESM loans would still be part of national debt and would thus not solve the problem of sovereign debt sustainability.  While the idea of using the ESM together with OMT might get around this constraint, this would effectively mix fiscal and monetary policy, as discussed above.

 

Second, the ESM was not founded for a crisis like this one but rather to provide liquidity support for individual countries that got into temporary problems.  But COVID-19 is not an asymmetric shock hitting one or some countries, but a shock that has hit all economies, though at different points in time. Finally, the tapping of the ESM comes with a stigma, not only in terms of market signals, but also politically, unless all countries commit to tapping the ESM at the same time.

 

 

The economic case for COVID debt mutualisation

This leaves the idea of Coronabonds, as for example suggested by Bofinger et al. (2020) or Giavazzi and Tabellini (2020.  But why should countries with higher fiscal policy space take on liability for the benefit of countries with lower fiscal policy space? There are several answers to this question: one answer is that of economic self-interest. The countries currently most affected by the virus in human and economic terms are among the countries with the lowest fiscal space even though they are most in need of a fiscal stimulus. On the one hand, a lower fiscal stimulus from these countries dampens the recovery throughout the euro area and the Single Market. On the other hand, a strong fiscal stimulus that turns sovereign debt of these countries unsustainable can result in a vicious cycle of lower growth perspectives endangering access to sovereign debt markets, which in turn lowers growth perspectives further. Such a vicious circle will not only result in more divergence within the currency union, but negatively affect all euro area countries, not even to mention the risk of a possible exit of countries with unsustainable government debt from the euro area.  

 

The experience of the past decade should be a clear warning signal. The Global Financial Crisis and the Great Recession increased sovereign debt burdens throughout the euro area and ultimately resulted in the Eurodebt crisis, deepening social and economic misery and contributing to the rise of populism. There is a clear economic case to avoid that the COVID-recession is followed by a second Eurodebt crisis! Arguing that even a hint of debt mutualisation would result in a further rise of populist parties in Germany, Netherlands and Finland ignores that such a rise would follow from another Eurodebt crisis anyway and underestimates the pan-European spirit of solidarity that can be awoken through right political leadership.

 

 

The political case - Looking at history

The last global pandemic – the Spanish influenza in 1918-20 came at the end of World War I. European countries already devastated by the war faced an additional human and economic burden. The next two decades brought nationalistic resentment, authoritarianism and fascism – culminating in World War II and the Holocaust. While I would not for a moment argue that the Spanish influenza had a decisive role in this turn of history, I cannot avoid seeing some parallels in the current circumstances.

 

The European Union, founded after World War II, has contributed to 75 years of peace in our continent. The current pandemic brings the chance to a common European approach, building on decade-long cooperation and institutional infrastructure, thus “updating” the role of the European Union as peace project. The failure to do so, on the other hand, will undermine the case for Europe even further and will give further impetus to populist if not authoritarian parties. We should have learned over the past ten years (Brexit and a close shave with Grexit) that progress in European integration is not irreversible and not having a common approach to this crisis can have serious political repercussions. The recent open letter by Italian politicians of the centre-left, reminding Germany of the debt rescheduling in 1953 and accusing the Dutch of robbing other European countries of tax revenues (Calenda et al., 2020) gives us a small flavour of what could be the beginning of a slow reversal of decades of European integration.

 

Finally, the moral case

 

Finally, there is a moral case: Germany is receiving COVID-patients from other countries at the time of writing; a clear sign of European solidarity. But the crisis will not be over once the first COVID wave has receded – rather the public health challenge will be replaced by an economic challenge – why should European solidarity be less important or justifiable for economic recovery than for public health challenges? As many developing countries will struggle with public health and debt challenges in the years to come, global solidarity is the only feasible way forward – starting in Europe is important.

 

Why now?

There are arguments that now is not the time to build the necessary institutional framework for coronabonds or comparable funding structure and that the use of existing structures, including the ESM and the ECB, is preferable. I have argued that this would be the wrong path.  While it might help hold off pressure, financial markets anticipate future problems. As important, however, is it to send a political signal of European solidarity now. This is especially important for the younger generation whose early adult experience will be dominated by the COVID fallout. We do not need another Lost Generation or Depression Babies (Malmendier and Nagel, 2011)!

 

What is needed now therefore is a signal on the highest political level – a signal of fiscal policy solidarity, driven as much by economic self-interest as by historic lessons and the moral case for pan-European solidarity.

 

References

 

Bofinger, Peter, Sebastian Dullien, Gabriel Felbermayr, Michael Huether, Moritz Schularik, Jens Suedekum and Christoph Trebesch. 2020. Europa muss jetz finanziell zusammenstehen. Frankfurter Allgemeine Zeitung, 21 March

 

Calanda, Carlo et al. 2020. Brief an unsere deutschen Freunde, 31 March

 

Erce, Aitor, Antonio Garcia Pascual and Ramon Marimon. 2020. The ESM can finance the COVID fight now. VoxEU 6 April

 

Giavazzi, Francesco and Guido Tabellini. 2020. Covid Perpetual Eurobonds: Jointly guaranteed and supported by the ECB. VoxEU 24 March.

 

Horn, Sebastian, Josefin Meyer and Christoph Trebesch. 2020. European Community Bonds since the Oil Crisis: Lessons for today? Kiel Policy Briefs 136.

 

Malmendier, Ulrike and Stefan Nagel. 2011. Depression Babies: Do Macroeconomic Experiences Affect Risk Taking? Quarterly Journal of Economics 126, 373-416.

 

Reinhart, Carmen and Jacob Kirkegaard. 2012. Financial Repression: Then and Now. VoxEU, 16 March

While in lock-down, I have been able to finally read papers that I have meant to read for a long time as well as papers that I was supposed to discuss at conferences that have now been cancelled.  Here are some of them:

 

Davidson Heath, Matthew Ringgenberg, Merhdad Samadi, and Ingrid Werner recent paper “Reusing Natural Experiments” might turn into quite an influential paper as they shed doubts on our profession’s habit of reusing natural experiments as identification strategy in several studies. The identification challenge in economics and finance can be addressed in different ways, one of them being natural experiments, where a certain policy is introduced for some firms, states, households but not others, or is introduced at different points in time, again in a manner that is quasi-random.  Given that the universe of such natural experiments is limited, they are being reused. However, as the authors show, this leads to false positives.  As the ultimate null hypothesis being tested in these different paper is the same (what was the effect of the experiment?), the different tests are not independent of each other.  The good news is that there is a solution, developed by Romano and Wolf (2005), in the form of using adjusted t-statistics to control for the “family-wise error rate”.  While the authors focus on two specific natural experiments in finance (enactment of state business laws and regulation SHO), this is obviously a much broader concern. One of the natural experiments that I have used in a paper with Ross Levine and Alex Levkov is the branch deregulation episode in the US, widely used in many previous papers. While I am reasonably confident in the robustness of our findings (among other reasons due to the use of different datasets than previous papers in the literature), it certainly makes me think.  Maybe an idea for a PhD student to explore this or other policy-related natural experiments and gauge their robustness.  There is also an interesting parallel to the legal origin literature (started by La Porta et al.), which has shown that there are differences between Civil and Common Code countries along a variety of policy areas (media freedom, labour laws, creditor and minority shareholder rights, business registration etc.). Given that legal origin is related to so many policy areas, it cannot really be used as instrument for any of these.  More generally, it is now widely recognised in the institution-growth literature that it is hard to identify the causal impact of a specific policy on real sector outcomes if you use a natural experiment as instrument, given that a given natural experiment has impact on many policy outcomes.

 

This paper, however, also sheds light on a broader concern in the finance and economics profession: once a natural experiment has been “discovered” in the profession, there is an army of research economists and PhD students applying this experiment in different settings. While our profession has “learned” to cluster standard errors and saturate regression models with fixed effects, which often makes some significant effects turn insignificant, this paper certainly challenges us in new ways on the robustness of empirical studies.

 

Edoardo Acabbi, Ettore Panetti and Alessandro Sforza have an interesting paper on “The Financial Channels of Labor Rigidities: Evidence from Portugal”, an interesting addition to the emerging labour and finance literature.  Using the Lehman Brothers shock resulting in an interbank market freeze in late 2008, they find that the credit shock explains about a third of the employment losses among large Portuguese firms between 2008 and 2013, an effect that is larger for more labour intensive firms, but independent of their productivity level (so no cleansing effect of the crisis). They explain this effect with liquidity constraints emerging from lower credit supply and their inability to easily adjust wage costs due to labour market rigidities.   A nice paper using micro-level data on credit, corporates and employees.

 

April Knill, Baixiao Liu and John McConnell have and interesting paper on the influence of media on real sector decisions. In their paper Media Partisanship and Fundamental Corporate Decisions, they show that  during the presidency of George W. Bush, firms led by Republican-leaning managers headquartered in regions into which Fox was introduced shift upward their total investment expenditures, R&D expenditures, and leverage. Comparing managers who donate more to Republicans than Democrats in areas with Fox News to Republican-leaning in areas with no Fox News, there is a significant differences in these corporate outcomes, while there is no such differences for non-Republican-leaning managers.

 

Finally, CEPR has launched a new online peer-reviewed review to disseminate emerging scholarly work on the Covid-19 epidemic – Covid Economics, with papers that are not peer-reviewed but evaluated by a large editorial board. In the first issue, there are interesting papers on the historical evidence on the effects of pandemics on return on assets, who can and who cannot work at home across different geographies and stock market reactions to COVID-19 news.

As the COVID-19 pandemic continues its march across the globe, with the epicentre having moved from Asia to Europe (with another move towards the Americas possible in a few weeks), the socio-economic disruptions have increased the likelihood of a global recession and with that of problems in the financial system.  What can policymakers do now and what should they be prepared to do when the damage will become clearer when the virus has receded?   While there is a high degree of uncertainty and limited information, lessons from previous crises can come in useful to define possible policy actions and gauge policy actions that have been taken.  The following discussions will focus on three main policy steps:

 

(i)             Governments have to stand ready as the ultimate loss absorber, in the first instance for the real economy, but also for the banking system

(ii)           This has to happen on the EU or eurozone level, given limited fiscal space for some countries

(iii)         This has to be announced clearly and early on to create confidence

 

Proactive measures needed

 

COVID-19 and the disruption it has caused and continues to cause constitute an enormous shock to both real economies and financial sectors, reflected in financial market distortions, mis-aligned prices (which arbitrage should make unsustainable in normal times) and funding concerns for many market participants, including banks. The problems originate in the economic disruption: not earning money, households might not be able to repay mortgages and consumer credits; not having clients or not being able to produce goods/services results in lost revenues for firms, undermining their ability to repay loans. But it is more: where they have them available, firms are drawing down credit lines to have a sufficient cash buffer during times of economic disruption. This trend is exacerbated as access to market finance is drying for most firms that used to have access to it.  While banks can help overcome their clients’ liquidity constraints, they have a limited ability to do so.  Initiatives such as by the UK government and Bank of England as well as of the German and French governments to offer funding liquidity for banks and credit guarantees can be helpful in this context. Fiscal support measures can also help mitigate the negative effect of the crisis on banks’ asset quality by ultimately targeting the source of the losses.

 

One of the defining characteristics of bank lending over the business cycle is its procyclicality: in a recession banks reduce lending rapidly, especially to smaller enterprises and riskier borrowers. While some of this lending retrenchment is demand-driven, agency conflicts at the core of banking point to substantial supply-effects. Regulation can further exacerbate this procyclicality, requiring forward-looking loan classification (as under IFRS 9) and provisioning, as well as forcing an increase in risk weights and thus capital.   Anticipating negative effects from the disruption for real economy and financial sector and mitigating these negative effects is therefore critical and urgent. Steps taken by supervisors across Europe to (i) lower countercyclical buffers where currently above zero, (ii) reduce capital requirements, allowing banks  to operate temporarily below the level of capital defined by the Pillar 2 Guidance and the capital conservation buffer (CCB), and (iii) allowing banks to operate below 100% of the liquidity coverage ratio (LCR) are adequate and can help reduce risks of lending retrenchment. Capital forbearance seems the correct way to go; hiding losses less so.

 

In addition, it seems advisable to stop the clock on the timeline for implementing further capital increases under Basel III reforms as well as delay the EBA 2020 stress tests (as it has already decided to do). Building capital buffers is important, but timing is critical.

 

While all these measures can help mitigate credit retrenchment and thus avoid a deeper recession, losses for banks and reduced equity buffers will still be a concern for markets. While these losses might not show until later this year, financial markets will price them in as soon as more information become available, which will require further forward-looking actions, discussed below.

 

 

Instilling confidence

 

Government is the ultimate backstop for absorbing losses in crisis situations like this one. One of the critical tasks for policymakers is to provide a maximum degree of certainty and instil confidence. As much as this applies to the public policy response to the health crisis caused by the virus, it also applies to the financial sector.  Communication is critical in these circumstances. We saw both good and bad examples last week, with Christine Lagarde’s remarks during her 12 March press conference that the ECB was not in the business of reducing spreads causing immediate negative financial market reactions as well as positive reaction to the correction of these remarks by her subsequent interview and the blog by ECB’s chief economist Philipp Lane the following day.  Standing ready as lender and market-maker of last resort and providing clear signals that central banks will stand ready to avoid any price overshooting and market freezes is critical in such situations.

 

Planning ahead

 

Assuming projections on how the virus will play out turn out to be accurate, the attention will turn to economic recovery later this spring and early summer. This will also be the moment, when there will be a clearer picture of the losses in the financial system and policy actions will be needed. The regulatory reforms of the past ten years, including bank resolution frameworks, will then be put to their first massive test.  

 

As many economists, I have pointed to missing elements in the banking union: a common deposit insurance scheme and a limited funding backstop for the SRF. While the former has still not been addressed, there is progress on the latter, but probably not in time for the current crisis.  Another misstep in my opinion was that a new regulatory framework was being implemented without the legacy of the crisis being addressed first. The Italian approach to bank failures in recent years can be easily explained with this legacy: bailinable debt that was politically not bailinable and legacy assets that had not been resolved yet resulting in taxpayer support where such support was – at least in principle – not to happen under the BRRD. A final item on the unfinished agenda has been to cut the link between banks and governments in the eurozone, which would require concentration limits for sovereign bonds and the creation of the safe assets. Obviously, these are not reforms that can be introduced in time for a possible crisis later this year, but one can hope that a crisis might be the trigger for finally completing the banking union.  

 

It is widely accepted that the bank resolution regimes established under the BRRD across the EU and on the euro-area level are not adequate for a systemic banking crisis.  If we see widespread bank undercapitalisation if not failures, a flexible and systematic approach is needed, and on the Eurozone rather than national level.  

 

We might easily come into such a situation later this year when authorities in the eurozone are faced with several mid-sized if not large banks showing significant undercapitalisation. At a time when the real economy will try to get back on its feet and will have to rely on bank lending for this, widespread recapitalisation efforts with taxpayer support might be the only option.  Applying an approach built for idiosyncratic bank failures – including bail-ins and liquidation -, on the other hand, might deepen the crisis further.

 

Some countries, most prominently Italy, might not have the fiscal policy space for such a recapitalisation of banks and might also face limits in direct support for the real sector. This is where a eurozone response is required. While the ESM has the option (so far not used) to directly recapitalise banks, the total amount is limited to 60 billion euros. An alternative option, more adequate for a systemic crisis situation and suggested by several economists, is to establish a eurozone-wide bank restructuring agency (e.g., Beck and Trebesch, 2013).  Such a temporary agency could be in charge of restructuring viable and non-viable banks throughout the eurozone, funded by the ESM and possibly leveraged with private sector funding. Such an ad-hoc approach would also signal that these are special circumstances and that the eurozone is not falling back into the bailout mode.

 

 

The moment for European solidarity

 

There has been less coordination across EU countries in public health responses than optimal.  Many countries have also taken decisive actions to address the economic disruptions caused by the virus-induced social shutdown, while there are tentative efforts at the EU level to follow suit. However, the fiscal firepower of such efforts on the EU level is simply not enough. A longer recession and increased fiscal policy demands might turn some member countries’ fiscal position unsustainable, further undermining their banking sector, and deepening the crisis further.

 

For the eurozone to survive such risks, a eurozone- or EU-level approach is needed. This is the moment of European solidarity, required on the highest political level, i.e., the European Council (EU heads of governments). As wrong as president Lagarde’s remarks were during her 12 March conference (“we are not in the business of reducing spreads”), as clear is it that it is fiscal policy that has to finally come to the table.  Monetary policy has carried for too long the burden. Yes, the ECB will again step forward when needed, but it is clear that this is politically not a long-term crisis resolution strategy.

 

It is time for a fiscal policy “whatever it takes” moment in the euro area. During the eurozone crisis, there was often talk of moral hazard risks coming with “bail-outs” of peripheral countries of the euro area. As wrong as these criticisms were then, there is no basis whatsoever for such concerns now, as this is an exogenous shock.  It is important to stress that it is not enough for the European Commission to loosen budget guidelines for national governments, as financial markets will still price in countries’ debt sustainability. Now is the time to put the money where the words are – a post-pandemic eurozone budget where fiscally stronger countries help fiscally weaker and more affected countries. Addressing a possible systemic banking crisis jointly can be part of such an effort.

 

And even though events are still unfolding, and the final tab has not been passed on, stating upfront and clearly that eurozone governments stand together and will fiscally do whatever it takes, can be incredibly useful!