Josef Bonnici: The changing nature of economic and financial
governance following the euro area crisis
Introductory remarks by Professor Josef Bonnici, Governor of the Central Bank of Malta, at
the Malta Financial Services Authority, Attard, 17 January 2013.
* * *
The success of the European monetary union was always contingent on three
considerations. The first requirement is the maintenance of fiscal discipline; the second is
effective financial regulation and the third condition is the management and minimization of
macroeconomic imbalances. In reality, these requirements were often not met. In fact, there
was a general lack of awareness of their importance.
For the past several years, the headlines have been dominated by the ramifications of the
European crisis, which was first manifested in the banking system and then in sovereign debt
markets, and subsequently in the economic slowdown and related problems that followed the
introduction of fiscal consolidation.
The European Central Bank has engaged in a wide range of policy measures that seek to
expand liquidity and restore normal conditions in the banking sector and in the financial
markets. These monetary policy measures include conventional or standard measures,
which have reduced policy rates to very low levels.
In addition the ECB has adopted various non-standard measures, which have included long
term refinancing operations that inject ample liquidity into the financial system. The ECB has
gone a step further by announcing an Outright Monetary Transactions (OMT) programme.
This is designed to repair the link between policy rate cuts and ample liquidity provision, on
the one hand, and lower borrowing costs, on the other. It is also meant to counter the
socalled redenomination or convertibility premium that compensates investors for the perceived
risk of a breakup of the monetary union. OMT are actually equivalent to traditional open
market operations that central banks have long resorted to in order to provide stability and a
better functioning of the monetary transmission process that can get impaired in certain
circumstances.
The unfolding of the crisis has revealed various intertwined dimensions of the existing
fragilities and a broad range of imbalances. In various ways, the problems that are evident in
the euro area are of a structural nature, resulting in a number of governance reforms that are
currently underway. Inappropriate banking practices, weak regulatory frameworks, fiscal
slippage and deterioration in competitiveness are now recognised as the main sources of the
crisis.
A fundamental aspect of the banking crisis is the failure of regulation, which allowed financial
institutions to engage in excessive risk that was not matched by adequate capital protection.
Systemic risk was exacerbated via strong linkages between financial institutions.
Economic fragilities were worsened by the burden imposed on government budgets by bank
bail-outs, the lack of market funding available to sovereigns, and the negative impact of
sovereign debt downgrades on bank balance sheets. Lack of trust spread across the euro
area, with this contagion creating a mutually reinforcing loop between weak sovereigns and
bank credit conditions. Although policies have now been in crisis management mode for five
years, the interbank market has yet to return to its normal state, reflecting the extent of the
lingering damage within the financial sector.
To a considerable extent, the common currency masked vulnerabilities related to the build-up
of various imbalances, since such imbalances could no longer be addressed by exchange
rate corrections.
These factors have raised questions on the viability of the European single currency model
as this has perhaps failed to achieve the targets it was primarily set-up for. The extent of
these fragilities is reflected in Chart 1, which shows a convergence in sovereign yields in the
run-up to the formation of the monetary union, followed by a decade-long stability.
In retrospect the low yields were clearly not consistent with the underlying fiscal positions or
economic fundamentals at the national level. Indeed, low interest rates enabled governments
to pile on additional debt at relatively cheap interest costs. This period coincided with
deterioration in competitiveness and wider current account deficits as peripheral countries
continued to finance such deficits via capital inflows. Eventually, when markets switched their
focus to economic sustainability, the flow of capital reversed direction, sovereign debt was
downgraded and yield spreads widened dramatically, as seen in Chart 1.
Chart 2 provides a contrast between two groups of countries. It focuses on the current
accounts of euro area countries (as per cent of GDP) and shows the difference between
various countries running generally current account surpluses, and selected countries in the
periphery with a negative balance. These deficits are financed by a corresponding capital
flow in the opposite direction.
For each year, the upper band depicts the range of current account surpluses for a group of
countries that include Germany, Luxembourg and the Netherlands. Similarly, the lower range
depicts the corresponding range of deficits for Cyprus, Greece, Italy, Portugal and Spain.
The divide between the groups is notable and it is not surprising that those countries in the
lower part of the chart featured prominently in the unfolding crisis. Eventually, when markets
reoriented their focus towards economic unsustainability, the flow of capital reversed
direction; market discipline now took the form of capital flight.
Governance problems are perhaps better understood by looking more closely at the origins
of the Greek situation. On the fiscal side, Greece was not adhering with the Maastricht
criteria while its competitiveness was being eroded. This situation was aggravated since
government spending was underreported.
Writing in 2011, Ioannis Sarmas, my former colleague at the European Court of Auditors,
presented three dimensions of the Greek governance problem: "[first] the lack of an internal
control system allowing the government to pilot the country out of turbulence zone;
[secondly] the absence of a culture of accountability requiring public fund managers to
demonstrate the results achieved and finally ... the inadequate powers for the auditing
mechanisms preventing them from focusing on the waste of public money."1
Governance reforms
I will now move on to major reforms at the European level that are addressed to correct
weaknesses in governance.
On the fiscal side, governance has been enhanced by the strengthening of the Stability and
Growth Pact. There appears to be broad consensus that to avert the recurrence of the crisis,
fiscal consolidation should be enshrined in the governance structure of every country.
Surveillance is enhanced and the monitoring of economic policies is becoming more
comprehensive. To this end, the Fiscal Compact obliges all euro area countries to run a
structurally balanced budget. In particular, the problem of sustainable budget planning is
addressed by introducing a country-specific medium-term budgetary objective, which
involves a cap on growth of public expenditure that is in line with the medium-term rate of
growth. The Fiscal Compact also accelerates the application of the excessive deficit
procedure by introducing sanctions when the debt and deficit to GDP ratios are excessive.
Fiscal surveillance has been extended to a broader excessive imbalances procedure, which
goes beyond fiscal imbalances and seeks to identify and correct a range of macro
imbalances and shortcomings in competitiveness. In fact, various euro area member states
ran into problems despite of their adherence to the SGP criteria, to the extent that they
nonetheless manifested other types of imbalances, such as excessive private indebtedness.
Preventive recommendations are provided to member countries at an early stage in the
formation of imbalances.
The severity of the financial crisis has also exposed the inadequacy of the current
financialsector regulation and supervision. As already indicated, macro-prudential risks were
overlooked and the link between sovereigns and banks was underestimated. In reaction to
this, European institutions and member states have engaged in a major overhaul of bank
regulation and supervision with the objective of creating safer, sounder and more transparent
financial institutions.
One of the major initiatives to strengthen the governance framework was the establishment
of the European Systemic Risk Board (ESRB). In its first year of operation, the ESRB tackled
key issues relating to the interaction between three factors: the creditworthiness of European
sovereigns, the increasing difficulty of banks in raising funds, and weakening economic
growth. Furthermore, the ESRB adopted three public recommendations on:
i) the macro-prudential mandate of national authorities;
ii) lending in foreign currencies;
iii) US dollar-denominated funding of credit institutions.
It is important to note that the voting members of the General Board of the ESRB include the
Governors of National Central Banks. Indeed, ESRB activities are based on strong
cooperation between its members. A key part of the ESRB's work is to combine the analysis
produced by the micro-supervisors and central banks. Clearly, the central bank's role of
ensuring financial stability has extended to the international level, implying further
responsibility in decision-making.
In Malta, the cooperation between micro- and macro-supervision is embodied in the setting
up of the Joint Financial Stability Board. The Central Bank of Malta, in its capacity as the
macro-prudential authority, has agreed with the MFSA to set up a Joint Financial Stability
Board which will be formally constituted in a few weeks. The objective is to enhance the
cooperation between the two bodies for the assurance of the stability of the financial system.
The intention is to strengthen the resilience of the financial system and to mitigate the
buildup of systemic risks. To these ends, the Board's mandate includes the development of
mechanisms that would identify risks to financial stability, and the establishment of the
necessary macro-prudential policy tools. The Joint Financial Stability Board will also be able
to make recommendations to the CBM or MFSA boards on macro or micro prudential issues,
as the case may be. The board is also responsible for the follow-up of recommendations
made by the ESRB.
A further euro area governance reform relates to the Single Supervisory Mechanism (SSM)
which involves the establishment of effective and early intervention mechanisms. The SSM
endows the ECB with the ultimate responsibility for specific supervisory tasks related to the
financial stability of Euro area banks. The rationale for a single supervisory mechanism
comes from the increasing interconnectedness between financial institutions and markets
across the euro area.
In addition, the proposed banking union does not only provide for the shifting of supervision
of banks to the European level, as in SSM, but also brings up for consideration the
introduction of an integrated system of bank crisis management and deposit protection.
Various recent reports, such as those authored by Liikanen, Volcker and Vickers,
recommend a structural reform of the banking sector. The proposed reforms are designed to
limit the likelihood of banking crisis, improve the resolvability of banks and safeguard
taxpayer interests. Furthermore, the Liikanen Group concludes "that it is necessary to require
legal separation of certain particularly risky financial activities from deposit-taking banks
within a banking group."
Conclusion
Regardless of the particulars of the eventual governance changes, it is clear that the
economic and financial crisis has been the spark for reforms that may reshape economic
institutions and financial supervision at both the national and international levels. These
highlevel governance reform changes will also filter down to the corporate level, especially at the
level of financial institutions, affecting also borrowers and lenders across the economy.