Olli Rehn: Europe, EMU and the banks
Keynote speech by Mr Olli Rehn, Deputy Governor of the Bank of Finland, at the Italian Banking
Association, Rome, 14 May 2018.
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Accompanying slides of this speech.
Ladies and Gentlemen,
First, let me thank the Italian Banking Association for the invitation to join you today. It is a great
honour to speak here, at the roots of European finance, knowing the role played by Italian banks
in the development of modern banking since the Renaissance. Even more so, as I have always
admired Italy's strong and hopefully continued European engagement. During my European
duties I was a regular visitor to Rome for economic and political consultations, and I want to keep
up this practice of European bridge-building and constructive dialogue in my capacity as a central
banker in Finland.
I would like to first discuss Europe's current economic situation and then how to strengthen
Economic and Monetary Union further. I will draw in my analysis from the lessons learnt during
the financial and debt crisis and from my experiences in the eurozone financial fire brigade during
the crisis. My focus will - very intentionally - be on what the economists call first-best solutions,
i.e. finding optimal economic and policy solutions in the medium term, while I will refrain from
assessing second-best constraints, i.e. the positions of Member States or the constraints set by
domestic politics in the short term.
The discussion on EMU reform often becomes quite technical. While details do matter, I believe
it is useful to approach the question from a broader perspective before going into institutional or
financial technicalities.
Namely, the institutional transformation of the EU, or reform of the eurozone, is anything but only
a 'technical' matter. It is profoundly related to Europe's relevance and influence in the world. This
goes for both international security matters and for global economic governance. In the
contemporary world, where the United States is distancing herself from global governance,
where the United Kingdom is leaving the EU, where Russia is resorting to power politics, and
where China is getting stronger and stronger, it is ever more important for Europe to act united to
be stronger together and to defend multilateralism in international relations.
While we know that policy priorities in Member States differ, and common security and defence
policy, as well as refugee, immigration and border-control issues, are understandably high on the
EU agenda today, nevertheless eurozone reform is essential, indeed critical, for the broader
endeavour to strengthen liberal democracy and international institutions, which is at the heart of
Europe's peace project and part of her DNA. In other words, our efforts to reinforce EMU are part
of a broader endeavour to strengthen Europe, so that it will be better in serving its citizens, by
enabling their entrepreneurship, innovation, prosperity and security.
But to succeed, we must put our own house in order first. The crisis revealed serious
weaknesses in the institutional structure of EMU. It revealed especially how financial stability
concerns - in particular the stability of the banking system and of the government bond markets
- had been neglected when EMU was created. Financial stability was the 'neglected stepchild' of
Maastricht, it has been said.
The crisis finally galvanized the Union to action. There was an important, even vital, wave of
institutional reforms which came about during the peak of the euro crisis. We should now seize
the opportunity provided by the current favourable economic situation and complete the most
significant remaining reforms, in order to make EMU more resilient before the next recession
arrives. Good times should indeed be used to reform.
So where do we stand today? The eurozone economy has now been growing for over five years.
Growth is broadly based across sectors and countries. The ECB's latest forecast from March
foresees growth to be 2.4% this year and 1.9% in 2019.
Figure 1. Euro area grown for 5 consecutive years (ppt slide)
The recent positive trend can be seen in this graph, showing GDP in the euro area, Italy and
Germany. Euro area GDP reached its pre-crisis level in 2015. However, this includes somewhat
different country-specific paths. German output reached its pre-crisis level already in 2010. While
Italian output is still below its pre-crisis level, it has now returned to a growth path.
Figure 2. Euro area unemployment rates (ppt slide)
Positive developments in output and growth have also suggested encouraging trends in the
labour markets. Euro area aggregate unemployment dropped to 8.5% in March 2018. The
unemployment rate is trending down in almost all Member States. The German unemployment
rate has dropped to a record low 3.5%, whereas unemployment remains persistently high in the
countries that suffered most from the financial crisis; here in Italy it is 11.0%.
Overall, there was a strong expansion in the euro area economy in 2017. However, short-term
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indicators suggest that the pace of growth has cooled somewhat in early 2018. Some of this
could be explained by temporary factors - such as the cold winter in Europe - but recent data
points to some moderation in the pace of economic growth from the high rates observed at the
end of 2017. Nevertheless, the overall economic outlook for the euro area is strong, supported by
favourable financial conditions, a strong labour market and steady income growth.
Yet, forecasts are always uncertain, and this one is no exception. Currently, risks to the
mediumterm economic outlook seem to be tilted on the downside. Externally, downside risks stem from
a possible increase in protectionism, geopolitical tensions, repricing of risks in the financial
markets and increased indebtedness in some emerging economies. Internal risks relate to
uncertainties surrounding the implementation of reforms in the euro area, and to the public
finances and banking sectors in some member states.
Monetary policy remains accommodative
Despite the recent recovery, euro area inflation has remained below its historical average for a
prolonged period of time. This has been puzzling and has inspired economists to find several
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different explanations for the persistently low inflation.
Without going into a detailed list of these explanations, it seems that the financial and debt crisis
that the euro area faced was exceptionally deep and persistent, which has had an impact on
inflation expectations. However, the latest estimates of excess capacities point to a closing
output gap. This, together with the ECB's accommodative monetary policy, is expected to lead to
a gradual pick-up in inflation rates. The ECB's recent forecast expects euro area annual inflation
to reach 1.7% on average in 2020.
The ECB Governing Council reiterated on 26 April that an ample degree of monetary stimulus
remains necessary for underlying inflation pressures to continue to build up and support headline
inflation developments over the medium term. The Governing Council stressed the importance of
patience, persistence and prudence in its monetary policy-making.
But monetary policy alone cannot provide sustained and balanced growth in Europe. Therefore, it
is important that economic reforms and strengthening the eurozone are kept on the Member
States' policy agenda. Next, I will address some of the key issues of reform.
Completing the Banking Union
Completing the Banking Union is crucial for the stability of the European banking system, and
hence a necessary priority of eurozone reform.
Significant progress has been made on the Banking Union since 2012. The Single Supervisory
Mechanism and the Single Resolution Mechanism have been established. At the same time, the
financial stability of the euro area has improved. The capital positions of euro area banks have
strengthened, as can be seen from Figure 3.
Figure 3: Euro area banks' capital positions are strengthening (ppt slide)
However, the work to strengthen the euro area financial system and to increase stability must
continue. It is important to strive further to reduce the probability of shocks that could
jeopardizestability of the euro area banking system.
In this respect, priority should be given to strengthening the resolution and deposit guarantee
schemes.
Let me say first some words on the setting up of a fiscal backstop to the Single Resolution
the privately financed capitalization tool of the Single Resolution Mechanism (SRM).
Fund,
Such a fiscal backstop is important in order to give solid credibility to the commitment of the SRM
to resolve, wind up or reorganize failing banks, quickly and effectively. As ECB President Mario
Draghi said in Firenze on Friday, public risk-sharing through backstops helps reduce risks
across the system by containing market panics when crisis hits. The backstop would be a
reserve instrument, activated only if the Single Resolution Fund becomes temporarily short of the
resources required for its tasks, even after the owners and eligible creditors of failing banks have
borne the losses allocated to them.
Financially, the backstop could operate as a credit line in the reformed European Stability
Mechanism. It should be fiscally neutral, so that, over time, the Single Resolution Fund and
ultimately the banking industry itself would replenish any funds drawn from it.
Let me turn to the issue of deposit guarantee scheme, the ultimate objective of which is to
prevent bank runs. A bank run is usually caused by lack of confidence in a single bank or in a
banking system. The stronger and more credible the deposit guarantee scheme is, the less likely
it is that it will have to be used.
The sustainability of the suggested new European deposit guarantee scheme has been
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assessed in a recent study published by the ECB. It states that even in the event of a major
banking crisis, deposits could be secured by a common deposit guarantee fund. The fund would
be financed by the banking sector. An interesting result of the study is that very little
crosssubsidization would take place between countries when the funds are collected from banks on
the 'polluter pays' principle, i.e. according to their risks.
A common European deposit insurance scheme would significantly increase the stability of the
euro area banking system compared with the current situation in which national funds are
responsible for the deposit guarantee. The goal should be that confidence in the secured bank
deposits is equally strong throughout the euro area.
Reducing risks in the euro area banking system
The implementation of a common European deposit insurance scheme can be enhanced by
reducing risks in the euro area banking system. Overall in the euro area, significant progress
has already been made, as the level of non-performing legacy assets has decreased. This
development is clearly visible in Figure 4.
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Figure 4: NPLs are decreasing in the euro area (ppt slide)
As we know, the position of countries varies a lot concerning the share of non-performing loans
(NPLs) of the total stock of loans across the euro area, as does the speed of reduction in their
amount (see Figure 5). Spain did utilize well and effectively its ESM-funded financial-sector repair
programme, which started in summer 2012, and has moved further towards solving the problem
by reducing the share of NPLs to around 5% by the end of last year, i.e. close to the euro area
average. Italy took action later and has managed to reduce the amount of NPLs in its banks by
about 30% in two years, and the share of NPLs in Italy in 2016-17 came down from 16% to
around 11%. Hence, while progress has been made, there is still plenty of work to be done to
maintain the positive trend in NPL reduction.
Figure 5: The reduction of non-performing loans by country (ppt slide)
In any case, to mitigate risks in the banking system, it is important to reduce the amount of NPLs
further. The position of the Bank of Finland is that the resolving of legacy problems should be
separated from the management of future non-performing loans. The SSM has already published
a proposal on provisioning methodologies for new NPLs that will increase banks' loan loss
provisions and resilience.
To ensure the most effective reduction of NPLs, legacy problems should be handled with a
combination of bail-in and recapitalization by national funds, in line with the state aid guidelines
(2013) set out by the Commission. Transitional provisions should provide an opportunity for this
by facilitating the write-down of non-performing exposures to a level that enables market-based
solutions, e.g. the selling of NPLs to investors. In due course the transitional provisions should of
course be abolished.
Market-based solutions are obviously the primary alternatives for resolving non-performing loans.
However, a single solution alone is hardly the answer. History has taught us that the most viable
solutions are usually a combination of several alternatives.
Going forward, and thinking particularly about the stability and resilience of the European banking
system, it is also important that banks' exposures to their home countries' sovereign bonds be
reduced. One solution is that banks could be required to have more capital if they want to hold
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high amounts of a single country's sovereign bonds. This concentration charge would give
banks an incentive to diversify their sovereign bond holdings. It would also support market-based
risk-sharing in the euro area.
Why would this be important for the future of the eurozone? Simply because breaking the
undesirable links between national banking sectors and their sovereigns is one of the
fundamental reasons for creating Banking Union. Let's keep this overall objective firmly in sight
and mind when pursuing reform.
ESM reinforced
Secondly, Europe's financial firewall, the European Stability Mechanism, should be further
developed by reinforcing its capacity to take decisions and extending its toolbox with a more
workable and effective precautionary credit instrument.
In the event that the euro area faces excessive market turbulence, the ESM should be able to
take rapid, effective decisions to help stabilize the situation. Decisions on conditional loans or
credit lines could in an emergency situation be taken by a reinforced majority of e.g. 85%; recall
that the IMF board, while striving for consensus, can take decisions by a simple majority.
Decisions on the capital base would continue to be taken by unanimity, underlining the
Parliament's budgetary powers.
For a precautionary credit instrument, a pertinent benchmark is provided by the IMF's Flexible
Credit Line (FCL), which was successfully used during the crisis by three countries: Colombia,
Mexico and Poland, as a crisis-prevention instrument against market turbulence. None of the
three countries had to draw on these lines, as the FCL provided an effective backstop for these
countries and strengthened market confidence during the time of elevated risks.
So, in my view the primary reform of the ESM now needed is to enhance its concrete
functionality and capacity to act in cases of market turbulence. But I duly recognize there are
other proposals on the table as well. One is to change the name of the ESM to European
Monetary Fund, EMF. Would this be justified? To my mind the nameplate is less important than
the substantive improvements in the functioning of the ESM. Besides, the ESM has become a
positive, solid brand, based on the high integrity and professional quality of the institution and its
staff, under the competent leadership of its Managing Director, Klaus Regling.
Another reform proposal relates to the institutional dimension. To increase accountability, the
European Commission has proposed to transfer the ESM into the EU Treaty and put it under
parliamentary control of the European Parliament, in a rather similar way as the ECB is - mostly
focusing on the full right of demanding and receiving information. On the other hand, the
Commission proposal would maintain the key policy decisions and executive functions in the
hands of the Board of Governors. This includes the decisions to approve of conditional financial
programmes and the appointment of the Managing Director. Hence the Commission proposal is
actually less of a great federalist leap forward than some fear and others wish.
In principle, there are two alternative ways of making progress in European cooperation, either by
the well-tested Community Method or by the intergovernmental method, which some years ago
was described as the Union Method. For the EU to continue making legitimate progress in
integration, in my view it is necessary to take good care of the Community method, since it is
able both to provide the effective capacity to act and the legitimacy to take decisions. It is based
on the Commission's right of initiative, its independence and professionalism, the qualified
majority rule in the Council and co-determination by the European Parliament. It enables the
Union to take decisions and keeps all Member States - including the small states - on board.
Revisions of fiscal rules: the expenditure rule
Let me turn to my third and final subject: the revision of fiscal rules, in particular by introducing
the expenditure rule into the EU fiscal rules.
In the future, the economic and Monetary Union can work smoothly only if the public finances of
all member countries are credibly on a sustainable footing. A combination of fiscal policy rules
and market discipline related to government borrowing is necessary to ensure this. Fiscal rules
should be sufficiently simple to ensure that, in normal circumstances, we can be certain in
advance that they will be adhered to when budgets are prepared.
The expenditure rule can usefully be defined as a medium-term ceiling for the real growth of
general government expenditure, set in relation to the estimated future economic growth and
taking into account the stock of public debt. In my view, such a rule, focusing on mid-term debt
sustainability and solidified by concrete multi-annual ceilings on budget lines, would probably
serve better as an operational fiscal policy guide than the current rule that is based on the
structural fiscal balances.
Our present system of fiscal rules and fiscal policy coordination is a result of the reforms agreed
in 2011, the so-called six-pack. This strengthened the euro level governance of fiscal policy in a
significant way. In the past five years, the overall budget deficits of euro area countries have
diminished substantially. Last year, the aggregate General Government Deficit was less
than 1% of euro area GDP. Indebtedness (defined as the ratio of government debt to GDP) has
started to decline. Of course, the situation varies across countries, especially regarding the level
of accumulated debt.
Figure 6: Fiscal deficit in the euro area 2000-2018 (ppt slide)
Despite the positive developments of recent years, I think the present system of fiscal rules and
policy coordination in the euro area is far from perfect. My concerns are that 1) the rules have
become very complicated; 2) the system has not been as effective as hoped, especially in the
past; and 3) it is more procyclical than necessary.
These problems with the current system of rules are interrelated:
The complexity of the rules results largely from efforts to make them less procyclical, by applying
such concepts as structural deficits instead of drawing the rules in terms of the actual, nominal
deficits. The measurement of structural deficits is notoriously difficult, however, which adds an
element of discretion in the application of such rules - not making the results politically easier to
accept. At the same time, the inevitable procyclicality of the deficit rules makes them hard to
implement (especially in recessions) and therefore less credible in the first place.
Reliance on rules would be less of a problem if 'market discipline' could be trusted to keep the
finances of the Member States on the narrow path of sustainability. By market discipline we
mean the constraints that market perceptions of a country's creditworthiness puts on its
borrowing.
Market discipline is a necessary part of an economic system where all actors are ultimately
responsible for their decisions - even when the decisions go wrong. However, this does not
mean that market discipline as such would operate in a smooth, always effective manner from
the societal or economic point of view. As evidence, we can recall that market discipline did not
work well in the years leading up to the crisis (when the markets were disregarding the
accumulation of risks), nor did it work well when the crisis was at its most intense (when the
markets reacted in a disruptive way).
This experience is fully in accordance with the Delors report of 1989. This report, which served
as a blueprint for Monetary Union, noted that market forces can exert a disciplinary influence on
the fiscal policies of the member states, but added:
'...market perceptions do not necessarily provide strong and compelling signals and (that)
access to a large capital market may for some time even facilitate the financing of economic
imbalances. Rather than leading to a gradual adaptation of borrowing costs, market views about
the creditworthiness of official borrowers tend to change abruptly and result in the closure of
access to market financing. The constraints imposed by market forces might either be too slow
and weak or too sudden and disruptive.'
Because of the often on/off nature of market behaviour, the euro area needs effective and
credible ex ante rules for fiscal policy that will prevent countries from hitting the financing
constraints on the markets.
Expenditure rules provide governments a less procyclical way to commit to sustainable public
finances than deficit rules do; by being less procyclical, they are also easier to stick to, and
therefore more credible. A number of countries, such as the Netherlands, Sweden and Finland,
have used expenditure rules as the major building block of their medium term fiscal frameworks
for a long time over the past decades, with relative success. The expenditure rule thus supports
responsible fiscal policy, and increase national ownership of sustainable public finances. It could
well be applied across the EU.
The need for further economic reforms
It is not only our common currency area which is in need of reform. The biggest bulk of beneficial
economic reforms are in the responsibility of national policy-makers. These reforms would be
beneficial for the welfare of euro area citizens by promoting long-term income and employment
growth, resilience of the economies to adverse shocks, and social fairness and inclusiveness.
By facilitating adjustments to regional shocks they would ensure the smooth functioning of the
euro area and the efficient transmission of monetary policy. Therefore, better economic
structures have importance also from the perspective of monetary policy.
What is then meant by 'better economic structures'? This phrase covers a wide range of policy
agendas, but these are commonly understood as flexible product and labour markets. In addition,
well-functioning and trustworthy public institutions lead to better economic outcomes.
Figure 7. Ease of doing business and GDP per capita (ppt slide)
Due to their many faces, measuring the quality of economic structures is not straightforward.
One common measure is the World Bank's 'Doing Business' indicator, which compares the
ease of doing business across countries. From the graph we see correlation between the
indicator and GDP per capita. There is also some evidence that those euro area countries that
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had better functioning institutions recovered faster from the latest financial crisis. The indicator
also reveals large differences in the ease of doing business across euro area Member States.
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Whereas the best performers are close to the global top performers, the weakest Member
States are hardly in the global top 50. Anyway, every euro area Member State should be active in
enhancing their economies.
An example of successful reforms are the pension reforms that many EU Member States
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implemented over the last decades. These reforms have enhanced fiscal sustainability, helped
to maintain adequate pension income and also contributed to increased labour participation
rates.
During the recent crisis many countries reformed their economies, and these reforms have
contributed to the current upswing, but will also bear fruit in future. For example, Italian labour
market reforms have brought your labour market institutions more closely in line with international
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benchmarks, and there are already some tentative signs of its positive impacts.
Which reforms should each country then take, for their own sake? The most rewarding reforms
depend on each countries' current structure and need to be tailor-made for local circumstances.
However, the OECD has found that implementing reforms in different areas seem to provide
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significant synergies. For example, labour market reforms will facilitate the necessary
reallocation of workers arising from product market reforms.
The European Commission's annual Country-Specific Recommendations provide a thorough
and tailored guideline for the serious reform agenda. It has, indeed, been disappointing to see
that the momentum for implementing these policy recommendations has weakened in the euro
area. The Commission has concluded that the overwhelming majority - more than 90% - of last
year's reform recommendations have been followed by only 'some' or 'limited' progress in
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implementation, while just one (of almost 80) of them has been substantially implemented.
Why is this worrying? Because the good times of solid growth and expansionary monetary policy
are not going to last forever. Monetary policy cannot be "the only game in town". The better times
should be used for reforms that may be difficult in the short term but carry benefits in the
medium-to-long term. And today's reduced funding costs for sovereigns should be used to
enhance debt sustainability, especially in countries where solid debt sustainability is not
selfevident due to the high level of public debt. This would help creating the badly needed fiscal
space in the next recession, both for individual member states and for the eurozone in
aggregate.
Conclusions
In conclusion, there is a strong case to move on with the ever-changing evolutionary Union. The
dichotomy of 'federation or death' has been put forward too often, and frequently for propaganda
reasons. But let me reveal you a secret: it is fake news.
Namely, the euro area will not survive by simply becoming a federation or transfer union - but
neither will it break up just because of not becoming one. Life is seldom black-and-white.
Instead, there is an evolutionary third way - what we need is both a sense of direction and a
sense of realism. The essential guiding principle in reforming euro area economic governance
should be that steps towards increased solidarity through co-insurance and risk sharing are
combined with increased responsibility and economic sustainability. Solidarity can only be built
on solidity, for the sake of both economic sustainability and political legitimacy.
While the institutional reform of Economic and Monetary Union is important, Europe needs to
work towards sustainable growth and job creation on all fronts. Putting the real economy and
reforms truly centre-stage means that we should continue to work for a Europe that opens up our
citizens' opportunities to innovate and build new businesses, and thus create jobs, for a Europe
that seeks to promote sustainable growth through free-trade agreements, despite headwinds; for
a Europe where citizens and businesses can benefit from a genuine single market; and for a
Europe that guarantees civil rights and social justice in the digital age.
These are the concrete, functional goals for sustainable growth and job creation that really matter
to our citizens in Europe, which should always be our yardstick. They should be supported by
rock-solid financial stability by completing the Banking Union. This is a policy agenda that can
help making Europe relevant and moving on.
Thank you very much for your attention!
1
The preliminary flash estimate on the GDP growth rate for the first quarter of 2018 was 0.4%, while in the last
quarter of 2017 the growth rate was 0.7% from the previous quarter.
2
For a thorough review of the discussion see Constâncio, V. (2017) 'Understanding and overcoming low
inflation', Remarks at the Conference on 'Understanding inflation: lessons from the past, lessons for the
future?', Frankfurt am Main, 21 and 22 September 2017; and Yellen, J. (2017) 'Inflation, Uncertainty, and
Monetary Policy', Remarks at the 'Prospects for Growth: Reassessing the Fundamentals' 59th Annual Meeting
of the National Association for Business Economics, 26 September 2017; see also Kortela, Oinonen & Vilmi
(2018) 'Reports of the Phillips curve's death are greatly exaggerated', Bank of Finland Bulletin 1/2018.
3
Completing the Banking Union with a European Deposit Insurance Scheme: who is afraid of
crosssubsidisation? ECB Occasional Paper Series No 208 / April 2018
www.ecb.europa.eu/pub/pdf/scpops/ecb.op208.en.pdf?557c7f15bddfac62f842fd08920b1e6e.
4
The NPL ratio in Italy was 11.1% in Q4 2017.
5
This option is suggested by a group of French-German economists: Reconciling risk sharing with market
discipline: A constructive approach to euro area reform, January 2018
cepr.org/sites/default/files/policy_insights/PolicyInsight91.pdf
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Draghi (2017), 'Structural reforms in the euro area', Introductory remarks at the ECB conference 'Structural
reforms in the euro area', Frankfurt am Main, 18 October 2017; and Bank of Finland (2018), 'Euro countries
recovered from crisis at different paces', Bank of Finland Bulletin 1/2018.
The top 3 performers are New Zealand, Singapore and Denmark.
8
For further information, see Carone, G. et al. (2016). Pension Reforms in the EU since the Early 2000's:
Achievements and Challenges Ahead. European Commission Discussion Paper 042, December 2016.
9
For a detailed analysis see Pinelli, D. (2017). The Recent Reform of the Labour Market in Italy: A Review.
European Commission, Discussion Paper 072, December 2017.
10
OECD (2016), Economic Policy Reforms 2016: Going for Growth Interim Report, OECD Publishing, Paris.
11
For a detailed analysis see ECB (2018). 'The European Commission's 2018 assessment of macroeconomic
imbalances and progress on reforms'. ECB Economic Bulletin, Issue 2/2018, March 2018, Box 8.