Vítor Constâncio: The role of Europe in global rebalancing
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the Expert
Seminar "Asia's role in the global economy forum", organised by the Official Monetary and
Financial Institutions Forum (OMFIF), Singapore, 12 July 2013.
* * *
Ladies and gentlemen,
I want to thank OMFIF, particularly David Marsh, as well as all the organisers of this
Conference for inviting me to address you today.
In discussions on global economic imbalances, the euro area often played a secondary role.
Academic debates about global imbalances prior to the crisis typically involved the United
States and Asia, with the euro area largely excluded as its aggregate current account was
broadly in balance.
And looking ahead, on the face of it, the same story is largely true.
The policy debate is focused on how the global situation will develop in the presence of two
counter-veiling forces: the United States likely moving away from its traditional role as the
global "spender of last resort"; and external surplus economies, notably in Asia, still largely
relying on an export-based growth model. The euro area, running a non-significant current
account surplus, is seen as a largely neutral force.
But this does not mean that what happens in the euro area is irrelevant for other regions.
Naturally, the euro area banking and sovereign debt crises have been a cause of concern for
the world economy from the perspective of growth prospects and as a possible source of
financial turbulence. And the international cooperation that is so vital for the health of the
world economy implies that the three regions should achieve their internal balance with
growth and low unemployment, maintaining at the same time a long term situation close to
external balance. In the present globalized economy this cannot be achieved without
cooperation on their macroeconomic policies. Any set of policies implemented by the US,
Europe and Asia that does not consistently corrects global macroeconomic imbalances is not
sustainable and could lead to new crises.
What I would like to do in my remarks today is to emphasise two specific channels where
developments in the euro area could have an important impact on the global economy.
Channel one: rebalancing towards sustainable growth
The first channel is related to the structural adjustment taking place within euro area
economies which could, in time, correct the imbalances internal to the euro area thus
overcoming a major European vulnerability allowing Europe to make a contribution to global
demand and hence global rebalancing.
Euro area countries are currently taking a series of policy measures both to raise their growth
potential and to make growth more sustainable.
They are achieving greater sustainability by moving towards an economic model based less
on external borrowing and more on internal competitiveness. Indeed, according to
harmonised competitiveness indicators based on unit labour costs have all registered
significant improvements since 1999, Ireland (-19% since 1999), Spain (-9.5%), Greece
(-9%), and Portugal (-6.6%). The loss of competitiveness accumulated until 2007 has been
totally offset since the beginning of the crisis. As a consequence, the EU Commission
forecast for this year is that all stressed countries will show a surplus on current account with
the exception of Greece with a deficit of just 1.1 % of GDP.
And euro area countries are increasing their growth-potential by implementing wide-ranging
structural reforms. These include product and labour market measures, but also deeper
reforms to tax systems, public administration and the judicial system.
Our monetary policy has been helping this process by improving our transmission
mechanism and stabilizing markets. The decision taken last year on the programme of
Outright Monetary Transactions (OMT) has been decisive in this respect. Our recent decision
to provide forward guidance regarding our main policy rate was also successful in stabilizing
financial markets unduly affected be spillovers from the recent FED announcement of future
tapering of Quantitative Easing (QE). Europe is behind the US in economic recovery and
inflation risks which implies that monetary policy has to stay accommodative for a longer
period of time.
Our forward guidance is in line with our policy framework as it does not refer to any date or
period of time but is instead totally conditional on developments in inflation prospects, in the
economy and in money and credit aggregates - the pillars of out monetary strategy.
At the same time, policy measures are underway at the European level that could help
expedite this rebalancing process. These include initiatives by the European Investment
Bank to boost lending to SMEs, and the possible introduction of contractual programmes with
financial incentives to underpin structural reform implementation in stressed countries. A
proposal by the European Commission on the latter is expected before the end of the year.
Channel two: a stable financial system through Banking Union
The second channel through which euro area developments can have a global impact is the
process of building a genuine Banking Union in order to ensure a robust banking sector.
As research by for example Borio and Distayat1 and Hyun Song Shin2 has shown,
developments in Europe were very relevant to global capital flow constellations. Looking at
gross rather than net capital flows, financial intermediaries in Europe were by far the most
important source of capital flows into the US, not emerging markets as the "global savings
glut" theory suggests.
Even today, the total stock of euro area bonds and equities currently held by US investors is
worth around 1 trillion euro, while euro area investors hold US bonds and equities worth
more than 2 trillion dollars.
All this means that the situation of the financial sector in Europe has major spillovers for the
global economy. And therefore the process of stabilising and strengthening the European
banking sector, which Banking Union represents, has very important international
implications.
Let me now speak about this in more detail.
The situation of the euro area banking sector
It has become fashionable for commentators to paint a picture of the euro area banking
sector as a source of persistent financial instability. The common theme is that euro area
banks are undercapitalised with potential losses still to be recognized. I do not deny that
there still problems to be addressed as I will explain later in my remarks but looking at the
more recent data, the situation of European banks is better than present market perceptions
and better than what many observers acknowledge.
First, there have been steady improvements in solvency positions of many euro area banks.
For large and complex banking groups in the euro area, covering about two thirds of total
assets, the median core Tier 1 capital ratio reached 11.1% in the first quarter of this year -
up from 9.6% at the end of 2011 and 8.3% at end-2009.
Second, euro area large banks have become less leveraged, from a level of 3,3 % of tier 1
equity to 5% now. This was achieved mainly through capital increases.
This point is well illustrated in a recent speech by Thomas Hoenig3, FDIC Vice Chairman.
Indeed, he reports that the bigger US banks show a leverage ratio of tangible equity over
tangible total assets of 6.2%, using US accounting standards (US GAAP), whereas the main
European Banks have a level of 3.7% when using IFRS accounting standards. However,
according to FDIC calculations, if the US banks ratio would be calculated according to IFRS,
the same as in Europe, the ratio comes down to 3.8% very similar to the European level.
When calculated with the same accounting standards the average leverage ratios of the
large American and European banks are quite similar. The explanation for this has to do with
netting rules: under the US GAAP the American banks have total assets of 10 trillion dollars
but applying IFRS that is changed into 16 trillion dollars. This huge difference explains the
difference in the leverage ratios but, importantly, has necessarily to impact also the published
risk-weighted capital ratios of European and American banks. This means that the capital
ratios are then not comparable although that is many times ignored by market and media
perceptions, clearly to the detriment of European banks.
Third, the restructuring efforts in the stressed countries to strengthen their banks with the
help of the European Stability Mechanism (ESM) funds have led to improved funding
conditions for euro area banks. With the financing provided by the ESM, banks in Spain,
Portugal, Greece and Ireland have been recapitalized. Bank deposits in these countries have
risen by around 200 bn since September last year, and the cost of both deposit and bond
funding for banks has fallen significantly. Euro area banks' issuance of medium and
longterm debt has increased and we have also seen a noticeable pick-up in repo market activity.
All these changes have led to lower use of central bank liquidity. Hundreds of banks have
made use of the option to repay the liquidity provided through the ECB's three-year
longerterm refinancing operations. These repayments amount to some €300 billion, more than half
of the net liquidity injection of 500 bn, provided by our two big LTRO operations. Our lending
to bank counterparties has declined from 14% of the Euro Area GDP at the peak to around
8% today.
Despite these positive trends, there is still a negative perception in the market about
European banks and more measures are indeed necessary.
The fact that improved bank fundamentals have not been translated into higher price-to-book
ratios tells us that there is a confidence problem as regards euro area banks. And if this is
left unaddressed, it risks creating a vicious circle as a low price-to-book ratio means that it is
expensive for banks to issue equity, which might impinge on their ability to raise capital
through financial market channels in a cost-effective way.
Towards Banking Union
This is where Banking Union comes in. The transposition to the European level of financial
sector policies through building a strong Banking Union can play a pivotal role in rebuilding
trust in the euro area banking sector.
Banking Union has for now two key components: the Single Supervisory Mechanism (SSM)
and the Single Resolution Mechanism (SRM). The creation of a European Deposit
Guarantee Scheme which the third component has been postponed for the medium term.
The creation of the SSM, which we expect to be operational next year, should increase
confidence in the euro area banking sector through two main channels.
First, the SSM will provide reassurance to investors that supervision is consistent and
effective across all participating countries.
The SSM will operate as a single system, with a common supervisory manual applying to all
participating banks. The ECB will directly supervise large, systemically relevant banks. While
it would be inefficient for the ECB to supervise directly the thousands of remaining smaller
banks, we will have the authority to take over supervision of any small bank or group of
banks at any moment if deemed necessary. This means there will be no "blind spots" from
which financial instability could emerge.
Second, the implementation of the SSM should reduce concerns about hidden losses on
banks' balance sheets.
In accordance with the SSM regulation, the ECB will conduct a "comprehensive assessment,
including a balance-sheet assessment" of all banks supervised directly. This will apply to
around 130 banking groups operating in the euro area, which account for around 85% of
euro area banking assets.
The assessment will involve a Balance Sheet Assessment including an Asset Quality Review
to be conducted by the ECB. This will then feed into the overall stress test to be conducted
by EBA, in cooperation with the ECB. The results of both exercises should be ready before
we start actually supervising the banks next year.
We want this assessment to be as rigorous as possible. Consequently, we are prepared for
the fact that it may reveal capital needs. If so, the first responsibility is for banks to raise
capital themselves. But there may be a public dimension as well, which is why the European
Council on 27-28 June addressed the need for backstops to be in place before the exercise
is completed. Without these financial backstops being in place the ECB does not advice to
complete the whole set of balance sheet assessment and stress tests.
However, investors will not be fully confident in the euro area unless they believe that banks
can fail without causing financial instability. Otherwise, they will expect supervisors to
practice forbearance.
This is why the SSM needs to be accompanied by a Single Resolution Mechanism.
The European Commission announced last Wednesday a proposal for a Single Resolution
Mechanism based on the concept of a an agency with wide of autonomy and ultimately
dependent on the Commission for the crucial decision of putting a bank into resolution.
Different alternative institutional setups could be conceived but the existence of a SRM is a
key priority for Europe and I am very pleased to see in the proposal that the envisaged
timeline takes this into account, with the entry into force foreseen for mid-2014 and
operations commencing in January 2015. This aligns with the entry into force in 2015 of the
new legal framework for resolution in Europe, the Bank Recovery and Resolution Directive
(BRRD), which will provide a harmonised framework of resolution powers and tools.
While it is still too early to provide an in-depth assessment of the Commission proposal and a
more detailed assessment will be published in our ECB legal opinion, I would like to
welcome, from a personal point of view, some important points contained in the
Commission's proposal. First, the Authority will have the capacity for truly European
decision-making with no veto powers for national authorities. In my view this is key for
dealing swiftly and impartially with large cross-border banks, although the proposal
appropriately applies to all banks of the participating countries in the Single Supervisory
Mechanism, thus ensuring a cohesive system.
Second, the Authority would own a Single Resolution Fund which would be financed by ex
ante risk based contributions to be complemented by ex post contributions both paid inby the
industry. Although not specified, the proposal stipulates that the Fund would be able to
borrow from both private and public alternative funding means. These borrowings would
subsequently recouped from the industry, thus ensuring fiscal neutrality in the medium-term.
I would have preferred, however, that the proposal would have considered explicitly the issue
of a public backstop for the resolution fund in the form of a credit line that would have to be
repaid afterwards, as it is the case with the US FDIC.
The ECB has strongly advocated for an SRM comprising of these three elements: a single
system, a single authority, and a single fund. The proposal contains these three elements
and consequently reduces the harmful effects of sovereign-bank interactions by diminishing
the importance of implicit sovereign guarantees.
The SRM will operate in the legal framework established by the Bank Recovery and Resolution
Directive (BRRD), which was recently agreed by Member States' Governments. This Directive
foresees that bail-in becomes the first line of defence in dealing with banking crisis - indeed,
8% of liabilities will have to be bailed-in before resolution funds or other public funds can be
used, with depositors of persons and SME being given the highest preference. Nevertheless,
the full bail-in tools that includes the possibility of burning senior bank bonds and uninsured
deposits will entry into force only at the end of 2018. Before that date only shareholders capital
and subordinated debt can be used to resolve a bank. Insured deposits, secured borrowing
(including repos and covered bonds) are exempt from bail-in. I think that the bail-in principles
approved by the Member States and the respective timeline until 2018 are appropriate to allow
a transition period that is helpful to ensure stability in the bank bond market.
This new rules should support the work of the SSM by strengthening incentives in the
financial sector to exercise market discipline on problematic banks.
To sum up, the euro area banking sector is becoming more stable overall, and given the euro
area's central role in global financial intermediation, this creates positive spillovers for the
global economy. Banking Union will take this process forward by increasing confidence in
supervision and ensuring that banks that need to be wound down, can be. To the extent that
this supports credit growth to the private sector, this will also generate higher growth in the
euro area and help the global economy through that channel, too.
Conclusion
Let me now conclude.
Advanced economies, Europe in particular, face a long period of slow growth that will test the
quality of our institutions. The European social compact will have to prove its adaptability and
resilience. The Euro Area is still facing a painful crisis of imbalances, financial fragmentation
and low growth. Questions of excess inequalities and high unemployment will have to be
addressed.
Meanwhile the world will continue to march towards the Great Convergence cogently
described by Kishore Mahbubani in his latest book.
To fulfil its role in the process, Europe is addressing its structural problems which have been
holding back growth and at the same time it is ensuring that its banking sector contributes to
global stability and growth. Europe is undertaking a process of wide and deep reforms, of
which the Banking Union project is a major example, that will ensure a future healthier path
of economic progress.
As someone said, "a crisis is a terrible thing to waste" - and we are using this crisis to build a
stronger and more stable monetary union that will play a constructive part in global
rebalancing.
Thank you for your attention.