Yves Mersch: "Built to last" - the new euro area framework
Speech by Mr Yves Mersch, Member of the Executive Board of the European Central Bank,
at the Barclays Research Conference, London, 17 May 2013.
* * *
Ladies and Gentlemen,
The building we are in was bought by the Drapers' Company from King Henry VIII in 1543. It
has lived through turbulent times, from fires to conflicts - and, I should also say, various
financial crises. But Drapers' Hall has always recovered from the calamities it has faced. It
has been rebuilt, renovated, enlarged and embellished. Thus, it was built to last - but has
changed over the centuries. Today, I'd like to speak about a quite different building: the "new
euro area framework".
The euro area has been facing insufficiencies on several fronts, all at the same time. Let me
be blunt: it has had governance shortcomings, stretched states, fragile banks, shrinking
economies, sinking confidence in institutions and doubts about its integrity. Each of these
difficulties has exacerbated the others; it has been a vicious circle. The crisis did not
originate in the euro area, nor is it limited to it. But inside the euro area it has inflicted severe
losses and pain, particularly on the younger generation.
Yet, in the euro area an unsuspected amount of repair is under way. The threat of a break-up
has vanished since last summer. A new political economy is within reach. The foundations of
a virtuous circle are already here. My message today is that the euro area is being rebuilt to
last. Its foundations are being strengthened and new pillars and floors are being added. The
euro area will remain both viable and beneficial to its citizens.
In the light of these testing circumstances, I would like to give some tentative answers - to
Where do we stand? What are the strengths of the euro area? What's next?
four questions:
What remains to be done? I will then offer some final remarks, and answer your questions.
Where do we stand?
The European Central Bank has been in "crisis mode" for almost six years. The challenges
for us have escalated in various stages. Allow me to recall them very briefly.
• financial turmoil
The first stage was the that erupted in August 2007 when the US
subprime mortgage crisis started to unravel.1 Globally, counterparty risks rose and
confidence among market participants plummeted. This led to a drying-up of
liquidity, and a sharp increase in risk premia.
•
The second stage of the crisis started in September 2008 after Lehman collapsed.
Money markets froze, financial losses soared, bank deleveraging accelerated, and
financial stress spilled over to the real economy. Trade and growth were hit hard.
great
The ensuing global financial crisis gave rise to the recession, which affected
European countries disproportionately due to their high degree of openness.
•
The even more serious third stage came in May 2010 when the euro area sovereign
debt crisis erupted in Greece and spread to other countries.
What happened? After the launch of the euro, various cracks in the currency edifice
emerged. Public finances were weak in several euro area countries; macro imbalances were
persistent in others. Some countries experienced a boom in housing and construction and
productivity growth was slow in others. The triggering event of the turmoil, on the other side
of the Atlantic combined with the disappearance of "abundant money" exposed and
deepened those fault lines. Several European economies became steadily weaker.
The underlying reasons were several: there were shortcomings in governance (both national
and supranational), flaws in the design of the euro area, misjudgements by regulators and
supervisors, and also insufficient scrutiny by financial market participants as well as by credit
rating agencies. They did not sufficiently differentiate between borrowers. And I should not
omit from this list the many economists who failed to see the systemic risks building up. The
ensuing dysfunctional policy debate and the discordant national responses were also
harmful. Understandably, national disaffection rose, as did scepticism about the euro area2 -
this is a phenomenon I know you are rather familiar with.
Various doom-loops followed. The fates of governments and banks became ever more
intertwined. Sovereigns had to recapitalise impaired domestic banks and support feeble
domestic economies. In doing so, they accumulated extra debt. Perversely, even sound
banks have been affected by the weakness of their home governments and domestic
economies. Then, lower credit ratings and higher interest spreads of both banks and
sovereigns pulled each other further down. This hurt the real economy and started a vicious
circle that has been very difficult to stop and reverse.3
Banks across the euro area are now deleveraging and recapitalising, and the flow of credit is
still hampered in several countries, mainly those in which households and firms are also
trying to deleverage, while budget consolidation is under way. The functioning of the money
market is severely impaired, credit is squeezed and the transmission mechanism of
monetary policy is clogged.
The sovereign debt crisis came to a climax in mid-2012 when the risk of break-up seemed
acute. Investors began shifting deposits away from banks in stressed jurisdictions, often to
banks in countries where conditions were calmer. The deposit base fell in stressed countries.
Correspondingly loan growth deviated greatly across the euro area. Small and medium-sized
enterprises were, and still are, affected the most.
What has the ECB done? Over the last six years it has eased the credit squeeze, fought
back against the economic slowdown, and countered financial fragmentation by slashing
interest rates, flooding the banking sector with liquidity and lending widely. It took large scale
conventional monetary policy measures to prevent deflation. Its unconventional measures
prevented a meltdown of the financial system and aimed to restore the impaired transmission
of monetary policy. Yet, credit flows remain weak and growth is still anaemic.
To sum up where we stand: the sovereign debt crises of the euro area is a multi-layered
affair: economic and financial imbalances plus failings of governance and flaws in
institutional design, plus an erosion of trust and confidence. It's an exceptionally complex
situation. Five euro area countries are now undertaking EU/IMF adjustment programmes,
while a few others are addressing imbalances outside a programme.
What are the strengths?
Despite the depth of the crisis, the exceptional "flow and stock adjustments" under way, and
ongoing financial market tensions, there are still some strong components supporting the
building of the new euro area framework and holding things together.
The first strength is the resilience of the single market, which has steadily transformed the
now deeply interconnected euro area economies. Companies and banks have a European
perspective and reach. We are each other's stakeholders. Economic integration is a diffuse
process. It is the true engine of European integration and is generating largely benign effects.
The single market represents the intrinsic value of the euro area. It is a common good. It is
an asset shared by all its citizens - a fact which is not given enough recognition as a
stabiliser during these difficult times.
The lies in the solidity of our financial infrastructures: they have withstood
second strength
the full force of the crisis. The Trans-European Automated Real-Time Gross Settlement
Express Transfer (TARGET2), has enabled money market access throughout the crisis and
for all countries: the cumulated imbalances are now steadily receding. In 1998 there were
18 large-value payment systems: that number fell to six in 1999 and now there are two,
which means that both efficiency and financial stability have been enhanced. Central clearing
counterparties (CCPs) for securities and derivatives declined from 13 in 1999 to nine in 2012.
This entails greater efficiency gains by pooling activities. And more is coming. In 2008, the
Single Euro Payments Area started to take effect due to time-lags. And the securities
settlement systems will change radically once TARGET2-Securities becomes operational.
This project is fully on track.
The third strength lies in the widespread acceptance of the need for adjustments and
reforms in all dimensions of the crisis. The political authorities have taken action. They are
already overhauling the political economy of the euro area, and establishing new governance
to restore fiscal sustainability and prevent and correct macroeconomic imbalances. The
Stability and Growth Pact has been tightened up by the so-called "six-pack" of economic
governance measures, including the Macroeconomic Imbalance Procedure (MIP), and they
in turn have been complemented by the "two-pack". Moreover, euro area countries are
summoning up the courage to change - although it is painful in some regions. To quote Jean
Monnet, one of the founding fathers of the European Union: "People will only accept changes
under the pressure of necessity." Indeed, change is under way in Europe. And the
impressive political determination to reform together is not stopping at the national level.
Also a fourth strength is that as a result of the crisis, a "crisis management and resolution
framework" has emerged at the European level- and it is working. The initial stage was a
fiscal backstop, the European Financial Stability Facility, and then the European Stability
Mechanism. Confidence is slowly returning to both financial markets and high streets, even if
growth and job prospects remain weak - the latter two being lagging indicators of the
recovery under way. All this shows that European countries can turn themselves around.
To sum up the strengths: the "repair work" on the euro area foundations is under way.
Imbalances are slowly receding. Also there is the wide international circulation and relative
strength of the euro as well as a stable demand for the euro as a reserve currency.
Yet, we are aware that deep reforms throughout the new framework are only as effective as
they are completed, transposed, well explained, understood, adhered to, and given the time
to display their effects. We know that we are not completely out of the woods.
So what's next?
With the establishment of the ECB in June 1998 and the launch of the euro on 1 January
1999 monetary policy was centralised. Responsibility for the euro was entrusted to a strong
and independent central bank. The ECB has fulfilled its primary objective of price stability.
Fiscal policy, economic policies and supervision, however, have remained at national level.
As this architecture has proved to be flawed, the respective Presidents of the European
Council (Herman Van Rompuy), the European Commission (José Manuel Barroso), the
Eurogroup (then Jean-Claude Juncker) and the ECB (Mario Draghi) drew up what is known
as the "Four Presidents' Report". It advocates the completion of monetary union by way of an
additional "four unions".
These "four unions" are envisaged to mesh with each other, like cogwheels. The spin of one
sets the others in motion. Conversely, when the momentum of one decreases the others
follow suit. The banking union, the fiscal union, the economic union, and the political union4
can transmit and reinforce the dynamics of European integration.
Let me elaborate on some key features of the banking union - a project with which I am
closely associated. The fragmentation of the banking system along national lines has posed
a direct threat to the integrity of the single currency. We need to break the doom-loop
between sovereigns and banks, restore the confidence of depositors and investors - in fact
rebuild trust in the whole financial system - as well as ease the reintegration of financial
markets. The banking union will help to restore the proper transmission of monetary policy
and relieve the ECB of some of the tasks undertaken during the crisis. Its importance and
urgency cannot be overemphasised.
The banking union comprises two main parts. One is the Single Supervisory Mechanism
(SSM), which is scheduled to start operating at the ECB in Frankfurt, at the earliest
12 months after the adoption of the regulation. The second part is the Single Resolution
Mechanism (SRM), which is a Siamese twin. The ECB cannot exercise this task as it will
undertake the analytical part of supervision. A separate authority is needed; perhaps one that
is attached to the ESM, for the resolution task as it implies a distributional impact which
belongs to the Executive prerogative. Still, close cooperation is warranted with the SSM and
DG Competition.
What is also clear is that the resolution body needs to operate at the same level as the
supervisor, i.e. the European level. This becomes even more obvious amid the potential
need to deal with cross-border operating banks.
The SSM will be a single supervisor for all banks established in the euro area, plus those
banks established in the EU countries which have entered into a close cooperation with the
ECB. So it will have a truly European focus.
It should create a level playing field for the European banking industry and remove any
national biases or supervisory forbearance, and prevent the hiding of bad assets - or even
leniency - towards so-called "national champions", a phenomenon that might have become
more acute during the crisis. It is a myth that such champions were in the interests either of
domestic economies or of national taxpayers. But the SSM will go well beyond that: it will
result in the elimination of asset and liability matching on a national level that has done so
much harm.
How will the Single Supervisory Mechanism function in practice? There will be a
twotier system of banks.
The banks considered to be systemically important, about 130 of them, will fall under the
direct supervision of the ECB. But all other banks, while remaining under national
supervision, will not be excluded from the ECB's supervisory reach. In fact, national
authorities will have to abide by ECB regulations, guidelines and general instructions. Hence,
they will be subject to the ECB's broad oversight mandate.
Yet the boundaries between the two tiers can also be adjusted if the need arises5 The ECB
may decide at any time to exercise direct supervision over any other credit institutions. This
will ensure the consistent application of supervisory standards as well as adherence to the
guidelines and instructions issued by the ECB.
The ECB will be responsible for the functioning of the SSM. In practice, the ECB will rely
heavily on existing national supervisors: their expertise and "proximity" to the supervised
banks are essential for the SSM to be effective. No domestic aspect or concern must be
overlooked. Even in the case of the systemic banks that will be directly supervised by the
ECB, national supervisors will still be involved in on-site inspections. In fact, there will be joint
supervisory teams.
The assignment of supervisory responsibilities to central banks mirrors the prevailing
consensus among experts and academics6.
There are many synergies between monetary
policy and banking supervision, and in our case there are benefits from sharing micro and
macro-information on monetary policy, bank supervision, and the oversight of payment
systems.
Moreover, an important lesson from the crisis is that there can be no price stability without
financial stability. Most of the time, monetary policy and financial stability measures work in
harmony. Still, there are concerns. There are several things we need to do, notably, steer
clear of the risks, as the ECB will be the prime liquidity provider for these banks; establish
clear safeguards against any potential conflicts of interest between the various ECB
functions as they could give rise to reputational risks. And at the same time we need to
reduce costs.
The SSM also represents a huge logistical challenge for the ECB. We are working hard on
this and are well aware that the rewards may be considerable. It is requiring a lot of
preparation at many levels including:
•
selecting highly skilled staff - many experts are already coming from national
supervisory bodies;
•
drawing up the final list of systemically important banks that will be directly
supervised;
• harmonising reporting requirements; working out procedures that will govern the
SSM's relationship with national supervisors; and
• preparing to review the quality of banks' assets, including legacy assets.
Let me add on the last point: Such a comprehensive assessment is needed before the SSM
becomes operational. This could be organised in a coordinated endeavour where the
workload is shared between by the centre and the national authorities. Calling upon external
experts, under the strict control of the SSM, will increase the credibility of the balance sheet
exercise because of the impartiality of third parties. Moreover, their expertise in certain areas
will add great value. The scope of their involvement might not extent the significant banks,
however.
First coordination has already started with the European Banking Authority (EBA) which in
the past looked upon the resilience of banks under stress scenarios. The SSM could
undertake the asset quality review in the third quarter of this year until the first quarter of next
year, and then in close cooperation with the EBA, conduct a stress test. This along with the
balance sheet assessment will be a major component of the comprehensive assessment.
The outcomes of the balance sheet assessment will also be an important input for the stress
tests. The combined results of both exercises could be published by mid-2014, just before
the SSM is scheduled to become operational.
As always in life, there is no such thing as a free lunch. The question arises: who will pay for
financial stability and, above all, who will pay in the event of a banking resolution? There are
two types of "costs": operating costs incurred in normal times and losses sustained in times
of crisis. As for the operating costs, European supervision will be financed by fees to be
levied on banks. However, there will be efficiency gains from avoiding the duplication of
services (national and European), so additional cost burdens for the financial industry will be
contained.
What happens if a viable bank lacks capital? Such a bank, wherever it is based in the euro
area, should first try to raise fresh capital from its shareholders or in the market. If it is unable
to do so - for example due to unfavourable market conditions - fresh funding should be
provided from a European recovery and resolution fund that is financed by all banks.
Such a fund should also help with resolution, for instance, to capitalise a bridge bank that is
later sold on the market. Bailing-in of stakeholders will also play an increasing role to cover
the cost of resolution. During the crisis we have seen the full spectre from mainly bailing-out
banks with taxpayers' money and bailing-in even depositors. A reliable framework is needed
to guide investors and savers. Therefore, the pecking order of a broad scope of bail-in
instruments needs to be defined. The list of exclusion should be limited. The Bank Recovery
and Resolution Directive (BRRD) currently being negotiated should clarify in particular the
positioning of unsecured depositors in the cascade. It is of crucial importance that an
agreement on the BRRD is reached in a timely manner to have a resolution and recovery
framework in place before the SSM starts operating.
Only as a last resort should rescue funds be temporarily drawn from the ESM. To ensure
fiscal neutrality, a loan to the European recovery and resolution fund should then be repaid
ex post via levies on viable banks, and of course, the proceeds from the re-privatisation.
Another rationale for the SRM as a separate entity is that a supervisor cannot give objective
verdicts on the viability of banks if then these banks can only be closed in a disorderly way.
That, in turn, could trigger contagion and endanger financial stability. In other words, if banks
cannot be resolved in a disciplined manner - known in advance and agreed upon - we could
drift into supervisory forbearance, evergreening and zombification of companies as well as
the banks themselves.
Hence, a resolution mechanism is essential for repairing financial markets. The capacity of
the banking sector to absorb risks will increase, which is currently the bottleneck of loan
provision to the real economy.
To sum up what's next: the banking union consisting of the SSM and the SRM will
contribute to financial soundness, stability and resilience. All this would help to restore the
proper transmission of monetary policy. The current very accommodative monetary policy
stance could reach those it needs to reach unhampered. Correspondingly, the need for
unconventional measures would diminish rather than increase. A single supervisor without a
resolution counterpart, however, would push the central bank into ever more risk-taking to
ensure financial stability, thus even threatening the independence of monetary policy.
What remains to be done?
The crisis has been - and still is - a wake-up call for the euro area. Initially, some stressed
countries were largely in denial about the need to tackle their imbalances. Precious time was
wasted, and that exacerbated the doom-loops. Then, things started turning around in mid-
2010. A new political economy is within reach. But in the longer-term, what else do we need
for the viability and prosperity of the euro area?
We need to firm up the progress on the fiscal union, the political union and the economic
union. Several elements of the fiscal union are ready. I listed them a few minutes ago: they
need to be transposed into national law, and adhered to at every level of government (i.e.,
national, regional, provincial and so on).
Concerning "genuine political union", our institutions also need to adjust to the higher level of
integration that constitutes the monetary union. While on the intergovernmental EU wide
level the Council has a counterpart on the euro area level, namely the euro group and the
Euro Working Group, the executive arm of the supranational EU level, the Commission, and
the legislator, the EU parliament, still lack an equivalent for the euro area.
Yet, the principal building ground of the new euro area framework is the economic union. In
the long term, we need euro area countries to become more flexible, open and to remain
relatively synchronised. This would increase shock absorption, improve resource allocation,
remedy the current heterogeneities, harmonise the transmission of monetary policies, and
boost growth potential, thus enhancing the resilience of the euro area as a whole. This
implies a need for deep changes in our societies.
Allow me to point out that over the last few years the ECB has not only been a guardian of
stability and among the most interested observers of the various deficit and imbalances
procedures, but we have also raised awareness of the need for profound transformations in
our political economy and in our societies. We have been advocates of change. In my view,
this is our most important unconventional measure, but it will never be able to replace
the self-responsibility of countries.
In one respect, solving the sovereign debt crisis of the euro area remains a supremely
national affair: namely, finding a consensus on, and domestic support for, new social
contracts among all national constituencies. The new political economy of the euro area and
the "four unions", i.e., what we are calling the new euro area framework, can provide a
sheltered environment for reforms and sustainable domestic social contracts.
In most of the stressed euro area countries this still requires tough choices across the
generations and over time: e.g. education versus pension entitlements, infrastructure versus
healthcare, research and development versus defence, and so on. Strengthening of tax
administrations and treasury systems, expenditure control, privatisation will also be crucial.
Reducing the costs of bureaucracy will matter more than ever across the euro area. There
are varying needs for true innovation clusters à-la-Silicon Valley, as well as investments in
scientific and technical education, research and development, encouragement of "angel
investments", and grassroots and sustainable banking. Labour markets need to become
inclusive and fair in every country, while encouraging labour mobility, in particular in a
monetary union. Greater competitiveness and sustainable growth of the whole euro area will
then follow.
To sum up what still needs to be done: each euro area country needs to find its own
trade-offs and support from its national constituencies. There might not be a single approach
fitting all. No "pact" can force such transformation through, and no monetary policy measure
- however unconventional - can replace it. Such "holistic" national therapies are
inescapable: without them, no change in the euro area's political economy and governance,
or financing facility can be sustainable.
The tensions and inequalities are clear for everyone to see: we can no longer postpone what
should already have been addressed. The new euro area framework is an opportunity.
Some final remarks
All currency unions evolve in their early years. Their institutions adapt to changing
circumstances, as we saw for example in the US, and several federal states in Europe and
even in the UK. The idea of Europe's Economic and Monetary Union (EMU) has evolved
over decades. The euro area envisaged in the Werner Report of 1970 was ahead of its time,
but planted important seeds. The Maastricht Treaty was a milestone and the most that
Europe could have achieved 20-25 years ago, but that was not enough. There were various
flaws in EMU's design and governance. In retrospect, systemic risks were partly
endogenous. We have learnt the hard way from our errors, and fortunately there are still a lot
of strengths in Europe/euro area.
The euro - and thus price stability and the future banking union - can provide a shield from
outside shocks, secure the benefits of a credible world currency, and contribute to
strengthening the single market and fostering internal stability. This structure would have
been unimaginable only five or six years ago: yet it might not suffice unless it is accompanied
by national reforms and new social contracts that in some cases have been postponed for
decades. The new euro area framework is being rebuilt to be viable and to last.