Andreas Dombret: The euro area - routes to a stable monetary union
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, at the Banken- und Unternehmensabend at the Bavarian Regional Office,
Munich, 28 November 2013.
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1. Introduction
Ladies and gentlemen
President Müller
It gives me great pleasure to speak to you this evening at the Banken- und
Unternehmensabend
at the Bavarian Regional Office here in Munich on the topic of "The
euro area - routes to a stable monetary union".
I'm sure we all agree on what the current action in the euro area is seeking to achieve: a
stable monetary union. But have we taken the right route to make sure that we actually reach
this destination? Everyone knows that all roads lead to Rome, but the routes to a stable
monetary union are few and far between. I believe that we are on the right path - at least
what we can see by the wayside gives cause for hope.
2. The national level - some early signs of success
Let's take the problem of competitiveness. Significant imbalances have been evident in the
euro-area countries' current account balances in recent years. Countries like Germany or the
Netherlands are consistently running surpluses, while others like Greece, Spain or Portugal
have produced nothing but deficits. These imbalances have been symptomatic of the
differences in competitiveness between the individual countries.
A topic which has made a comeback recently is the question of whether surplus countries
should also contribute towards redressing these imbalances. But at the end of the day,
structural problems in the deficit countries were what brought about these imbalances - so
that is where the adjustments must take place. We must ensure that the other countries
make their economies as competitive as Germany's, is how ECB President Mario Draghi put
it. Doing the exact opposite simply wouldn't work.
And casting a glance at the crisis countries, we can see that many of them have already
implemented necessary reforms, thereby boosting their competitiveness and narrowing their
current account deficits. The European Commission's latest estimates suggest that most
crisis countries will run a current account surplus this year.
Even more important is the fact that this adjustment is being driven not just by shrinking
imports but also by growing exports. All the crisis countries' exports are likely to edge higher
this year, with growth ranging from just under 1% in Portugal to roughly 4% in Spain.
The crisis countries haven't made quite as much progress in tackling their government debt.
They have undoubtedly made dramatic inroads into their annual fiscal deficits in recent
years. But despite all their efforts, they will all still be above the Maastricht Treaty's 3% deficit
limit this year.
At the same time, their debt levels continue to grow. At the end of this year, Greece's
sovereign debt will be more than 170% of the country's annual GDP. And things are not
much better in other euro-area countries. At the end of 2013, government debt as a
percentage of annual GDP will be 131% in Italy, 128% in Portugal and 133% in Ireland. So
this is an area where we have some way to go.
But we should not observe the crisis solely from the perspective of structural problems in
individual countries. So let's change our viewpoint and look at the crisis from a financial
stability angle - it is a different perspective, but the structural problems of individual
countries, above all sovereign debt, are naturally also an issue here.
3. A change of perspective - viewing the crisis from a financial stability angle
From a financial stability angle, the contagion channels were the key hallmark of the crisis. In
the first phase of the financial crisis, beginning in 2008, banks infected each other - first,
because they were financially mutually highly interconnected, second, because there was a
general loss of confidence. The second phase of the crisis then saw banks infect the real
economy, and the global financial crisis triggered a global recession. In Europe, banks
ultimately infected sovereigns - and sovereigns infected banks. It was this sovereign-bank
nexus which fuelled the crisis in the euro area.
Essentially, what we are talking about is a "doom loop". If government budgets run into
difficulties, this weighs on banks - for example, if they hold government bonds on their
balance sheets. Looking at the loop from the opposite direction, if a host of banks - or an
individual large bank - experiences problems, then the government has no option but to
come to the rescue if the worst comes to the worst. This puts pressure on the government
budget.
This doom loop is a key problem for financial stability in the euro area. But how can we sever
it? Generally speaking, it can be severed in either direction - anti-clockwise or clockwise, you
could say.
Severing the anti-clockwise loop means giving banks better protection against distressed
government budgets. Breaking through the clockwise loop, meanwhile, means making public
finances more resilient to faltering banks. Let me take you on an imaginary journey, if I may,
in both directions.
4. Anti-clockwise doom loop - sovereigns infect banks
If it is the anti-clockwise doom loop we are looking to tackle, there are essentially two ways in
which we can shield banks against distressed government finances. First, we can make
government budgets inherently more stable, thereby reducing the likelihood of them getting
into trouble. Second, we can introduce regulatory requirements to ensure that banks are
better protected in the rare event of a sovereign running into difficulties.
4.1 Preventing fiscal distress
Safeguarding the stability of government budgets is quite a challenge in the euro area on
account of the specific structure of monetary union. What makes the European monetary
union special is that it combines a single monetary policy with national fiscal policies.
The monetary policy for the 17 countries of the euro area is decided by the Governing
Council of the ECB in Frankfurt. However, the fiscal policies of the 17 members of the euro
area are decided by the national governments and parliaments - each country decides itself
on its own government revenue and expenditure.
With such lopsided responsibilities, the individual countries have incentives to run up debt. At
the end of the day, borrowing costs are distributed among all the member states of monetary
union - either indirectly via higher interest rates for everyone or - as is now the case in the
crisis - directly via the rescue packages. In the end, the community is jointly liable for the
manner in which individual countries manage their budgets. Liability and control are out of
step.
Basically, there are two ways to realign this imbalance: either the European level gains
certain control rights over national budgets - which would mean deeper political integration.
Or we leave control of fiscal policy at the national level. But then the national level also has to
assume liability for its policy - that would mean strengthening the existing framework of
monetary union.
The first path would amount to what is known as a fiscal union. But that would depend on the
countries of the euro area transferring national sovereignty to the European level - for
example, by giving the European level the right to intervene in the case of unsound
government budgets.
Such a waiver of sovereignty would be a radical change and require wide-ranging
amendments to national and European legislation. But more than anything, such a change
would need the support not only of policymakers but also of the general public. And, on this
point, we should remain realistic. It is not possible to identify any will to do that at present -
not in Germany or in any other country of the euro area.
This leaves us the second course of action: an improved Maastricht framework, a
"Maastricht 2.0", as it were. Among other things, that means strengthening the rules on
borrowing - the Stability and Growth Pact not only needs teeth, it also has to be able to bite.
These rules have since been tightened - now they have to be applied and complied with.
A "Maastricht 2.0" would also mean taking the no bail-out principle more seriously again,
however: no euro-area country should be liable for the debts of another. But that calls for the
possibility of sovereign default as the ultimate logical conclusion of individual national
responsibility. Sovereign defaults have to be possible without destabilising the financial
system of the euro area as a whole. And this brings us to the question of how we can protect
banks from situations like these.
4.2 Protecting banks against distressed public finances
Fiscal distress is particularly problematic for banks that hold government bonds on their
balance sheets. And more than anything, it was banks in the programme countries and in
Italy and Spain which bought up huge volumes of their domestic governments' sovereign
debt - even during the crisis.
At the end of August, Italian banks' exposures to Italian general government amounted to
10% of their total assets. The equivalent figure for Spanish banks was 9%. What is more, it is
chiefly weaker banks - poorly capitalised ones that are highly dependent on capital market
funding - which bought up sovereign debt.
So if we are looking to offer banks greater protection against distressed public finances, it is
government bonds we must target. From the perspective of prudential regulation, there are
two factors which play a role here.
The first item regards banks' capital. Under the current regime, banks do not need to hold
capital against the risks of loans to sovereigns - unlike other loans. The thinking here was
that sovereign borrowers could not default and that loans to governments were therefore
risk-free. And, if no losses could develop, it wasn't necessary to establish capital buffers. If it
wasn't already necessary beforehand, the crisis has certainly forced a rethink.
Against that backdrop, it appears urgently necessary to change the rules. If banks were
required to hold capital against the risks of their government bond portfolios, this would make
them more resilient to fiscal distress. At the same time, banks would have an incentive not to
buy such large volumes of government bonds.
And this takes us to the second issue: capital alone is insufficient. A crucial tool of risk
management is diversification. The rule of thumb is "never put all your eggs into one basket".
A cap on loans to an individual sovereign should therefore also be introduced.
Such caps have already been a fact of life for loans to the private sector for some time. They
prevent banks from becoming overexposed to a single borrower. This makes them less
vulnerable to the default of that borrower - and this is something needed not just for private
borrowers but also for government borrowers.
5. Clockwise doom loop - banks infect sovereigns
But we have to sever the doom loop in the other direction, too - clockwise. We have to
protect government budgets from problems in the banking sector. The Irish case showed us
just how urgently necessary this is: in 2010 Ireland, in order to save its banking sector, ran
up debt amounting to 30% of GDP - the fact that this is largely taxpayer funds we are talking
about here does not make the problem any smaller, of course.
Breaking the doom loop in that direction requires the same underlying strategy we have
already applied. First, we have to make banks more stable so that distress is less likely.
Secondly, we have to ensure that, if banks do run into trouble anyway, this does not put a
burden on public budgets.
5.1 Preventing bank distress
If we bring up the subject of how banks can be made more stable, we open up a large field
which reaches far beyond the boundaries of Europe. Reforming banking regulation is a
global topic and is being conducted at the global level. The G20 leaders have developed a
comprehensive reform agenda, a large portion of which has already been completed.
Discussing regulatory reform in detail would be beyond the scope of this speech. With
respect to banks, its central pillars are: new capital rules and new liquidity rules. And, here,
we have come a long way since the crisis. The new rules under Basel III require banks to
hold more and higher-quality capital than ever before. At the same time, we have agreed on
an international liquidity standard for the very first time ever. As soon as the new rules are
finally in place, banks will be much more stable.
Yet rules are merely the foundation of a stable banking system. Someone also has to ensure
that the rules are applied - that is a matter for banking supervisors. And, with regard to
Europe, a further element enters the scene: the banking union.
In early October, the EU economic and finance ministers formally agreed to establish a
Single Supervisory Mechanism (SSM) as the first pillar of the banking union. The SSM is
scheduled to start its work in November 2014.
Joint supervision will make it possible to supervise banks everywhere according to the same
high standards. That will prevent regulatory arbitrage. At the same time, it will prevent a
situation in which a purely national supervisor unwittingly cuts domestic banks too much
slack without any justification.
The banking union is unquestionably the largest European project since the introduction of
the euro. We should therefore exercise particular prudence when implementing it. This
includes initially conducting a careful and comprehensive review of the state of the European
banking system. This inventory has already begun, and it will ensure that all legacy problems
are disclosed prior to the introduction of the SSM. The time schedule for the banking union
project is certainly ambitious, but I am confident we will be able to keep to it.
However, neither better rules nor a single supervisor can prevent individual banks from
becoming distressed. And that is also a good thing: the possibility of failure is a cornerstone
of a market economy. It must, therefore, be possible for banks to fail without rocking the
entire financial system. Looking at our vicious circle, this leads us to the question of how we
can protect sovereigns from banks' distress.
5.2 Protecting sovereigns from banks' distress
We are ultimately discussing a problem which already became relevant in the 2008 financial
crisis: that of "too big to fail". Banks can become so large or so highly interconnected that
their failure can jeopardise the stability of the entire financial system. The collapse of Lehman
Brothers showed us all what that can mean.
In order to prevent the financial system from collapsing, governments can be forced to
rescue large banks in an emergency - also using taxpayer funds. That not only weighs on
public budgets but gives banks distorted incentives. It encourages them to take greater risks.
It is like the toss of a coin: heads, the bank wins; tails, the taxpayers lose.
Finding a solution to the "too big to fail" problem will be critical in order to protect public
budgets from banks' distress. What we need is a resolution mechanism which will allow even
large banks to be resolved without jeopardising the financial system or requiring the taxpayer
to foot the bill.
Looking towards Europe, this is where the second element of the banking union comes into
play: a single recovery and resolution mechanism for banks.
What will initially be decisive here is to define a clear liability cascade. Who is liable when
banks founder? Shareholders and creditors undoubtedly should be at the very front of the
line when it comes to shouldering losses. Taxpayers should be the last link in the chain, if
they are even in the chain to begin with.
A Bank Recovery and Resolution Directive, which would cover all these factors and thus
represent a great step forward, is currently being discussed at the European level. The draft
version currently on the table, however, still leaves discretionary scope in deciding the extent
to which creditors shall be held liable. In the interests of market discipline, that should be
changed. It is also important that the resolution mechanism be introduced at the same time
as the SSM, if at all possible.
On the whole, however, the banking union is a key milestone on the way to a stable
monetary union, not least because it will help to sever the sovereign-bank doom loop - at
least clockwise.
6. Conclusion
Ladies and gentlemen, we have examined the crisis from the perspective of financial
stability. A key element is the doom loop of mutual contagion between banks and sovereigns,
the vicious circle.
We will have to pull levers at several different places in order to sever this loop. We have to
improve the framework of monetary union, especially with regard to the rules for sovereign
debt. We have to adapt banking regulation. We have to elevate banking supervision to the
European level. And we have to establish mechanisms which allow banks to be resolved
without impacting on public budgets or taxpayers.
We should remain aware, though, that we will not be able to solve all problems through
government regulation and government supervision. Financial stability starts first and
foremost with banks themselves. It is the responsibility of banks to act as carefully and
prudently as possible. And, in that respect, the banks squandered much in the way of
confidence during the crisis.
Changes are needed here, ladies and gentlemen. We need a change of culture in the
banking world. Banks have to return to the original role of the financial system: as a provider
of services to enterprises in the real economy.
Together with the exigencies already mentioned above, this change of culture will enable us
to reach our destination: a stable monetary union enabling prosperity and growth for all.
Thank you very much.