Andreas Dombret: Monetary union, banking union, capital markets union
- financial integration in Europe
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, at the American Chamber of Commerce, Munich, 15 July 2015.
* * *
1. Introduction
Ladies and gentlemen
Thank you very much for your invitation - I am delighted to be able to speak to you today. As
some of you may well know, I was born in the United States and still have my US passport
alongside my German one. And my international upbringing is one of the reasons why the
efforts of the American Chamber of Commerce to promote and foster mutual dialogue are
very close to my heart alongside the US and German passports.
The world we live in is truly globalised - countries are no longer islands but parts of a highly
interconnected system. And that particularly holds true, of course, for countries which have a
common currency. The year 2010 is a case in point. That was the year in which Greece's
financial problems tipped the entire euro area into crisis.
2. Greece - an update
And now, five years on, Greece is still hogging the headlines. The new elections called in the
country early this year marked the start of marathon negotiations that have been dragging on
for more than five months now. When talks stalled a little under three weeks ago and the
Greek government called a snap referendum, many thought that Greece's days in the euro
area were numbered.
The referendum was followed last week by talks on the prospect of an entirely new
assistance programme which early this week produced an agreement in principle. But that's
not the end of the story, because negotiations hammering out a third assistance programme
cannot get underway before parliaments in a number of countries have been consulted - and
one of those countries is Germany. Plus there are a raft of technical issues that need to be
addressed.
So although a basic accord has been reached, we should not lose sight of the challenges
that lie ahead, especially so for Greece's banks - time really is of the essence here. The
imposition of capital controls and bank holidays placed Greek banks in an artificial coma
twoand-a-half weeks ago. But in my view, this ersatz stability does not relieve European banking
supervisors of their duty to come up with a diagnosis and identify the right course of
treatment for the Greek banking system. I see four particularly important questions here.
What can be said about the health of banks domiciled in a country facing colossal
financial challenges?
What can be said about the health of banks whose balance sheets are awash
with debt instruments either issued or guaranteed by their sovereign?
And what about banks whose capital bases consist, to a very large extent, of
deferred tax assets which will only be of value if and when the banks return to
profitability and the sovereign is solvent?
And last but not least: what can be said about the large proportion of
nonperforming loans saddling the balance sheets of Greek banks, which is more
likely to have risen than declined given the bleaker economic outlook for Greece?
Even after Monday's agreement, none of these questions can really be answered with any
degree of satisfaction. And if one also considers that Greek banks have been closed for
more than two weeks now, it's simply impossible not to doubt their solvency. I share these
doubts.
So much for the sobering diagnosis. What, then, is the right course of treatment? I am of the
opinion that at least four things need to be done.
First, any new assistance programme needs to ensure that Greek banks are
adequately recapitalised. Estimations suggest a figure of up to €25 billion will be
needed. That figure should be our yardstick, but it needs to be underpinned by a
rigorous asset quality review. If, contrary to expectations, more capital is needed,
there should be scope to top this figure up.
Second, an ample supply of liquidity needs to be safeguarded in case depositors
plan to withdraw more cash once the recapitalised banks reopen.
Third, capital controls need to be gradually lifted over an extended period of time.
And fourth, the structure of the Greek banking sector needs to be scrutinised.
What I'm getting at is this: are all four of Greece's major banks viable going
concerns with a long-term future?
My remark just now about the structure of the banking sector is pertinent, not least, because
it was agreed that the Greek government would transpose the European Bank Recovery and
Resolution Directive (BRRD) into national law by 22 July. That would create the toolkit
needed to resolve banks in an orderly fashion, first and foremost the bail-in instrument. I
believe that this instrument needs to be made available in Greece as swiftly as possible -
that is, ahead of the mandatory introduction date of 1 January 2016. Looking at the structure
of Greece's banking sector, the question is whether it is possible to consolidate the country's
banks without seriously distorting the competitive environment. This is a question that needs
to be answered without delay.
To sum up - time is of the essence, especially so for Greece's banks. Everyone should be
aware that Monday's basic agreement marks the start of the real work. Now it is up to all the
parties concerned to do their jobs to make sure that five months of negotiations weren't in
vain - and the focal point here, for me, is the Greek banking sector.
After all, it's not just Greece we're talking about here but the euro area as a whole. And many
seem to believe that the crisis in and over Greece has cast doubts over the very process of
European integration. But I do not share that view. The proper response, in my view, is not
less, but more, integration. And we took a major step towards deeper integration by
launching the European banking union.
But we need to look beyond the banking sector and train our sights on the capital markets as
well. Extending and integrating the capital markets can also contribute to shoring up the
foundations underpinning monetary union. After all, a common currency needs integrated
financial markets to thrive.
This idea of a capital markets union has increasingly taken shape in recent months. Back in
February, the European Commission presented a green paper outlining a framework for a
European capital markets union. The Bundesbank sees the capital markets union as a
sensible project that is conducive to deepening European financial integration further still -
not only in the euro area but across the European Union.
But how exactly do we define a capital markets union, and how can we make this idea
reality?
3. Diversification - strengthening the capital markets
The European capital markets union essentially sets out to achieve two goals. First, to
strengthen the role played by the capital markets in funding the real economy. Second, to
deepen capital market integration across national borders.
The first goal sometimes prompts the question whether a financial system geared to the
capital markets is superior to one built around banks. Empirical research into this question
can be summarised quite succinctly - we're not quite sure. But what we do know is that both
systems have their merits, which vary depending on how well a country's economy is
developed and how it is faring at a given point in time.
The better developed an economy, the less the banking sector spurs growth and the more
capital market financing comes into play. Also, market-based financial systems help to take
the sting out of recessions that follow in the wake of financial crises. Bank-based financial
systems, meanwhile, are more adept at evening out "normal" cyclical fluctuations.
However, the latest financial crisis has opened up another vista. A system in which the real
economy is wholly reliant on a single source of financing - be it the banking sector or the
capital market - will run into difficulties when that well runs dry.
So, at the end of the day, it's not a question of choosing either one or the other. The idea
behind the European capital markets union is not to give up on bank-based financing, but to
harness capital market financing as an add-on. And Europe still offers plenty of potential in
this respect. Measured in terms of economic output, the US equity market is more than
oneand-a-half times the size of its European counterpart, while the US venture capital market is
five times the size of that in Europe, and the US securitisation market is larger still than the
European market.
It ultimately all comes down to the old economic adage that you shouldn't put all your eggs in
one basket. Or, to couch it in rather more technical terms, it's all about diversifying the
sources of corporate financing. If we give the capital markets a more prominent role in
funding the real economy, that will give businesses broader and better access to funding - to
the notable benefit of small and medium-sized enterprises. What it will also do is create a
more efficient financial system that can better support sustained economic growth.
4. Integration - establishing a single capital market
The second objective of the European capital markets union is to deepen the integration of
the capital markets. What benefits do integrated capital markets have to offer? One of the
biggest advantages, undoubtedly, is that they can help to improve risk sharing. The
underlying technical question is this: to what degree does an economic shock impair private
consumption?
And this is where the capital markets perform a key buffer function. In the USA, for example,
the integrated markets for capital cushion around 40% of total cyclical fluctuations between
the US federal states. If a negative shock hits an industry or a specific region, then this loss
is spread widely beyond that region. But in return, shareholders throughout the country also
receive a share of the profits during the good times. The credit markets, meanwhile, play less
of a role as a buffer, cushioning around 25% of cyclical fluctuations. Fiscal buffers play by far
the least important role, with fiscal mechanisms cushioning just 10-15% of economic shocks.
All in all, the different buffers absorb almost 80% of an economic shock before it can have an
adverse effect on private consumption.
The situation in Europe is slightly different: here, it is primarily the credit markets which act as
buffers - and not particularly effectively at that. All told, just 40% of a shock is cushioned
before it can hit private consumption. So boosting the role of the capital markets and
integrating them more effectively across national borders would help to improve risk sharing
in Europe and dampen fluctuations in consumption.
In summary, then, a capital markets union offers two takeaways. First, strengthening the role
of the capital markets as a source of funding for the real economy can promote economic
growth. Second, integrating the capital markets more deeply across national borders can
improve risk sharing. The bottom line is that the European capital markets union is a
worthwhile project.
5. Turning the idea into reality
Simple though the basic idea of a capital markets union may be, putting it into practice will be
a difficult undertaking. The capital markets are a complex beast, and capital market funding
comes in many shapes and sizes. Corporate bonds, private and listed equity capital, venture
capital and peer-to-peer loans are just some of the instruments in the market. And integrating
them affects not just the financial instruments themselves but also integral components of the
respective markets, like exchanges and central counterparties.
So any attempt to establish a capital markets union will automatically involve a raft of
different measures in a wide variety of areas. It's no surprise, then, that the European
Commission's proposals are very wide-ranging.
The goal of boosting the role played by capital market financing can be best achieved, in my
view, by placing the spotlight on the equity capital markets. That's because equity capital is a
form of capital market financing that is particularly effective at stabilising fluctuations.
But let's begin with the other side of the coin, so to speak, with debt financing. Debt contract
terms don't normally adapt to suit the borrower's situation. The redemption amount doesn't
change when the borrower runs into difficulties. Risk is only shared with the lender if the
latter grants further credit to bridge the difficult spell or agrees to a haircut if the borrower
becomes insolvent.
The value of equity capital, by contrast, always moves in line with events. Equity capital is
rather like an insurance policy against risk and creates a buffer that can absorb losses.
Boosting the role played by equity capital financing thus curbs the incidence of insolvencies
and diminishes fluctuations in investment and growth. Let us not forget that equity capital
showcased this stabilising quality during the course of the European debt crisis. Debt
financing in Europe was seen to be more susceptible to capital flight than was equity capital
financing.
This experience would suggest it is worth considering doing away with the unequal tax
treatment of equity and debt capital. Reforming the corporate taxation regime is naturally a
difficult task, and strong political will would be needed to push it through. But introducing a
more neutral tax regime for equity and debt capital would not only reduce the appeal of being
highly leveraged, but also boost efficiency levels across the board.
As for the goal of integrating Europe's capital markets more deeply, there are a number of
areas offering quick wins, one of which is the market for high-quality securitisations. Although
Europe's securitisation markets came through the financial crisis relatively unscathed, they
are lacklustre by comparison.
That's why a handful of initiatives have been launched to rekindle the continent's markets in
securitised products. These include the European Commission's efforts to establish a
framework for simple, transparent and standardised (STS) securitisations. Emphasising
these three qualities is crucial, given the lessons learned from the crisis. The securitised
products which contributed to the crisis were neither simple, transparent nor standardised.
Quite the opposite, in fact - there was a proliferation of complex and opaque products that
led to the problems we are all too familiar with. So in my eyes, the Commission's initiative is
a sensible move to revitalise the securitisation market and promote the flow of funding to the
real economy.
Speaking as a banking regulator, it is nonetheless important, of course, to regulate
securitisations appropriately. What we should avoid at all costs is a situation in which we
soften the existing financial market regulation in an effort to nurture certain market segments.
Another quick win would be to standardise the regime for private placements. Yet another
would be to tweak IPO prospectus requirements in a move to do away with unnecessary red
tape. Looking into the more distant future, it would make sense to harmonise insolvency law,
company law and tax law.
However, we should not focus on the institutional and legal framework to the exclusion of
everything else. It would probably also be worthwhile to take into account soft factors such as
cultural preferences for certain forms of financing or financial literacy levels. These are areas
we will also need to address if we are to achieve our goal of establishing a European capital
markets union.
6. Conclusion
Ladies and gentlemen, the road to a European capital markets union is a long and winding
one. The journey will be arduous and time-consuming. There will be challenges and
resistance we must overcome along the way. So we need to be realistic about what we are
setting out to achieve.
And yet we have travelled this road to deeper financial integration for 16 years now - since
the year, in fact, in which we launched the euro as a common European currency. And we
must not falter. If we want European monetary union to be a true success, we will need to
press ahead towards ever deeper integration.
We took a huge stride on this path in November 2014 with the launch of the banking union.
Now the next major step is in order - the establishment of a European capital markets union.
A capital markets union which includes not just the member states of the euro area but
embraces the entire European Union.
On that note, I would like to bring my speech to a close with a quote that has been attributed
to Robert F Kennedy. "There are those that look at things the way they are, and ask why? I
dream of things that never were, and ask why not?" Looking at the capital markets union, I
believe we should take this confident and optimistic outlook to heart.
Thank you very much.