Andreas Dombret: Opt-in or opt-out? The future of the European Union in
light of the UK referendum
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, at the Atlantik-Brücke, Hamburg, 23 Juni 2016.
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1. Introduction
Mr Schwenker
Mr Kracht
Ladies and gentlemen
Yet again, Europe finds itself at a crossroads, at least it does from the UK's perspective.
41 years on from the UK referendum in which the country came out in favour of becoming a
member of what was then the European Economic Community, the people of Great Britain
and Northern Ireland are, as I speak, once again voting on the "European question".
Though this decision is quite clearly one for the UK alone to take, voices in all quarters have
been sounding a note of caution right up to the last minute. One very notable example is the
IMF's Christine Lagarde, who recently underscored the many benefits that the European
partnership brings for the UK after an IMF paper sketched out a distinctly bleak future for a
post-Brexit UK economy. Echoing Ms Lagarde's remarks, Federal Reserve chair Janet
Yellen warned that a UK vote to leave the EU could have "significant economic
repercussions".
UK voters alone will now have to make of these scenarios what they will. Now is neither the
time nor the place to pass judgement on the decision to hold a referendum or the pros and
contras of the respective standpoints from a UK angle.
I will instead look at matters from a European vantage point and invite you to discuss what
today's referendum means for the European Union. In doing so, I will take a look at both the
direct challenges we will face in the event of a Brexit and the long-term outlook for the EU.
2. Standing firm in the face of uncertainty: the direct repercussions of a Brexit
for the EU
Ladies and gentlemen, half of the UK's exports go to other EU countries. 46% of foreign
direct investment in the UK comes from the EU; the other way around, the figure is 43%.1
Thanks to the UK's long-standing membership of the EU, its economy now enjoys closer ties
than ever before with its European partner countries. Figuratively speaking, a Brexit, then,
would set in motion highly complex divorce proceedings and herald a protracted spell of
uncertainty.
What a Brexit would mean in practice depends to a large extent on what's hammered out in
Brexit negotiations. While the mechanics of leaving the EU are now codified in Article 50 of
the Treaty of European Union, that article only maps out the process and preliminary
twoyear timeframe within which an agreement is to be negotiated between the Union and the
withdrawing member state.
Both sides would undoubtedly be interested in maintaining the existing trade links. But at the
same time, there should be no doubt that the EU should resist any efforts by the UK to
cherry-pick the most advantageous terms.
A glance at the agreements that exist with other countries makes it plain that sharing a
market always means sticking to a common set of standards as well. The European Free
Trade Association (EFTA) for Iceland, Liechtenstein and Norway, for instance, is tied up with
membership of the European Economic Area (EEA). But this also means applying the full set
of EU legislation, a notable component of which is the freedom of movement - an issue that
"Brexiteers" have cited in the run-up to the referendum as one of the reasons why they think
the UK should leave the Union. By contrast, the alternative model used by Switzerland,
which is not part of the EEA, does not initially envisage the country having freedom to access
the common market. In all likelihood, individual arrangements which grant access won't be
possible without concessions. And with a jungle of contractual small print to contend with,
time constraints will mean that the negotiating parties will be unable to repeatedly redraft
proposals in their efforts to hammer out an agreement.
So it's anything but certain how the legal situation will ultimately pan out. The terms of the EU
Treaty would remain in force during the negotiation period. But businesses on both sides of
the Channel would be unable to forge out any longer-term plans as long as these conditions
haven't been clarified - so planning uncertainty is bound to be costly. And it's very much up
in the air whether the spell of uncertainty will be over after two years or whether the
negotiating parties will have agreed by mutual consent to extend the negotiating period.
Putting aside the tall order of gauging the economic fallout of a Brexit decision, there is
naturally another question which arises from a European angle and for me personally as a
central banker - given that a "leave" vote might spark a turbulent market response, how far
will Europe's banking and financial system remain stable and continue to function properly?
Financial markets have already started to price in a Brexit scenario, and heightened volatility
and climbing risk premiums are coming to the fore in the lead-up to the referendum. It's a
safe bet that markets will remain in turmoil if the UK chooses to leave the EU.
For example, the pound is open to exchange rate risk, as it could devalue again strongly
should there be a vote to leave the EU. Effects can also be expected on the stock markets.
In particular, British bank shares could come under pressure if the markets expect a Brexit to
push up banks' wholesale funding costs to the detriment of their profitability. Seeing as the
financial sector accounts for a much greater share of the UK economy, at 6.7%, than it does
in the rest of Europe,2 UK bank shares will be at the epicentre of market jitters. So it's not
surprising that Mark Carney, governor of the Bank of England, has spoken out, as part of the
BoE's monetary and financial stability mandate, on the repercussions of a Brexit and points
to the likelihood of negative short-term effects.3
That's why European supervisors wasted no time in urging euro-area credit institutions to
precisely quantify and continuously review their forex, credit, equity and bond market risks,
simulate scenarios and draw up "contingency plans". The vast majority of banks have treated
the Brexit scenario with the seriousness it deserves and are rigorously prepared to face the
aftermath - in some cases, their preparations have required a great deal of time and effort.
The same goes for central banks, too, of course. They're ready to face up to the real risk of a
"leave" vote. As things stand today, I think the risk that might emerge, say, from a theoretical
UK rating downgrade or a possible revaluation of the UK property sector is manageable
overall, but of course, no one really knows for sure.
As for the EU, a Brexit would also cause some fallout in the medium term. European banks
based on the continent operate in the UK market and have branches in London. The UK
capital is also home to a great number of non-European institutions which use the EU's
passporting regime to conduct business in any other EU country - that makes London a hub
for the entire European market.
If the UK voted to leave the EU, institutions in Germany and the other EU countries that
operate branches in the UK would face the prospect of losing access to this passporting
regime or seeing it be changed. This would force institutions to either convert their London
branches into standalone subsidiaries and to apply for them to be licenced by the Bank of
England or shift their operations out of the UK and into the euro area - two immensely costly
options, might I add. But saying that, it is also true that if the UK opts to leave the EU, we will
have to wait for the outcome of post-referendum negotiations before anything can really be
said on the EU's passporting regime that will stand up in court.
But for financial centres elsewhere in the EU, the Brexit scenario opens up a number of
opportunities over the medium term. Also, a larger number of foreign banks look set to switch
from the UK to mainland Europe - and that's something that might even benefit the Frankfurt
financial centre. London's pulling power as a venue for European bond and forex trading
would shrivel. For even today, supervisors take a critical view of the fact that euro trading is
based mostly in London, and therefore outside the euro area. This criticism would intensify if
the UK chose to leave the EU, of course. The same can be said for clearing business and
central securities depository services, at least for euro-denominated business - supervisory
authorities will need to be a lot more tolerant if this business is to be allowed to be conducted
not just outside the euro area but outside the EU as well. If truth be told, that's a level of
tolerance I can barely imagine.
Looking at the medium-term horizon, the European Union also needs to consider how, given
the close links between financial agents in the UK and continental Europe, it intends to
safeguard financial stability in Europe if a more national brand of regulation and supervision
is reintroduced on the other side of Channel. While UK banks aren't currently affected by the
Single Supervisory and Resolution Mechanisms of the banking union, they do need to
comply with the Single Rulebook.
Incidentally, the European Banking Authority plays an important role in this regard. Not only
does the EBA ensure a harmonised interpretation of the rules, it also promotes interaction
and dialogue on supervisory practices in the member states. And as I'm sure you all know, it
is currently headquartered in London. So if the UK voted to leave the EU, the EBA wouldn't
only have to find a new home; it would also have to rebuild the prudential cooperation with
the UK from scratch.
So a "leave" vote throws up a vast number of planning issues and raises considerable
uncertainty. But even if the electorate came out in favour of "remain", there would still be
some loose ends to deal with in the relationship between the UK and the rest of the
European Union. Just consider, for instance, the question as to how the revision of the EU
rules that were agreed in the event the UK remains in the EU actually affects economic and
political dynamics within the EU.
3. Strengthening crisis resistance: the long-term outlook for the EU
Ladies and gentlemen, the outcome of the referendum is something that Britain will have to
resolve on its own - it is not something we will be able to influence. What we can influence,
though, is the EU itself, and its ability to function. And this is where I see the far more
consequential issues affecting Europe's future.
For the UK referendum should be understood less as the result of the anticipated benefits of
exiting - earlier on, I gave you an insight into some imponderables and risks of leaving the
union - but more as the outcome of widespread dissatisfaction with the European Union.
And, should the UK vote to remain in the union, the referendum will most likely not represent
a resounding commitment on the part of Britons to the EU.
In addition, as we all know, dissatisfaction with the EU is not a purely UK phenomenon, but
instead has grown significantly in many member states. Support for Eurosceptic parties is
mounting. A UK vote in favour of Brexit could also launch a movement in other member
states to look into ways of leaving the EU. Moreover, even if the UK votes today to remain,
we cannot expect underlying attitudes towards the European Union to change overnight.
Motives for dissatisfaction may partly be found in domestic politics. On the other hand,
however, a search for causes also needs to include the European Union's specific actions,
such as how it has dealt with refugees, the euro crisis, and the general cost-benefit
considerations of harmonised rules and an "ever closer union" - at this juncture, I will not go
into detail on individual topics, as that would be beyond the scope of my mandate.
What reverberates everywhere, however, is the question of whether the European Union is
capable of taking decisions effectively and efficiently. The EU has yet to demonstrate its
ability to deal with diversity - cultural or economic - and to channel it in the right directions.
Let me explain this now in view of the euro area and outstanding reforms.
The challenge of channelling diversity in the right directions has come up quite prominently in
monetary union. In a large economic area, it is quite natural for individual regions to evolve in
a variety of different ways; owing to the structures of their economies and societies, they will
not respond to change in the same way. The underlying question is this: how can the system
as a whole respond to such asymmetrical shocks? Put differently: how can the EU be made
more crisis-resistant?
In a single monetary area such as the euro area, there are no more exchange rates to adjust;
therefore, other channels are needed to cushion imbalances, such as adjustments to prices
in the factor markets, sufficient labour force and capital mobility, or also, of course, a
stabilityoriented economic and fiscal policy.
Despite a variety of efforts at harmonisation, there are still 19 different sets of economic and
fiscal policy in the euro area. Yet these states are not all necessarily addressing their
respective structural problems in an appropriate manner because EU-level sanctioning
mechanisms are either non-existent or, to put it mildly, being underused. It has also occurred
in the past that, in dealing with their structural issues, governments have fobbed off part of
the negative fallout of national policy measures on the rest of the euro area. Over the course
of the euro crisis, this became clear in connection with sovereign debt.
Other policymaking areas, too, are exposed to the threat that other member states will be
forced to pay the consequences for individual member states' policy errors. The European
Union is consequently increasingly being viewed as a synonym for a lack of will to reform
and as a dumping ground for national risks.
Let me frame the reform problem this way: Europe is facing the challenge of overcoming
obstacles to reform along the route to a sustainable and coherent community order. There is
certainly more than just one solution. The option of reforming the common economic and
financial framework towards stronger European liability, however, is predicated upon
transferring more national sovereignty to the European level. If we look at the discontent
about "ever closer union," it appears as if this option is currently a political non-starter.
However, another way for the European order to ensure synchronicity between actions and
liability for their consequences is that these consequences are borne where the vast majority
of scope for action is located: by national decision-makers. This means that they need to
take responsibility for their actions and have convincing incentives to eliminate the structural
problems.
I would like to illustrate this now by citing two topical areas of financial reform: first, sovereign
debt, and second, European deposit insurance. Both reforms are related to the nexus
between sovereigns and their domestic banks. And, in both cases, as obviously apparent as
the problem is, enthusiasm for reform still remains to be demonstrated.
The excessively close sovereign-bank nexus is a primary example of a factor which can
make sovereign debt a structural problem, as it can engender an unhealthy mutual
interdependence. It is precisely the large stocks of sovereign bonds on the books of domestic
banks which is creating dependencies.
The Bundesbank was one of the first to point out the role of the preferential regulatory
treatment of government bonds as a key aspect of the problem. Banks are currently not
required to set aside any capital against loans to euro-area sovereigns, unlike loans to
enterprises or households. Nor are there any caps or ceilings on their lending to these
borrowers. Banks therefore have, at least in the short term, a huge incentive to invest in
government bonds. Sovereigns likewise benefit over the short term since they can easily
obtain funding through the artificially inflated demand for government bonds - yet at the
same time this lessens the pressure to reform, to consolidate government finances and
achieve debt levels which are sustainable over the long term.
The crisis showed more than clearly that even euro-area government bonds may be exposed
to risk. This is why, in my view, risk-based capital requirements need to be extended to cover
banks' on-balance-sheet lending to sovereigns.
I also believe it still makes sense to limit banks' exposures to individual sovereigns - much
like the large exposure limits for private-sector borrowers. That way, even if these borrowers
were to default, banks would still have enough capital at their disposal.
If the preferential regulatory treatment of sovereign debt were done away with, this would
also increase investors' incentives to take greater account of the differing risk profiles of the
individual states, which in turn would thus strengthen the disciplinary function of capital
markets. Countries that pursue unsustainable policies would then face rising risk premiums.
Where political action needs to be taken is known - however, the EU now needs to
demonstrate that it is, in fact, willing to act.
There is a similar political constellation regarding the topic of deposit protection. Under the
European Commission's current proposal, existing national protection schemes - which are
already operating under standards which have been harmonised across Europe - will
gradually be replaced by a European deposit protection scheme.
Although we have a Single Supervisory Mechanism in Europe under which banks are
supervised according to uniform European guidelines and harmonised rules, as well as a
Single Resolution Mechanism to go with it, the financial situation of the supervised
institutions hinges on the state of the economy, as well as, of course, the legal framework of
the affected country. Insolvency, for instance, is still governed by a patchwork of very
different national regimes. Rushing all too madly to introduce a European deposit insurance
scheme would not only create an unfair situation in which some banks would be more likely
to dig quite deeply into the shared pot; it would also tend to reduce the pressure on member
states to conduct reforms.
Let me once again reiterate the guiding theme of my foregoing remarks: there is an in-built
conflict between short-term relief and the balance between actions and responsibility for their
consequences, and thus also the basis for a rules-based order that can function in the long
run. It is not only at the EU level but also, and in particular, member states where unpleasant
structural reforms have to be undertaken in order to make the EU less vulnerable to crises.
Time is of the essence and, given the challenges we are facing in the EU, should not be
wasted.
4. Conclusion
Ladies and gentlemen,
at this hour, the UK's future in the EU is balanced on a knife edge. We won't have to wait
longer than tomorrow to learn how the UK has voted: whether it wishes to remain a member
of the EU or to leave. However, we should not worry only about the immediate impact of the
referendum - be it "Brexit" or "Bremain". What will be more decisive over the medium to long
term, however, will be to find good solutions to the problem of chronic dissatisfaction with
Europe's institutions. We have to confront the detected deficiencies in a decisive manner.
Europe must demonstrate its ability to conduct credible political reforms.
This task is necessary irrespective of today's referendum in the United Kingdom. Should the
UK vote to leave the EU, however, one thing is certain: Europe's political landscape will be
missing a voice of caution and a proponent of stability and the market economy. That is
something I would highly regret; however, it is my hope that Britain's known penchant for
pragmatism will prevail this evening.
Thanks you very much for coming, and I would now be pleased to join you in a discussion.