SPEECH
BY MEMBER OF THE BOARD OF GOVERNORS
PER CALLESEN, DANMARKS NATIONALBANK AT
FINANCE DENMARK'S EXECUTIVE CONFERENCE,
3 SEPTEMBER 2018
The European banking union in perspective - is there risk sharing and
3 September 2018
joint liability?
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Thank you for inviting me to speak.
Many of us who are present today had an opportunity to focus on the
economy at the annual meeting of the Association of Local Banks a few
months ago. So I will provide only a brief summary - without any figures.
Instead, my presentation will be about international cooperation and
specifically the European banking sector and the reinforced banking
cooperation, also known as the banking union. I will not cover all aspects of
this topic, but will focus on the issue of risk sharing, i.e. whether some
institutions will be liable for the debts of others.
The main conclusions will be: (1) The economy and financial stability are
still on a steady course. (2) International rule-based cooperation is under
pressure. That gives cause for concern and emphasises the need to
protect the cooperation that exists and that we are able to participate in. (3)
As regards the banking union and the euro area, a clear picture is
emerging - so far and looking ahead - of very limited money transfers between
member states. In other words, there is limited risk sharing and joint
liability. Some Europeans lament this, and there are arguments both for
and against risk sharing, but there are good reasons why the institutions
have been designed as they have.
The economic and financial situation
Four short remarks about the economic and financial situation:
Firstly: The economic recovery has been successful until now. It has been
carefully nurtured with reforms and what we might call macroprudential
nudging. We have avoided a situation where government and parliament
have lost patience. Consumers and investors are spending money earned
rather than borrowed on consumption and investment. And this time
around, banks have been more hesitant to grant risky credits. In short,
we have not seen a fiscal or credit expansion with a resultant boom and
bust cycle this time. We must ensure that this continues.
So, secondly, our imbalances are small. We also have a large current ac-
count surplus. When the economy reverses - as it will, although we do
not know how and when - domestic factors need not trigger a deep
recession. But there are major external risks linked to the procyclical fiscal
boost in the USA, something as old-fashioned as trade restrictions, as
well as weaknesses and, perhaps, experiments in several European
countries and emerging markets.
Thirdly, we have capacity pressures, but so far without inflation. This can
lead to loss of market shares, but we cannot produce more than our
labour resources permit. There are signs that this pressure is affecting
productivity. We must take care, but the situation is not as bad as it was
during the upswings in the mid-1980s and mid-2000s.
Fourthly, times are also good in the financial sector, although risks are
increasing. Far into the upswing, interest rates remain very low, there are
a number of international risks, and there is fierce competition to provide
loans in a low-demand market. It is time for a larger countercyclical
capital buffer. We have a sound real economy with buffers, but there is
limited scope for reducing interest rates and providing fiscal stimuli next time
the economy goes into recession. When that happens, the financial
sector cannot and should not be part of the problem.
International cooperation under pressure
Now I will turn my attention to international cooperation. We are
fortunate to live in an age of rule-based international organisations set up by
a few forward-looking generations that came just before ours.
In the field of economics, the IMF, the World Bank, the WTO, the OECD,
the EU and the euro project should be highlighted. These institutions
have treaties and statutes, governing bodies representing all member
states, voting rules, tools for further development and settlement of
disputes, and courts of law and rulings with equal treatment.
It ought to be self-evident why rule-based cooperation is a good idea for
everyone, and especially for small and medium-sized countries. Unless they
choose isolation, they would otherwise have to approach the largest and
strongest countries one by one, on a case-by-case basis, and then adhere
to the standards set by the largest and strongest countries. Settlement of
disputes would be dependent on the goodwill of the various large
countries.
It requires vision, outlook and a long time horizon for large countries to
commit to rule-based cooperation, as they will have to give up some ac-
tual decision-making power. They have to argue their cases, they may
find themselves in a minority in concrete voting situations, and in legal
dispute resolution the rules apply, not the sizes and short-term interests
of the parties. So why did the large countries choose not only to
participate, but also to lead the way when setting up these institutions?
Presumably it helped a little that binding cooperation is fair and intellectually
satisfactory. But a much more decisive factor has probably been that, in
economic terms, it is far more efficient for everyone, and the alternative is
political chaos, with anarchy, shifting and random alliances and eternal
conflicts, not least between large countries.
Seen from our perspective, as a small country, rule-based cooperation has
to some extent been challenged by institutions with the major powers as
members - such as the G7, G20, FSB (Financial Stability Board) and Basel
Committee - for they do not operate with treaty rules and equal treatment,
and furthermore we are not invited to join them. On the other hand, they
are more concerned with coordination and advice rather than direct
decision-making. The EU and the ECB sit at the table and serve as buffers in
relation to implementation. And perhaps it is just as well that the largest
countries meet up in smaller forums and have an opportunity to avoid
frustrations they may have in the rule-based institutions where they need to
negotiate with many other large and small countries.
It is more serious if large countries withdraw from existing agreements,
prevent the rule-based institutions from working efficiently or go solo
and test the limits of or act in direct contravention of the written or
unwritten rules of the institutions. Or if medium-sized and small countries
individually get the notion that they will be able to decide more
themselves by withdrawing from the institutions. In this case they face a
difficult choice. Either they must follow the rules laid down by others -
without having any influence on them. Or they must accept the loss of
prosperity and the hassle imposed on the government, businesses and
citizens from opting for isolation and their own rules, plus harvest possible
windfalls that may come in the form of bilateral agreements.
Unfortunately, there are topical examples of both situations, and in some countries
there is pressure to follow suit. This also poses a risk to Danish prosperity
and influence. It is important to keep the value of broad international co-
operation in mind, also when focusing (more narrowly) on issues such as
the banking union, and the implications if Denmark at some point
decides to join it.
The development of the banking union
The banking union is not fully developed and is not likely ever to be. There
will always be new issues and proposals to consider. But the largest and
most important pieces have fallen into place with the Single Supervisory
Mechanism and the Single Resolution Board, both of which are
functioning.
The participants are currently discussing the collaboration under the
heading of "risk reduction and risk sharing. The heading is not
wellchosen, as it gives an impression of a "quid pro quo" mindset. In reality,
the "discussion" comprises a number of elements that are all
wellfounded, also when viewed separately.
The discussion has been organised, e.g. via the development of a set of
indicators for the soundness of the banking sector. These may be of
separate interest, but will also be used as criteria for the development of the
potential European Deposit Insurance Scheme, EDIS - which I will return
to later.
Risk reduction
As in this country, banks in the rest of Europe are also benefiting from the
stronger economy and the efforts to clear up the mess left by the crisis.
Return on equity has risen despite a slightly depressed interest margin,
but with considerable variation between member states. The German
banks stand out with relatively low earnings. There has been
consolidation within the sector, as also seen in Denmark.
The European banks are better capitalised. This is because they hold
more capital, but also because their risk weights have fallen. (This reflects
an improved cyclical position and better credit management, but also the
discontinuation of weak banks and divestment of non-performing loans.)
Liabilities are also being issued to meet the MREL (Minimum Requirement
for own funds and Eligible Liabilities). Observance of the MREL is to
ensure that eligible liabilities can be written down or converted into equity
in a reasonably orderly manner if the institution is failing and is
systemically important. In that case, it must be recapitalised and continued in a
new form. It will take some years before the MREL is fully built up. In
Denmark we have also begun to build up MREL funds, although no MREL
requirement yet applies to mortgage banks, as you will know.
As regards liquidity, it has been agreed to apply the two liquidity ratios,
LCR and NSFR1, as indicators.
The LCR has, on average, increased considerably in most member states,
and the distance to the 100 per cent requirement is increasing. The NSFR
requirements are also generally met.
The spread in the share of non-performing loans has been a significant
barrier in relation to encouraging the economically strong member states
to engage in more risk sharing. In terms of legislation and practise, the
ability and willingness of member states to realise the underlying assets
and collateral pledged for non-performing loans, e.g. in the form of
enforced sale, also differ. This is to a considerable extent politically or
culturally motivated. The volume of non-performing loans has fallen in most
member states, and they have to a larger extent been taken into account
in the banks' financial statements, e.g. in the form of impairment charges.
All in all, the indicators show a clear improvement in the banks'
soundness. As regards capital adequacy and liquidity, the EU requirements are
generally met. The situation in relation to non-performing loans is im-
proving, but further improvements are required in some member states.
Risk sharing in perspective
What is more important than current indicators of banks' soundness -
which may change - is the ability to understand and interpret the
institutions that are already or may at some point be involved in risk sharing
between banks and government finances across member states. An
insurance element of this kind may be useful when handling specific crises
as it may reduce spillover effects between banks in crisis-ridden member
states. And it can reduce interdependence between banks and the
governments of their home countries. On the other hand, it may seem unfair
and may even increase institutions' risk appetite if taxpayers or banks in
other member states are liable for the consequences of decisions and
risk-taking beyond their control.
Both views can be justified. But it is a fact that the decisions made within
the union show a strong aversion to risk-sharing and to some
participants - banks or sovereign states - being liable for incidents or decisions
made in other member states. This can be illustrated from four different
angles.
My first example is the loan programmes for crisis-ridden member states
from the IMF2 and the ESM3. Especially the Greek programme has been in
focus in recent years. These loans are intergovernmental and extend far
beyond the banks, but they are, in principle, interesting in relation to
understanding the dominant European mindset that applies, also in the
banking union. That is why I will elaborate a little on this issue. My point is
that the programmes consist of loans and liquidity support, subject to
specific terms and conditions. They have involved neither direct nor indirect
fiscal transfers. Today these programmes are seen as a success, although
the picture of a Greek recovery is still somewhat blurred, which is hardly
surprising. After all, it took several decades before Denmark had fully
recovered from the situation in the early 1980s, when the economic
challenges in some respects resembled those faced by Greece today.
The debts of Greece have been written down, but only for private-sector
creditors. The interest terms have been very accommodative and Greece
annually saves several per cent of GDP on its government interest
payments. For example, Portugal's interest expenses are higher, even though
its debt is lower. But the interest rate has not been lower than that at
which the IMF and ESM have been able to borrow in the market. The
principals of the loans have not been reduced. Instalments and interest
payments have been postponed considerably, but have not been written
down. There has been a reduction in the margin lenders add to their
financing costs, and there is a possibility that the ECB will waive its profit
on market purchases of Greek government bonds, but again there have
not been any fiscal transfers from other member states.
In the international press, increased write-down of debt, also to other
governments, has been called for. But write-down of government lending
is a fiscal transfer, and there are good reasons why this has not taken
place. In that situation, taxpayers in the lender states would feel that they
were bearing the costs of decisions made in borrower states - decisions
that they could not influence. This would provide a basis for political
conflicts in and between member states. Taxpayers and the government of the
borrower state would have a joint incentive to ease fiscal plans if others
were ultimately to foot the bill. And it may be difficult to raise government
loans for other crisis-ridden member states in future if they can
subsequently be converted into income transfers.
Fiscal transfers can be perceived as "taxation without representation".
And there is a legitimate need for member states to be allowed to test
their own policies and hence also to bear the consequences. A balance is
struck because there is a common fiscal framework which is discussed on
an ongoing basis. The rules are politically rather than legally binding. Can
it be simplified? It is doubtful. Does it work? Yes, when member states use
it as support for sound policies rather than making it a scapegoat. So it
solves some, but not all, problems. Nor can the banking union be
expected to solve all problems.
Backstoppers are the assistance programmes that impose strict
conditions on the borrowers. This will always be controversial, but the
requirements are milder than the conditions and interest rates that a
crisisridden member state may obtain on market terms.
Another example is the crisis management of individual banks in recent
years, e.g. in Italy and Spain. It should be remembered that although the
BRRD/SRMR4 rules apply, the build-up of MREL funds has by no means
been completed yet. In the most controversial cases, the EU institutions
assessed that the banks concerned were not systemically important in a
Community context, and the further management of these banks was left
to the national authorities. Those authorities then insisted that the banks
had regional systemic importance and obtained the approval of the
European Commission for measures with an element of state aid that does, to
some extent, distort competition. If this indicates a flaw in the system, it
lies not in the banking union but in the general EU rules on state aid,
which might be criticised for not having been brought in line with the
BRRD. However, there has not been any talk about using shared funds in
connection with crisis management by e.g. the SRF. The measures taken
have been at the expense of the relevant member state itself.
A third example is contributions from the SRF, the Single Resolution Fund
financed by the banks. They are incredibly well protected. SRF funds can
be used only after bail-in of the equivalent of 8 per cent of the liabilities
of a failing bank. This typically corresponds to 25 per cent of the
riskweighted assets. Calculations show that during the crisis period after
2008 only one systemically important European bank had losses
exceeding this threshold. Furthermore, contributions from the SRF may not
exceed 5 per cent of the bank's liabilities, and it is a receivable claim, not an
income transfer.
This structure is a result of a more fundamental shift (with the BRRD) in
the approach to financial regulation after the financial crisis, to the effect
that crisis resolution of failing banks should take place using owner and
creditor funds. This shift may initially have been aimed at preventing the
use of government funds, but it has also significantly reduced the
opportunity to use funds collected from other banks. In other words, the
crossborder insurance element has been overtaken by a healthier crisis
resolution model.
The fourth example is the EDIS, in relation to which negotiations have
been slow. In objective terms, there is a good case for a single deposit
insurance scheme in a banking union. The risks of national banks are
continuously affected by national conditions, but with single supervisory and
resolution mechanisms it is natural also to have a single deposit
insurance scheme. But supporters and opponents seem to exaggerate the
respective pros and cons of such a scheme.
Possibly a single deposit insurance scheme will have a stabilising psycho-
logical effect on the depositors of potentially failing banks. But people
tend to overlook the fact that creditor legislation has been amended so
that deposits in general and covered deposits in particular rank first in
the creditor hierarchy. So the Deposit Guarantee Fund can be invoked
only after extremely large losses in a bank, including loss of all senior
debt and uninsured deposits. Hence, the relevance of EDIS is linked to
banks funded almost exclusively by deposits covered by a deposit
guarantee. We should also note that the ECB in the spring published an
interesting analysis5 showing that even far deeper crises than the one in
200809 would not be able to deplete a fully phased-in deposit insurance fund
of 0.8 per cent of covered deposits. Underlying reasons include the credi-
tor preference for deposits and the build-up of MREL funds. Overall, the
system has now been structured in such a way that deposit insurance
schemes - be they national or European - will in practice play a very
limited role in the resolution of failing banks.
Concluding remarks about the banking union
There are a number of other, strong, arguments in favour of participating
in the banking union, including: further development of the single market
with more competition, for the benefit of consumers and firms at home
and the ability of banks to operate in other member states. Stronger
supervisory powers in terms of capacity, depth, methods and the
opportunity to take a broader perspective. Better management of cross-border
financial activities. Greater credibility in relation to the bail-in rules, and
greater certainty that failing banks will be treated in the same way. And
like all other international cooperation for a small country: influence on
rules and practices that must, in effect, be observed in any case - includ-
ing having a spokesperson in institutions such as Basel and the FSB,
where we are not invited to sit at the table ourselves. And after all, the
vast majority of Danish banks are of a size which would place them under
direct Danish supervision, also in a banking union. But based on the
single supervisory practice - which has its advantages.
As you will have understood, the insurance element is not at the core of
the banking union. An insurance element does exist for use in extreme
situations with failing banks, but otherwise its role will be very limited. So
the insurance element and its counterpart - fear of liability for problems
incurred by banks in other member states - are neither key arguments for
participating in nor remaining outside the banking union.
I am not claiming that transfers between the EU member states do not
and should not exist. Transfers have taken place for many years, via the
EU budget, and the amounts are considerable. Several member states
receive up to 3 per cent of their GDP on the basis of a number of
objective and structural criteria. So it would not be new or exceptional if other
elements of the cooperation were also to include such transfers. But
neither the euro project nor the banking union have involved or envisage
transfers between member states to any substantial degree. And in
practice, the institutions are systematically designed to minimise the likeli-
hood of such transfers. That will probably characterise also future
developments within this area.