vitor constancio : the european crisis and the role of the financial system speech by mr vitor constancio, vice - president of the european central bank, at the bank of greece conference on “ the crisis in the euro area ”, athens, 23 may 2013. * * * slides to the presentation can be found on the ecb ’ s website. introduction let me begin by thanking the bank of greece for inviting me to this important conference attended by so many prestigious researchers. there are, of course, several narratives and interpretations about the way the crisis unfolded in the euro area. for some, it is mostly a story of unsound fiscal policies and excessive sovereign debt ; for others, it is principally a story of competitiveness losses engineered by uncontrolled unit labour costs ; and for others still, it is essentially a traditional balance of payments crisis in a “ fully fixed ” exchange rate regime. in more recent years, the narrative of seeing it as a banking crisis has gained attention, combining it with the sovereign debt crisis to create a story of “ two debt overhangs ”. naturally, there is a grain of truth in all these narratives, as is to be expected given the complexity and interplay of factors within a major international crisis. however, more than trying to discuss a cogent overall interpretation of the euro area crisis, i would like to explore two perspectives : • first, what were the root causes and key initial drivers of the crisis? • second, what role did the international financial crisis, originating in the us, play in triggering the european crisis? the first question is important to identify the possible shortcomings in the design of monetary union that need to be corrected to avoid future crises. it is my contention that the main driver of the crisis was located in the financial sector, particularly banks which intermediated large capital flows towards the periphery, creating imbalances that became unsustainable when a sudden stop occurred following the international crisis and the abrupt revision of price of risk that it entailed. the second question is useful to consider whether the construction of monetary union would have been sufficient to ensure a gradual correction of vulnerabilities and avoid a crisis, if a major international shock had not occurred. one can speculate that, left alone, the euro area may have been able to gradually overcome its own vulnerabilities through a process of interregional rebalancing. but we can never be certain about that. fortunately, this

two channels. • first, a number of euro area banks had substantial balance sheet exposures to the us housing market. constancio, v. ( 2005 ) “ european monetary integration and the portuguese case ” in the third ecb central banking conference, published by carsten detken, vitor gaspar, gilles noblet ( editors ) “ the new eu member states : convergence and stability ”, ecb 2005, available in http : / / www. ecb. int / pub / pdf / other / neweumemberstatesen2005en. pdf bis central bankers ’ speeches • second, when the general global re - pricing of risk triggered by the us sub - prime crisis materialised, it had serious adverse consequences for local financial stability in those countries. facing losses on several of their assets, banks were forced to rebalance their portfolios in order to meet regulatory capital standards. they rapidly increased their holdings of “ safe ” government debt, as a rule denominated in domestic currency. this development was especially obvious after the collapse of lehman brothers which triggered an unprecedented flight - to - safety. at the same time, in many euro area jurisdictions public finances were strained to the limit by the recession - induced collapse in tax revenues and by the necessity to recapitalise failing banks. overall, this meant that banks were becoming more exposed to their sovereigns at precisely the moment when sovereign creditworthiness was declining – creating the conditions for the infamous “ bank - sovereign loop ”. … and from banks to real economy the full effects of these developments emerged in 2010 when sovereign debt tensions appeared in countries with large recent increases in public debt and budget deficits, and / or poor long - term growth prospects due to neglected structural reforms. in this way, the general banking crisis developed into fiscal crises in specific european countries, causing severe recessions in those under stress and at some points endangering the stability of the euro area. the way in which this phase of the crisis developed took some observers by surprise, in particular the contagion effects, self - fulfilling cycles and possibility of multiple equilibria. contagion has been demonstrated to exist in the euro area from sovereigns to sovereigns and from sovereigns to banks, in both directions. two recent ecb working papers3 show that contagion also exists among banks themselves and from them to the real economy. in this case, the study demonstrates that the post - 2009 recovery in bank lending in the syndicated