luis m linde : “ the new hegemon or last country still standing ” speech by mr luis m linde, governor of the bank of spain, at the frankfurt finance summit 2014, panel iv : the new hegemon or last country still standing, frankfurt am main, 20 may 2014. * * * as a result of the crisis, the institutional and intellectual setup of european monetary union is being deeply revised. fresh views on the role of stability across several dimensions – including fiscal and macro - financial – have emerged and taken over the old approach of the maastricht treaty. several players, including, indeed, the ecb, are contributing to this overhaul. i would like to review the main elements of the old institutional setup, the weaknesses revealed by the crisis and the way a reinforced culture of stability is contributing to their repair. the monetary union designed in maastricht included, in addition to the ecb and the single monetary policy, a relatively loose governance framework for the euro area based, first, on a fiscal discipline device – the stability and growth pact – and, second, on coordination for the remaining economic policies – the broad economic policy guidelines –. the setup also relied on governments, households and firms being able to internalise the stability patterns required within a monetary union and counted on financial markets penalising those who would not do so. what we observed before the crisis, and what we became painfully aware of when it erupted was, however, that public and private agents in some countries did not change their behaviour, that financial markets did not play any disciplining role and that the loose application of the stability and growth pact and the broad economic policy guidelines rendered them ineffective as stabilisation devices. the pact and the guidelines were not strong enough to prevent the accumulation of a series of imbalances. we also discovered two other gaps during the crisis : too little attention had been paid to how financial markets work within a monetary union and no crisis management mechanism was available. to be stable, the european building needed operational repairs. the stability principles, as conceived in maastricht, were insufficient and a new culture of stability had to take over. the ecb acted on several occasions to curb the so - called “ tail risks ” – the risk of the monetary union breaking up – and to gain the time needed for others ’ actions to bear fruit. it is worth noting, however, that monetary action can hardly go beyond this as the cracks detected in the building were

the latent risk ) and at the end of 2001 it stands at 27 %. at current rates, the statistical fund will reach its peak at the end of 2004. as far as the cyclical behaviour of banks, it is too soon to say, but we tend to think that the anti - cyclical nature of the statistical provision is influencing bank behaviour. i must confess that gaining acceptance among banking institutions for our new provisioning scheme was not easy. banks were reluctant to see their bottom line profits indented, arguing that the spanish provisioning system was already demanding ( tight asset classification rules plus on - site monitoring and enforcement by bank of spain inspectors, not to mention high solvency ratios by international standards ). apart from banks ’ initial, and understandable, criticism, some other voices have been raised, although not very loudly, against dynamic provisioning. some of them can be readily refuted. others merit careful discussion because the alternatives they propose may affect financial stability. the most obvious criticism is that a system of dynamic provisioning smoothes bank profits. it is true that the statistical provision tends to smooth profits over the course of the cycle. but it is no less true that the current ex post provisioning system ( i. e. setting aside a specific provision when the impaired asset appears ) artificially increases the volatility of banks ’ profits. and what is more important, this increased volatility in the latter case has less to do with economic fundamentals ( i. e. expected losses ) than with accounting rules. if expected losses appear from the beginning of the operation, banks should start to provision them at the very outset. this means an increase in provisions and a decline in bank profits during expansionary periods, just when credit risk expands the most. when the downturn arrived and expected losses turn into real losses, the impact of provisions on profits would be lower since a significant amount of the expected loss had been previously acknowledged. to the extent that the extra volatility of bank profits is the result of an insufficient recognition of expected losses, dynamic provisioning only restores part of the distortion created. from a prudential point of view, it is clear that dynamic provisioning limits dangerous capital erosions in times of plenty, requiring banks to provision expected losses and avoid paying out dividends ( remember the insurance case ). some observers mention that there is no need for ex ante provisioning since future margin income is enough to cover expected losses. for supervisors, however,