As the epicenter of the global financial crisis has migrated from the US financial system in 2008 to the "submerging economies" in Europe, so also has the need for innovative solutions moved from Washington and New York to Paris, Frankfurt, and Berlin. This is appropriate because it was naïve German Landesbankers, irresponsible European real estate lenders, and euro area imbalances that pushed Europe into the acute crisis from which it suffers today. In the United States, the institutional financial and regulatory framework was in place to enable a rapid and innovative management of an unforeseen crisis. The US Treasury and Federal Reserve established a close working relationship between fiscal and monetary authorities to stem the sources of risk and contagion. Now, as European policymakers have belatedly established a functioning pan-European fiscal agent, they are beginning to learn from the US crisis response.
In the United States, starting four years ago, several interventions were implemented in a close collaboration among the Treasury, the Federal Reserve—especially the Federal Reserve Bank of New York (FRBNY)—and the Federal Deposit Insurance Corporation (FDIC). Most famously, in September 2008 the FRBNY provided an $85 billion emergency credit facility to AIG1, despite not being AIG's regulator or having any direct involvement in the insurance industry. Then in November, following the Congressional passage of the Troubled Asset Relief Program (TARP), the US Treasury invested $40 billion of TARP funds in senior preferred AIG stock, which was used to reduce the FRBNY loans. At the same time, the FRBNY provided up to $52.5 billion for two new special purpose vehicles—Maiden Lane II LLC and III LLC—to enable them to purchase securities from AIG.2 In total up to $182 billion was committed in this coordinated effort between the US Treasury (through TARP) and the FRBNY.
AIG was not the only beneficiary of such innovative US governmental collaboration. In January 2009, under the Asset Guarantee Program (AGP), Citibank placed a pool of $301 billion of distressed or illiquid assets in a loss-sharing arrangement with the Treasury (through TARP), the Fed, and the FDIC. The intent was to help stabilize Citigroup, a systemically important financial institution, which faced a potential loss of market confidence because of these asset holdings. Citigroup exited the arrangement in December 2009.
Moreover, in November 2008, the Federal Reserve created the Term Asset-Backed Securities Loan Facility (TALF), under which the FRBNY extended loans of up to $200 billion with a term of up to five years to holders of eligible asset-backed securities.3 Loans provided though TALF have been non-recourse, enabling the borrower to exit by surrendering the collateral. However, as TALF loans were extended for the collateral market value less a haircut, the borrower bore the initial risk of a decline in the value of the security.
The FRBNY also got a commitment from the US Treasury for a 10 percent "first loss credit protection" position up to $20 billion, subsequently reduced to $4.3 billion in June 2010, when the TALF was closed for new loans with $43 billion outstanding,4 with any losses on pledged collateral above that level to be covered by the Federal Reserve.
In other words, in agreeing to set up TALF, the Federal Reserve received an explicit credit guarantee by the US taxpayer through the TARP program, which enabled the central bank to extend loans to thousands of counterparties and take on more credit risk than would otherwise likely have been possible.
In the United States, the crisis was characterized at the beginning by concerns over the lack of individual institutions' regulatory authority. Before the approval of TARP, there was also unease about the lack of Congressional approval for the commitment of public resources. These worries posed obstacles for the expeditious launching of collaborative emergency financial interventions. But in Europe the obstacles were far more profound.
At the beginning of the crisis, the only truly pan-European institution in existence to deal with the financial crisis was the European Central Bank (ECB). No pan-European fiscal authority comparable to the Treasury in the United States existed. Neither was there an FDIC-like deposit insurance scheme. Consequently, policymakers in Europe have had to create entirely new institutions, and their collaborative efforts have only recently become possible.
The European Financial Stability Facility (EFSF), established in May 2010 to act as a fiscal agent for the entire euro area, was a case of collaborative efforts among different governmental institutions in the region. Their innovations were based on models that were implemented earlier in the United States. The July 21 euro area agreement on a new Greek bailout package, and on making the EFSF more flexible, marked a turning point. For the first time, that accord reflected explicit cooperative inter-institutional crisis mitigation efforts between the fledgling euro area fiscal agent, the EFSF, and the ECB.5
In the July 21 Agreement, the EFSF gained the ability to intervene in the euro area secondary government debt markets for the first time. It can do so, however, only on the basis of an ECB analysis "recognizing the existence of exceptional financial market circumstances and risks to financial stability." In other words, the ECB can veto such interventions.
More important, the EFSF can act in the same "insurance capacity" as risk capital ensuring that the ECB will not suffer losses from collateral provided by Greek banks in the central bank's repo-operations. This arrangement is similar to how TARP funds were used to provide first-loss insurance to the Federal Reserve's TALF program in late 2008.
The ECB's statute requires that only "financially sound" counterparties can participate in ECB auctions and liquidity provision—and only against collateral of adequate quality.6 With Greece's credit rating likely to be lowered to "selective default" as a result of the euro area demand for "private sector participation" in the restructuring of Greek government debt, Greek collateral would have been deemed ineligible as collateral by the ECB Governing Board.
To address that problem, euro area leaders agreed on July 21 to provide the ECB with up to €55 billion in "first loss capital guarantees" to protect the integrity of the ECB balance sheet against any credit risk from its continued acceptance of Greek government and guaranteed collateral. Another €20 billion was pledged to recapitalize the Greek banking system, if necessary, to ensure its "financially sound standing" as an ECB counterpart. An additional €35 billion was pledged by euro area leaders as "first loss credit enhancements" to the ECB in case of credit losses on Greek collateral.7 All these steps made this collateral acceptable to the ECB.
Thus, even as euro area leaders ignored the ECB's objections to private sector participation, they provided their central bank with the necessary "fiscal agent" financial protection to enable it to continue its liquidity provision and regular liquidity operations concerning Greece. Functionally, euro area leaders' commitments to the ECB were similar to the US Treasury's commitment of TARP money on a first-loss basis to the Federal Reserve's TALF program8. In both the United States and euro area, the fiscal and monetary authorities cooperated to enable the central bank to implement financial rescues of significant sectors in the economy.9
As the European debt crisis continues, it looks likely that similar examples of sovereign provision of "risk capital" will be required, aimed at enabling the ECB to continue to intervene in a still "fiscally under-institutionalized euro area." One sure outcome of the crisis has therefore been that, even in Europe, the once clear distinction between independent central banks and their sovereign backer(s) has become blurred, even as the financial system has been stabilized.
1. See US Treasury (2010), "Troubled Asset Relief Program: Two Year Retrospective," US Treasury, Washington DC. In return the FRBNY received preferred shares with 79.8 percent of the voting rights of AIG's common stock, which was placed in the FRBNY-controlled "AIG Credit Facility Trust."
2. Maiden Lane II LLC was formed to purchase residential mortgage-backed securities from AIG, while Maiden Lance III LLC was formed to purchase multisector collateralized debt obligations (CDOs) on which the Financial Products group of AIG has written CDS contracts. See Federal Reserve Board.
3. Eligible securities must have received two AAA ratings from the major rating agencies, and none of the major rating agencies can have rated the security below AAA or placed the security on watch for a downgrade. See US Treasury (2010:35), "Troubled Asset Relief Program: Two Year Retrospective," US Treasury, Washington DC.
5. See Euro Area Council Conclusions .
6. See ECB (2011), "The Implementation of Monetary Policy in the Euro Area," ECB, Frankfurt. The ECB in 2010 suspended its regular collateral requirement for Greek collateral and accepted junk-rated collateral. See ECB (2010a). Similar waivers were subsequently given to Irish and Portuguese collateral.
7. See press conference of Jean Claude Trichet after the July 21st Euro group meeting.
8. It is noteworthy and indicative of the political sensitivity in Europe of the mixing of fiscal and monetary policy actors that euro area leaders' commitments to the ECB were not mentioned explicitly in the leaders' Conclusions on July 21st. but instead were discussed only verbally at the press conference of the president of the ECB.
9. In the case of the United States, it was the asset-backed securitization markets that were rescues, while in the euro area, it was geographically the Greek economy.