The EU finance ministers met on March 30th and March 31st and—as predicted here—agreed to increase the euro area "firewall" in accordance with the expressed wishes of the G-20. Despite the press focus on the firewall's size, however, this step was not the most important item on their agenda to achieve the longer term stability of the euro area. Far more important was the ministers' discussion of a pan-European banking resolution framework.
Bear in mind that whatever the euro area decides will disappoint many financial market and media analysts.1 This group consistently looks for a risk-free outlook and assurances that investors will always be bailed out. As a result, anything short of a firewall that could cover the entire financing arrangements for Greece, Portugal, Ireland Spain, Belgium, and Italy lasting three years is inadequate and a sign that the euro area does not get it. (Three years is the usual length of an International Monetary Fund standby arrangement, typically estimated at least €1.5 trillion.)
Whether the firewall to be established is €500 billion, €700 billion, or €1.5 trillion, calls for ever larger amounts are based on an erroneous assumption of bottomless pockets for the core euro area pockets. They assume that Berlin and other northern European capitals have the capacity to guarantee all euro area debt. That of course is not the case in the real world. More importantly, however, these demands overlook the euro area's pooled sovereignty and lack of a centralized political authority. On matters of fiscal policy, the 17 national parliaments still have the final say in the euro area.
No matter what financial markets focus on, the overarching political concern in the euro area remains political moral hazard, i.e., the fear that a party takes on undue risks after a transaction has taken place, because its costs are now borne by someone else. Political moral hazard can be understood as the fear in one country that the politicians elected in another will not take full financial responsibility for the consequences of their actions. As long as the euro area does not have a single central political authority, these concerns will persist because of nationally rooted democratic legitimacy issues. German taxpayers, for example, elect only the German government, and they have no direct democratic influence over who forms the government in Rome or Madrid. Firewalls that would credibly offer full protection from contagion and from bad decisions made by the protected governments suffer from fundamental democratic illegitimacy. That they have proven impossible to erect in the euro area should not only be unsurprising but applauded.
Notwithstanding the euro area's political concerns about moral hazard, the recent bailouts have been approved by overwhelming majorities in the German Bundestag and elsewhere. Incorporating last week's announcements, the total potential German exposure has risen to €280 billion. The equivalent for the United States, which has a GDP about 4.4 times that of Germany, would be more than $1.6 trillion. Keep in mind that this rescue was not directed at Germany's own banks or consumers (as was arguably the case with East Germany after reunification), but other euro area members and their banks.
Germany obviously derives huge benefits from the euro area, but this is more than twice the scale of the Troubled Asset Relief Program (TARP), which is despised by many American voters, and more than 50 times the $20 billion contribution (about $29 billion in 2012 dollars) to Mexico in 1995 by the Clinton Administration, drawn from the Exchange Stabilization Fund (ESF). The US Treasury tapped that emergency fund because the US Congress would not approve it.2 In other words, while concerns over political moral hazard remain critical in the euro area, they are below the levels in other parts of the world. That fact, more than anything, should serve as a barometer for the political commitment to the euro.
Still, Europe, one of the richest regions in the world, should be expected to contribute the overwhelming majority of financial resources toward its own economic stabilization. Anything else would be a travesty. How much have the euro area and the rest of the European Union agreed to contribute? As usual, estimates are difficult because of the complex European institutional framework. The term "firewall" covers at least three different concepts—the totally deployed firewall (e.g., what money has been spent to date); the forward-looking firewall (how much money remains available); and the total deployed and deployable firewall (how much money could potentially end up being spent in total). Table 1 breaks down what the euro area has now agreed to do.
|Table 1 The euro area firewall (billions of euros)
|Deployed firewall to date
|EFSF component of Greek, Portuguese, and Irish IMF programs
|Euro area bilateral loans to Greece
|Forward looking firewall
|ESM paid-in capital
|ESM lending capacity (1)
|Remaining EFSF lending Capacity
|Total deployed and deployable firewall
|(1) The ESM Treaty Article 41 states that the ESM must maintain a minimum 15 percent capital up to the point where €500 billion in lending capacity is reached.
|EFSF = European Financial Stability Facility
EFSM =European Financial Stabilization Mechanism
ESM = European Stability Mechanism
So far, EU governments have committed €294 billion towards bailing out Greece, Ireland, and Portugal. In their statement on March 30th, the euro group committed itself to disbursing up to an additional €500 billion, although the full extra amount will only be available during the first half of 2013. (The European Financial Stability Mechanism, or EFSM, is guaranteed by all 27 member states, while some non-euro area members have also contributed bilaterally to the bailout of Ireland.) The euro area has also stated that "the payment of the capital will be further accelerated if needed," suggesting that in an emergency, the full €500 billion in new lending capacity would be made available immediately.
Is this commitment sufficient to solicit a continued International Monetary Fund (IMF) participation in euro area rescues, as well as new commitments from other G-20 nations for more resources to the IMF by late April? Judging from initial reactions from key G-20 constituents, the indications seem to be yes. The US Treasury stated, for example, that "the announcement by the Eurogroup reinforces a trajectory of positive efforts to strengthen confidence in the euro area. Over the last several months, European leaders have made significant progress in addressing the crisis, and we welcome their unequivocal commitment to reinforcing their currency union."
The Obama administration has played a key role in extracting an additional €200 billion in capital junior to any IMF (and thus US) bailout contributions from the euro area. Now the administration might not want to the run the risk to investor confidence of another big public fight with Europe during the US election season. The Chinese leadership—heading into its own transition later in 2012 with an eye on Chinese exports and a desire to avoid another decline in the euro/renminbi exchange rate—might also take a conciliatory political approach. The logic of cooperation extends to Japan as well. The only G-7 opposition to an expansion of IMF resources later this month might come from Canada, which would not be sufficient to block it.
The BRICS group (Brazil, Russia, India, China, South Africa) and other emerging markets will still likely try to extract additional voting influence at the IMF/World Bank in return for their capital commitments to ensure that these organizations remain governed on a "pay to play" basis. The biggest risk is that the decision on IMF resources may be postponed to the G-20 Summit in Mexico in June.
As for the more important issues discussed in Copenhagen, the six-month Danish EU Presidency restated its aim to achieve a common European bank resolution framework. Perhaps 80 percent of all credit intermediation in the euro area occurs through the banking system. Thus the issue of euro area banks deemed to Too Big to Fail (TBTF) is practically unavoidable. Robust banking resolution rules are thus critical for euro area longer-term stability. It will probably be impossible to completely sever the umbilical cord between euro area banks and their sovereigns. Resolution rules serve as the most critical instrument to reduce future potential financial and fiscal instability.
While nothing concrete was adopted on the issue in Copenhagen, and the EU Commission plans to produce legislative proposals before June, several important messages crystalized. First, a pan-European banking resolution scheme is the strong desire of EU finance ministers (although this lofty goal has been stated before). More important, this goal was framed in a discussion of bail-ins, resolution funds, and concerns over moral hazard and taxpayer money.
As discussed also in the EU Commission's recent communication on bank crisis resolution, the intent of an investor bail-in is to stabilize a failing financial institution without the need to commit public funds. The bank would be recapitalized through the writing down of the claims of private creditors, enabling the institution to continue essential retail customer services, while regulators reorganize it, sell it off or wind down parts of its business. Bail-ins here would be calibrated to impose losses first on shareholders but also on bank bondholders, while aiming to protect deposits, client assets, and other claims.
The ability to bail-in some types of euro area bank bond holders in the future seems on the table, and the principal discussion seems to be about whether or not it is to be mandatory. It was comforting to hear from European Central Bank (ECB) vice president Vitor Constancio at the press conference that the ECB is not opposed to such bail-ins provided that "objective triggers" are stipulated in the legislation and that the use of bail-ins not be left to the discretion of national regulators. The ECB seems to favor a more mandatory approach. Considering how the ECB blocked the bail-in of most of the bond holders in Irish banks 2010 (with large costs for Irish taxpayers), this stance suggests increasing ECB flexibility on this important issue.
The discussion of bank resolution funds was similarly encouraging. Constancio stated that the ECB favors a European level solution, which was also supported by ECB Executive Member (and until recently, German State Secretary for Finance) Jörg Asmussen. In separate comments, Asmussen called for "the setting up of a special fund for bank resolution at the euro area level, accompanied by the establishment of a joint supervisory and resolution regime." The euro area thus seems intent on addressing a deficiency in its institutional structure—namely, the lack of an integrated banking sector resolution authority and supervision. The precise demarcation of "European level solution" remains somewhat unclear. Lots of banking regulations are covered by internal market regulation and therefore these cover all 27 member states and notably the United Kingdom. On banking regulation, what is possible at the EU-27 level and what is possible at the euro area level will prove a tough political nut to crack. The new European Systemic Risk Board (ESRB) headed by the ECB president, Mario Draghi, also favors a relatively flexible macro-prudential framework for EU capital requirement legislation.3 In other words, member states should (in coordination with the rest of the euro area/EU) be free to choose higher national capital requirements. Hopefully the EU Commission's upcoming proposals will incorporate these ideas.
It is clear that in the longer run, at least, the European banks will be expected to pay for any resolution funds, whether at the national or European level. What we heard in Copenhagen suggests additional future costs for the European financial sector. Assuming that more types of European bank bondholders may have to accept haircuts in the future, this will add to the funding costs for the sector. In total, European governments seem increasingly intent on meting out pain to their banking sectors.
The political dynamics are driven by the realization that no agreement will be found on a European or even euro area Financial Transaction Tax (FTT). EU politicians therefore feel they have a need to reassure their restless electorates that they are being tough on the banks in other ways. Increased capital requirements, the prospects for more write-downs for bank bond holders, and the need to finance resolution funds all amount to a more productive pain for European banks than a non-globally implemented FTT. The apparent acceptance of sacrifice by the European banking sector of at least the bail-in issue—which was also highlighted by Vitor Constancio in Copenhagen—might indicate an acceptance in the European financial industry of this lesser evil.
Lastly, were the European Union to adopt a new banking resolution framework, the Irish government's case to renegotiate its expensive banking sector bail-out would improve. For the euro area and the ECB to insist that Irish taxpayers bear the full cost of paying off the majority of its private bank bondholders would be untenable, especially if they are changing the EU regulatory framework to prevent such outcomes in the future. As a result, any solution for Ireland in the form of an EFSF refinancing of the country's National Asset Management Agency (NAMA) promissory notes will be politically timed with the announcement of a new European banking resolution framework. But whether this can be achieved before the Irish referendum on May 31 is questionable.
It is early. But after so many bungled interventions, regulatory failures, and taxpayer funds wasted, Europe seems more intent than ever on finally doing something right and constructive about its banking sector.
1. See for instance http://www.ft.com/cms/s/0/8a784232-7a53-11e1-839f-00144feab49a.html.
2. The IMF contribution to the Mexican bailout was $17.8 billion, almost as large as the US bilateral contribution of $20 billion. Canada also contributed $1 billion and the Bank for International Settlements (BIS) $10 billion for a total of almost $50 billion. Ironically, considering recent events in the euro area, at the time European officials were very upset about the scale of the IMF intervention at $17.8 billion. See http://www.imf.org/external/pubs/ft/history/2012/pdf/c10.pdf.
3. See the ESRB letter to the EU Commission and EU Parliament from April 2, 2012.