Macroprudential policy in a currency union
The past 20 years in Europe have seen large swings in real and financial markets, and sudden stops of capital flows have exposed the fault lines of the European financial architecture. While the pre-crisis financial architecture centered around mechanisms to contain borrowing by the public-sector, this paper argues that incentives for the private sector to engage in excessive borrowing had not been taken into account adequately. Macroprudential policy is a core element of the post-crisis reform agenda, and it plays a particularly important role in the European monetary union.
KeywordsMonetary union EMU Macroprudential policy Monetary policy
1 The issue
Per capita incomes and levels of productivity in the euro area show a greater degree of dispersion than comparable figures across the US states.1 Does this imply that the euro area as a currency union is inherently flawed? Not necessarily: For a currency union to be sustainable, convergence of per capita incomes is not required. Yet, borrowing needs of the private and the public sector must be at sustainable levels, and they must be aligned with income (Wissenschaftlicher Beirat BMWi 2011).
Debt sustainability matters in a currency union of otherwise sovereign states, just as it does in a system of flexible exchange rates. If debt and income are not aligned, flexible exchange rates adjust, and they can overshoot. Exchange rate misalignment, twin crises, or sudden stop episodes are not confined to systems of flexible exchange rates. Yet, sudden stops within the euro area as a reaction to debt sustainability concerns were not on the radar of policy makers before the crisis.
The institutional design of the euro area acknowledges the decisive role of sustainable debt levels. The Stability and Growth Pact aims at preventing the build-up of unsustainable public debt levels. Prior to the crisis, it lacked at least two essential elements. First, it focused on the role of public debt levels only, thus overlooking that unsustainable levels of debt can also build up in the private sector. Second, no mechanisms were in place on how to deal with crisis situations.
As levels of private debt became unsustainable in some countries, solutions had to be found ad hoc, and governments intervened to bail out private creditors.2 Implicit government guarantees for the financial sector eventually became explicit. The result has been an increase in public debt and a downward spiral of adverse macroeconomic conditions, a sovereign crisis, and a banking crisis (Shambaugh 2012; Schmidt and Weigert 2013).
Against this background, post crisis reforms of the European institutional framework have two objectives. The first is to reduce the probability of future crises. The stability and growth pact has been reformed. The statistical system of reporting fiscal information has been overhauled. Reformed banking regulations, in line with the reforms agreed upon at the G20 level, aim at enhancing the resilience of the financial system. The Banking Union strengthens European supervision of banks under the Single Supervisory Mechanism (SSM).
The second objective has been to improve crisis resolution mechanisms. This includes the European Stability Mechanism (ESM), the introduction of Collective Action Clauses in government bonds, and explicit resolution mechanisms for banks with the Bank Recovery and Resolution Directive (BRRD) and the Single Resolution Mechanism (SRM).
In this paper, we argue that macroprudential policy is a core element of the post crisis reform agenda, and that it plays a particularly important role in the European monetary union which lacks a single sovereign. Focusing on the sustainability of public debt is not enough—mechanisms are needed to safeguard the stability of the financial system. Mechanisms are needed in order to ensure that private credit is sustainable and that the failure to service debt does not pose a threat to the stability of the financial system. Macroprudential policy has exactly that objective: Preventing the build-up of systemic risk, i.e. the risk of destabilizing negative externalities in the financial system, and preventing excessive leverage of the private sector. Macroprudential policy takes a macroeconomic perspective on financial sector health and on resilience. It thus complements monetary policy and microprudential supervision.
While close cross-border coordination of macroprudential policy is needed in a currency union, effective macroprudential policy starts at the national level. Many policies that can affect the stability of financial markets are under the responsibility of domestic policymakers. This includes policies affecting structural weaknesses of financial systems such as high levels of non-performing loans or overcapacities in the banking sector. But the political economy of financial sector reforms can also lead to policy inaction at the domestic level. Strong European institutions are, therefore, needed to overcome inaction bias and to address cross-border spillovers. Generally, establishing mechanisms to contain financial stability risks requires communication, commitment of policy-makers, and an informed public dialogue.
2 Trends in private and public sector debt
2.1 Trends in leverage
Given the importance of banks as intermediaries of private sector credit in Europe, leverage of banks is a major factor contributing to the stability of financial markets. Highly leveraged financial institutions have weaker buffers against shocks and may react to shocks in a pro-cyclical manner. While higher capital in the financial sector does not necessarily reduce the probability of crises occurring, it yet limits the real and fiscal costs of crises (Jorda et al. 2017). Leverage of banks increased during the crisis because losses materialized and wiped out part of the banks’ capital buffers. In countries with high rates of loan growth before the crisis, non-performing loans surged. Post-crisis, leverage has decreased as a result of higher regulatory capital requirements and market pressure. This increases the resilience of banks with regard to future shocks. At the same time, banks often remain more highly leveraged than they have been in historical perspective (Aikman et al. 2018).
2.2 Cross-border capital flows
During the crisis, many countries in Europe experienced a “sudden stop” of cross-border capital flows, necessitating adjustment on domestic factor and product markets to restore external equilibria (Buch et al. 2016). Cross-border capital flows channeled through the banking system have been particularly affected; flows of equity capital and in particular foreign direct investment have been more resilient (Buch et al. 2015). Generally, the degree of cross-border risk sharing remains limited in Europe, and the integration of bank retail markets has not progressed much in the post-crisis period (ECB 2017a, b).
In contrast to debt contracts, equity contracts feature “automatic” risk-sharing mechanisms: investors benefit from positive, upside risks but they can also lose their investments if a negative shock hits. In Europe, reliance on debt finance has fallen post crisis (ECB 2017a). But equity markets in general and venture capital markets in particular remain underdeveloped. Opportunities for cross-border risk-sharing are insufficiently exploited. The Capital Markets Union is a project which addresses constraints on the cross-border movement of (equity) capital; it can allow for more market-based risk-sharing in Europe, and can help to alleviate constraints that currently hamper reallocation in the real and financial sectors and prevent growth dynamics from being set into motion.
3 Post-crisis reforms
3.1 The current setting3
With post crisis reforms and the establishment of the banking union, the institutional set-up of the European and euro area financial sector changed fundamentally in three regards.
First, banking supervision of euro area banks was assigned to the Single Supervisory Mechanism (SSM) within the ECB. The SSM directly supervises systemically important banks of all member countries, while the supervision of less systemically important banks has been delegated to national supervisors.
Second, restructuring and resolution of ailing euro area banks now falls into the remit of the Single Resolution Mechanism (SRM) which can resort to a Single Resolution Fund (SRF) to finance resolution measures. The SRF is funded by a bank levy that varies with bank risk. The SRM addresses the too-big-to-fail subsidy. Its objective is to ensure that losses of failing banks are borne by creditors, not the tax payer. Exit of these banks shall be possible without putting financial stability at risk.
Third, macroprudential policy is a new policy area, which is a shared responsibility between the national and the European level. Almost every member state has a national Financial Stability Council, which is responsible for the implementation of macroprudential policy domestically. Surveillance of European wide financial stability risks is the task of the European Systemic Risk Board (ESRB), an EU body, which can also issue warnings and recommendations addressed to the EU as a whole or to Member States, the European Commission, the European supervisory authorities or national authorities. Importantly, with the creation of the Banking Union, the ECB assumes macroprudential responsibilities in the banking sector alongside national authorities. Unlike national authorities, the ECB can only tighten but not relax national macroprudential measures—for example, to counteract a possible inaction bias at the national level.
In terms of cross-border policy coordination of macroprudential policies, Europe is thus more advanced than other world regions.4 In Europe, policy coordination is particularly important for two reasons. On the one hand, within the Single Market, and absent exchange rate risks, there is a high degree of financial integration, and banks are active across borders (ECB 2017a). On the other hand, national financial markets retain a strong national flavor, not least given the responsibility of national policymakers for core policies affecting financial institutions and markets. Also, different types of financial systems coexist in Europe (ECB 2017b), which affects the vulnerabilities with regard to risks to financial stability.
3.2 First lessons learned5
Examples of bank resolution cases and bail in procedures in European banks
Source: Deutsche Bundesbank (2017)
Banca Monte dei Paschi
Banco Popular Espanol
Venetian banks (Veneto Banca/Banca Populare di Vicenza)
No resolution, precautionary recapitalisation by Italian government1
European Commission approves State aid on 4 July 2017
Resolution in framework of EU law
Single Resolution Board (SRB) identifies “public interest”
Application of the sale of business tool2
Insolvency under national law
SRB does not identify any “public interest” in resolution under EU law3
Liquidation following Italian decree of 25 June 2017
Date of ECB of decision and justification
28 June 2017: Confirmation of solvency: fulfilment of minimum capital requirements under Pillar I as at 31 March 2017
6 June 2017: Failing or likely to fail (FOLTF) due to liquidity position4
23 June 2017: FOLFT due to capital position5
Use of government funds
Italy grants State aid amounting to €5.4 bn in order to close capital shortfall resulting from the adverse scenario of the stress test in 2016
Following approval by the European Commission, Italy grants State aid up to €17 bn in the interest of financial stability in the region
Bail-in of creditors
Write-down of capital instruments
Conversion of subordinated debt into equity
€4.3 bn in total6
Write-down of shares
Conversion and write-down of additional tier 1 (AT1) instruments in the amount of €1.3 bn
Conversion of tier 2 (T2) instruments into shares in the amount of €0.68 bn7
Write-down of capital instruments
Conversion of subordinated debt into equity8
Changing patterns in the pricing of risk can provide indications on the effects of the new resolution frameworks. Abbassi et al. (2018) perform an event study of the evolution of bank CDS prices and stock returns in the context of bank resolution cases in Italy and Spain. Abnormal returns of (highly liquid) CDSs of European senior bank bonds declined right after winding down Banco Popular Español (Fig. 3). Descriptive statistics show no strong impact following the decision to subject the Italian banks to the national insolvency procedure. This could be interpreted as a lack of credibility of the new resolution mechanism. However, an alternative interpretation is equally plausible: markets might have been reassured that the bail-in of senior bond holders has not been required in most resolution cases as the bail-in of junior bonds already sufficed.
Event studies and descriptive statistics do not provide explanations for these observations. Testing whether markets perceive the SRM and the resolution tools as being credible requires a deeper analysis, accounting for confounding factors, and explaining heterogeneity across banks.
Generally though, these examples show that institution building needs time. A structured process of learning from the application of the new rules is needed in order to improve the framework where needed.6 For example, the decision that these banks have reached their point of non-viability—the “failing or likely to fail (FOLTF)” decision7—could possibly have been taken at an earlier stage. Moreover, there remain inconsistencies between the European resolution framework, European state aid rules, and national insolvency laws, which could be addressed. Finally, measures are needed to avoid risks from direct contagion in the banking system which may result from a bail-in of creditors: International rules limit the cross-holdings of bail-in liabilities within the financial sector when calculating Total Loss Absorbing Capacity (TLAC) (FSB 2015). Limits on cross holdings are useful to prevent spill over from the bail-in of bank creditors to other parts of the banking sector. For European banks, there are no restrictions of cross holdings of bail-in liabilities according to the Minimum Requirement for own Funds and Eligible Liabilities (MREL).8
4 Outlook and priorities for macroprudential policy
The past 20 years in Europe have seen large swings on real and financial markets. High growth rates prior to the financial crisis have, in many countries, been fueled by excessive credit growth. Sudden stops of capital flows have exposed the fault lines of the European financial architecture. The pre-crisis financial architecture has centered around mechanisms to contain public-sector borrowing. Incentives to engage in excessive private sector borrowing and—as the flipside—excessive lending have not been taken into account adequately. Mechanisms to manage financial crises were insufficient.
A lot has happened since the crisis. The crisis affected countries in Europe differently, and post crisis adjustment of the real economy has differed. Structural reforms triggered by the reversal of capital flows gradually contributed to better align financial liabilities with underlying fundamentals. Countries most affected by the crisis have reformed markets for goods and labor. Gaps in the institutional framework have been closed with new financial regulation, new institutions in charge of supervising the financial sector, and explicit crisis resolution mechanisms being put into place. Macroprudential policy has been introduced as a new policy field at the domestic level while, at the same time, being closely coordinated across European countries.
Post-crisis reforms include regimes for the recovery and resolution of financial institutions, increased capital buffers that allow institutions to better withstand adverse shocks, and improvements in systems for surveillance of risks in the banking and in the non-bank sectors. These reforms contribute to the resilience of the financial sector and mitigate negative contagion effects.
Despite these achievements, levels of debt remain high. Structural deficiencies in both, the financial and the real sectors remain prevalent. The challenge is to ensure sufficient dynamics that promote growth without threatening financial stability.
Against this background, we see the following priorities for macroprudential policy going forward.
First, many of the trends that affect the financial services industry such as globalization, the rate and nature of technological change, and global macroeconomic developments cannot be influenced directly by national policymakers. It is thus important to ensure that the playing field provides sufficient flexibility for financial sector firms to adjust to exogenous trends, to enable structural change, and to deal with legacy issues. Policies for dealing with non-performing loans facilitate an improved allocation of resources. Insolvency regulation plays an important role in this regard, as does the functioning of the secondary market for assets. In case financial institutions do not meet regulatory requirements, resolution mechanisms need to be applied.
Second, application of the new policies and institutions will provide evidence on their effectiveness and potential need for adjustments. Inefficient procedures at the European level may frustrate experience with the new framework. Some of these issues are currently being addressed by the EU Commission’s macroprudential review.9 Some notification procedures can, for example, be streamlined without sacrificing the objectives of reforms. Also, first applications of the resolution mechanisms indicate room for improvement. At the same time, any modification of the existing framework should be preceeded by a structured impact assessment, which takes social costs and benefits into account.10
Third, macroprudential policy is—at its core—a national responsibility. Domestic policy decisions thus play an important role for the stability of national and, ultimately, European financial systems. In some countries, a key challenge is to deal with non-performing loans on banks’ balance sheets, in other countries, overcapacities in banking systems generate incentives for excessive risk taking. The results may be increased exposure to aggregate risk and limited success with reducing implicit government guarantees.
Effective macroprudential policy is particularly important in a currency union where the degree of financial integration is high and where risks can spill over across borders. This requires strong support at the national level. Domestic policymakers need to engage in a constructive dialogue on the design, objectives, and implementation of macroprudential policy. Communication with domestic stakeholders is an important element of effective macroprudential policy, which goes beyond the activation of designated macroprudential policy instruments.11 Communication needs to be accompanied by teaching, training, and the development of intuitive narratives (Buch 2018). Communication is particularly important when lack of memory of the financial crisis can lead to overconfidence and the belief that “this time will be different” (Reinhart and Rogoff 2009).
While dispersion of real GDP per capita in the euro area hardly changed before the crisis, it has increased markedly after 2007, mainly reflecting the severe recessions in the countries most affected by the crisis. More recently, the increase of real income dispersion seems to have come to a halt (Gros 2018).
See Lane (2012) for a comprehensive account of the European sovereign debt crisis.
For an overview, see the BIS–FSB–IMF report on macroprudential policy frameworks (BIS, FSB, IMF 2016).
For details, see Deutsche Bundesbank (2017).
For an explanation, see EBA (2015).
See Commission Delegated Regulation (EU) 2016/1450 of May 23, 2016.
The Financial Stability Board has published a framework for the evaluation of the post-crisis financial sector reforms http://www.fsb.org/2017/07/framework-for-post-implementation-evaluation-of-the-effects-of-the-g20-financial-regulatory-reforms/.
On the importance of communication for macroprudential policy, see Committee for the Global Financial System (CGFS 2016).
- Abbassi, P., Bichlmeier, F., Falter, A., Mokinski, F. & Weigert, B. (2018). Assessing the credibility of the European resolution framework. Mimeo.Google Scholar
- Aikman, D., Haldane, A., Hinterschweiger, M. & Kapadia, S. (2018). Rethinking financial stability (Working Paper 712). London: Bank of England.Google Scholar
- Bank for International Settlements (BIS). (2018). BIS quarterly statistics on credit to the non-financial sector. Basel.Google Scholar
- Bank for International Settlements (BIS), Financial Stability Board (FSB), International Monetary Fund (IMF). (2016). Report on macroprudential policy frameworks. Basel and Washington.Google Scholar
- Buch, C. M. (2018). Financial literacy and financial stability. Speech prepared for the 5th OECD-GFLEC Global Policy Research Symposium to Advance Financial Literacy, Paris. Frankfurt am Main: Deutsche Bundesbank.Google Scholar
- Buch, C. M., Buchholz, M., Lipponer, A., & Prieto, E. (2016). Liquidity provision, financial vulnerability, and internal adjustment to a sudden stop. Frankfurt am Main: Deutsche Bundesbank.Google Scholar
- Committee on the Global Financial System (CGFS). (2016). Objective-setting and communication of macroprudential policies. (CGFS Papers No 57, Basel).Google Scholar
- Deutsche Bundesbank. (2012). The European Systemic Risk Board: From institutional foundation to credible macroprudential oversight. Monthly report, April, Frankfurt am Main.Google Scholar
- Deutsche Bundesbank. (2014). Launch of the banking union: the Single Supervisory Mechanism in Europe. Monthly report, October, Frankfurt am Main.Google Scholar
- Deutsche Bundesbank. (2017). Financial Stability Review. Frankfurt am Main.Google Scholar
- European Banking Authority (EBA). (2015). Guidelines on the interpretation of the different circumstances when an institution shall be considered as failing or likely to fail under Article 32(6) of Directive 2014/59/EU. EBA/GL/2015/07 London.Google Scholar
- European Central Bank (ECB). (2017a). Report on financial integration in Europe. Frankfurt am Main.Google Scholar
- European Central Bank (ECB). (2017b). Report on financial structures. Frankfurt am Main.Google Scholar
- European Commission (EC). (2013). Communication from the Commission on the application, from 1 August 2013, of State aid rules to support measures in favour of banks in the context of the financial crisis (‘Banking Communication’). Official Journal of the European Union, C216, 1–15.Google Scholar
- Financial Stability Board (FSB). (2015). Principles on loss-absorbing and recapitalisation capacity of G-SIBs in resolution—total loss—absorbing capacity (TLAC) term sheet. Basel.Google Scholar
- Gros, D. (2018). Convergence in the European Union: Inside and outside the euro. Paper prepared for an informal meeting of Economic and Financial Affairs Ministers, 27–28 April 2018, Sofia. Centre for European Policy Studies (CEPS). Brussels.Google Scholar
- Hellwig, M. (2017). Carving out legacy assets: A successful tool for bank restructuring? Preprints of the Max Planck Institute for Research on Collective Goods Bonn 2017/3, Bonn.Google Scholar
- Hellwig, M. (2018). Valuation reports in the context of banking resolution: What are the challenges? (Discussion papers of the Max Planck Institute for Research on Collective Goods Bonn 2018/6, Bonn).Google Scholar
- Jorda, O., Richter, B., Schularick, M., & Taylor, A. M. (2017). Bank capital redux: Solvency, liquidity, and crisis (Working Paper 23287). Cambridge: National Bureau of Economic Research.Google Scholar
- Merler, S. (2018). Bank liquidation in the European Union: Clarification needed Bruegel Policy Contribution Issue no 01. Brussels.Google Scholar
- Reinhart, C. M., & Rogoff, K. S. (2009). This time is different: Eight centuries of financial folly. Princeton University Press.Google Scholar
- Wissenschaftlicher Beirat beim Bundesministerium für Wirtschaft und Technologie. (2011). Realwirtschaftliche Weichenstellungen für einen stabilen Euro. Berlin.Google Scholar