EU financial market reforms: towards stronger euro
(Part IV)
In the fourth article on the analysis of the European economic and financial crisis, the attention is devoted to the reforms concerning the eurozone states. These reforms have some specific features as the eurozone states are tight by more stringent than other EU member states rules. So-called Maastricht criteria required these states impose additional efforts to keep the budget deficit and public debt in order. However, several eurozone states violated the rules, the fact that aggravated the running crisis. The EU efforts during 2008-11 tried to remedy the situation; most urgent measures were taken in the beginning of 2011.
Since January 2011, the eurozone “block” in the Union is comprised of 17 member states, including such great powers as Germany, France, Holland and Italy. Among the “regular” EU-10 there are “big players” too, e.g. the UK, Sweden, Denmark and Poland. But the eurozone-17 greatly overstretches in economic growth the rest of the Union both by population (330 mln out of total 500 mln, and more than 75% in EU's GDP). Hence, the EU's persistent attention to the stable common currency and efficient reforms among the eurozone states. Generally, these reforms are having very much to do with all other EU member states, as the requirements presupposes that all the EU members (except the UK, Sweden and Denmark) would make it for the eurozone, sooner or later.
Another aspect is that reforms and stringent regulations in the eurozone (so-called “economic governance”) somehow affect the economic development in the other EU member states, the fact that provided grounds to talk about “two-speed” development in European Union.
New supervisory authorities
In November 2010 the European Council decided to create a new European financial framework system and new supervisory authorities. The reform also involved a reorganisation of macro- and micro-prudential supervisory authorities. It was aimed to provide more stringent risk surveillance both in the system as a whole and in individual financial services. This is in line with the plan of the Hungarian Presidency, which is to promote the establishment of a framework system for crisis prevention and management, which is vital for the stable workings of financial markets and can contribute to the sharing of burdens in crisis situations.
According to the decision, a new body, the European Systemic Risk Board was set up in Frankfurt on 16 December 2010. It is responsible for overseeing the operation of the European finances at a macro level. Managed by Jean-Claude Trichet, President of the European Central Bank, the Board will be monitoring any system-level risk and identify any situation which requires a rapid intervention.
From 1 January 2011, three new European financial supervisory authorities have emerged: the European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority. These bodies will overlook the financial markets of the EU member states, in particular those of the eurozone, states with more coordination and more severance than before. In parallel, the three new European watchdogs and the European System of Financial Supervisors (ESFS), comprising member state supervisory bodies, will provide micro level surveillance.
The European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and the European Securities and Markets Authority (ESMA) will replace the previous EU committees responsible for financial market services, having had only consultative competences. The newly established organisations will have broader room for maneuvering. For instance, they may investigate alleged breaches of EU law and, in certain circumstances, may call on national authorities to eliminate regulatory deficiencies. As a part of their coordination tasks, they may in emergency situations adopt individual decisions requiring the competent authorities to take the necessary measures. In essence, the three authorities will be responsible for safeguarding the harmonisation of national regulations, but they may also contribute to the improvement of European regulations. The aims of ESMA include, for example, the introduction of a standard European insurance statute, and EBA will be responsible for developing the European rules of banking, payment and electronic payment services.
At the same time, Michel Barnier, EU Commissioner for Internal Market and Financial Services, emphasised that the EU does not intend to replace the national authorities with European level institutions. The aim of the EU, he argued, was to create a network of authorities, where the national bodies would be responsible for the daily surveillance, and the European authorities (using the expertise of the national institutions) would be responsible for coordination, monitoring and arbitration between national authorities (if needed). In this way the EU would contribute to the harmonisation of technical rules applicable to financial institutions in Europe.
Coordinating banks' operation
The Commission's idea is that European banks must be subject to coordinated scrutiny. The International Monetary Fund (IMF) already in May 2009 requested that EU should follow the US's example in conducting “stress tests” on individual and most problematic banks. The IMF warned that economic recovery in Europe – expected to start in 2010-11 – depended on bolder, more forceful and coordinated policy actions, with adequate public support. Hence, the EU banks have been facing a strong challenge, i.e. to clean up the banking system and install their recapitalisation as most essential steps in restoring trust in the financial system.
The EU, being the most economically integrated market economy in the world had not elaboarted adequate regional policies to eleminate crisis. It is both evident and disturbing that most measures to address the EU crisis had been undertaken at national levels. Though in 2010, the situtaion changed: the IMF and the EU joined the member states' efforts.
Financial sector needs more concerted actions by policymakers in order to restore market trust and confidence, argued Marek Belka, director of the IMF's European department and a former Polish prime minister. He called on banks and regulators to identify, quantify and ringfence toxic assets and to recapitalise through the private sector, though strong public support was needed, he argued (1).
Important impetus towards EU management efforts produced the de Larosiere group report on EU financial supervision. In October 2008, Commission President Jose Manuel Barroso mandated Jacques de Larosiere, former Managing Director of the International Monetary Fund and former Governor of the French Central Bank, to chair an independent high-level expert group on the future of EU financial supervision. The Group published its recommendations on 25 th of February 2009 (2).
Some member states followed the recommendations. For example, the German government adopted a decision (13 May 2009) endorsing national plan to rid the country's banks of their toxic assets, the move of tackling the crisis of confidence in Europe's largest economy. However the IMF said it was essential for the stress tests to be co-ordinated and that the EU lacked pro-active Europe-wide measures by the Union's institutions.
IMF called on the London-based Committee of European Banking Supervisors to set common parameters for national regulators in Europe to avoid the risk of competitive distortion. The requirement was based on the fact that Europe being the most economically integrated market economy in the world, which has not had the policies to address the crisis at the member states' level. The IMF acknowledged that certain crisis measures, such as bank deposit insurance schemes, regulatory and supervisory actions, had been unhelpfully diverse. So, the main issue was l ack of coordination.
Responding to the IMF messege, Europe's financial regulators and central banks have been carrying out “stress tests” on 19 national banks (however, both the criteria used in the EU and their outcome would not be disclosed publicly, nor would the balance sheets of individual institutions be examined). However, many bankers and investors believed full public disclosure was necessary to restore market confidence in financial institutions.
EU regulators saw the task of cleaning up the “toxic asset” problem as the most effective way of restoring confidence in the banking sector and restoring credit flows to pre-crisis levels. Many European banks have been reluctant to acknowledge that they were likely to need extra recapitalisation measures in the future.
“World Economic Outlook” repeated in October its April 2010 forecasts that Europe's advanced countries expected GDP contraction of 4 per cent in 2010 with the beginnings of recovery only in start of 2011. On monetary policy, the IMF saw little scope for further interest rate cuts following the European Central Bank's cut in 2010 to 1 per cent from 1.25 per cent.
Some experts say that unconventional measures, such as credit easing might become more essential if the EU comes closer to the point where the efficiency of interest rate actions could be exploited.
European Recovery Plan: financial supervision
Most urgent in the present crisis is the reforms in financial sector with adequate financial supervision in Europe undertaken by the EU institutions and with the member states' efforts. Although the financial and banking sectors are generally regarded as being regional and international in development, the banks are mostly subject to national regulations.
At the end of May 2009, the Commission's president J.M. Barroso highly praised the Larosiere Group's report, which was endorsed by the 2009 Spring European Council, on European financial supervision. The Larosiere Group prepared a report, which helped to create consensus among professionals and political leaders, as well as in the European Council, on the ways to regional recovery.
The Commission's President, assisted by the two commissioners, underlined that the main problem with what the Larosiere group proposed was how to move faster with the reforms in order to introduce the new system in the EU already in 2010-11 rather than in 2012.
The Larosiere Group's proposals are also forming major part in the European Economic Recovery Plan. The technical aspects of the plan complicated but the fundamental issues are simple: as soon as financial markets are mainly within the national reach, the EU must show collective political will to tackle future systemic risks before they get out of control.
More efficient financial supervision
The task would be performed at macro level through the European Systemic Risk Board , which assessed risks to the stability of the financial system as a whole. At micro-level, the European System of Financial Supervisors (for banks, securities, derivatives and pension funds) will enhance supervision of individual cross-border financial institutions. The Commission's idea is not to impose “centralising of power” and taking away national supervisors' role. It is rather to create a partnership between national supervisors and new European Supervisory Authorities, themselves based on existing committees of Member State supervisors. These are existing supervisors, but within an additional and real European concept and with the real European interest.
Removing impaired assets and the recapitalization and restructuring of banks are vital to underpin a supply of new lending. It is hoped that the EU measures on, e.g. capital requirements, credit ratings agencies, hedge funds and private equity would help re-establish confidence and restore the demand for credit. But those measures can only work fully if they are complemented by a more effective architecture for financial market supervision that reflects modern reality. The Commission wants Europe to be the first to implement its G-20 commitments on cross-border supervision showing the G-20 partners that the EU expects them to go ahead with the same speed and determination. It will maximise Europe's influence in developing the global financial system regulation.
The European Commission's approach is aimed at i mproving supervisory cooperation; this line of activities has been on ECOFIN Council's agendas for more than a dozen of years. However, very little progress has been achieved: lots of reports, lots of discussion but no real progress on the ground, argued former commissioner Charlie McCreevy in the 2004-10 Commission's college.
It was expected that the present crisis would have spurred ministers and supervisors to find better ways of working together. However, the crisis has had an opposite effect; it has reinforced the tendency for supervisors “to think nationally”.
Finance ministers in the member states have generally learned from the newspapers when a foreign owned bank on their territory was in difficulty. The authorities in the member states had no instinct to inform other supervisors or finance ministers about decisions they were taking which affected the banks operations in those member states.
The Commission's decision to set up the De Larosiere group was the only way to move this debate forward; the group's report has provided the catalyst to take discussions onto a new level. The proposals are aimed to equip the Single Market with a new and comprehensive system to preserve financial stability. It was decided that such system would rest on two pillars: micro-prudential supervision and macro-prudential supervision.
As to the micro prudential aspects, the new system (from 2011) is composed of 3 new European supervisory authorities: the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and the European Securities Authority (ESA). These would replace the current EU Committees of Supervisors (CEBS, CEIOPS and CESR). The new authorities would be working in a network with national supervisors. This network would develop common supervisory approaches to supervise all financial firms, protect consumers of financial services and contribute to the development of a single set of harmonised rules. The new European supervisory authorities should draw up technical standards, help ensure the consistent ECOFIN application of Community law and resolve disputes between supervisors.
Maintaining 3 authorities, the Commission (based on M De Larosiere's report) has envisaged creation of a coordinating or steering group among the three Authorities. This group would have as its function ensuring consistent supervisory approaches, strengthening cooperation as well as addressing cross sectoral challenges including financial conglomerates.
A critical issue is the proposed “dispute settlement” mechanism, which aims to balance home and host interest and come to more effective supervision. It is important to stress that decisions under this mechanism should not directly impinge on the fiscal responsibilities of the Member States. It would relate to issues concerning the organisation of supervision, the technical implementation of prudential rules and issues like balanced information sharing between home and host authorities.
In crisis situations the new Authorities would have a strong coordinating role: they should facilitate cooperation and exchange of information between competent authorities, act as a mediator when that is needed, verify the reliability of information that should be available to all parties and help the relevant authorities to define and implement right decisions.
The competences of the new Authorities would also include full supervisory powers for some specific entities such as Credit Rating Agencies; the aggregation of all relevant micro-prudential information emanating from national supervisors; and a certain role in the EU activities at the global level, mainly with regard to technical aspects.
In formulating his recommendations Jacque de Larosiere decided to put forward proposals that would not need Treaty changes. This was a pragmatic approach. The present proposals are designed to work in the context of current Treaty provisions and Court of Justice jurisdiction.
The reforms proposed would for the first time equip the EU with a pan-European macro-prudential supervision system.
Within the macro-prudential supervision, the Commission establishes a new body, the European Systemic Risk Board entrusted with the role of ensuring macro financial stability in the EU. Based on appropriate analysis, the Council would be able to detect potential threats to the stability of the entire financial system and, if needed, to issue early warnings about these threats and make recommendations to avoid them.
In doing so, the EU will be able to ensure that the MS escape from the boom-bust dynamic that is at the origin of the systemic failures that have characterised the functioning of European financial systems recently.
The Commission proposed (and the member states and Parliament agreed) that Systemic Risk Board was chaired by the President of the European Central Bank and that the ECB would play a key role in its functioning. Its members would include all the central bank governors of the EU-2, the Vice-President of the ECB, the chairpersons of the three new European Supervisory Authorities and a member of the European Commission. This composition reflects the links between micro- and macro- supervision and the necessary consistency between those and the role of the Commission.
It is important, argued the Commission, that the judgments made by the Council are based on information of the utmost quality. Therefore, the access to information is a key issue and it is crucial that the warnings and recommendations are followed by action. This new body would, obviously, liaise closely with the IMF, the Financial Stability Board and other international systemic-risk counterparts.
Establishing European and international set of accounting rules
At the G-20 meting in September 2009, a firm support was voiced for a single set of high quality accounting standards to improve capital flows and cut down on cross-border arbitrage in response to the financial crisis. However, achieving consensus proved to be sufficiently difficult. The EU proposed reforms to the European and international accounting rules (3).
In modern times, world's accountants as well as many investors and financial analysts are being able to compare accounts across borders. They argue, however, that this uniformity means capital would be allocated in a more efficient way. They hope that companies could less easily pick their regulators to suit them, and that accounting scandals such as those at Enron, WorldCom and Parmalat would occur less often.
The problem to be resolved in 2011
Nevertheless, the world financial turmoil drew particular attention to one fundamental question: how to measure what an asset is worth. The reason was that during the market panic, prices for most complex financial products such as derivatives plunged as markets froze – virtually regardless of the credit quality of the underlying assets. For some it created bargains that were snapped up. For most banks and hedge funds, however, it led to devastating holes on balance sheets because of the practice of marking assets at current market prices. The writedowns created a vicious circle where falling values prompted lenders to demand more collateral against their loans, which in turn forced overleveraged groups to sell assets, pushing prices down further. As a result, policymakers began to look with renewed favour at alternative procedures: allowing managers to judge values themselves or report them at what they originally cost and what cash they were expected to generate before they were sold.
The opinion that “fair value” accounting weakens financial and economic stability has persisted among many regulators and politicians, mostly in Europe. But some investors, notably in the US, have remained staunch in their defence of fair value because they say it is more transparent. Hence the G-20 leaders expressed keen support for a single standard to be introduced by June 2011.
European scene
The European Union's internal market commissioner, Michel Barnier proposed reforms to the European and international accounting rules, infuriating accountants and potentially scotching fragile hopes of global convergence. In an apparent power grab by Brussels, Michel Barnier has suggested future funding of the International Accounting Standards Board (IASB) might depend on whether it bows to political pressure from the European Commission to make changes to its governance.
Mr. Barnier's suggestion, made at a meeting of top accountants and regulators in London (September 2009), stunned the global accounting community by raising questions about IASB's independence during a period of crucial talks to establish an international set of accounting rules.
The G-20 meeting in London pledged support for a single set of high quality accounting standards to improve capital flows and cut down on cross-border arbitrage in response to the financial crisis. However, achieving consensus is proving increasingly difficult.
Crucially, many European policymakers believe prudential regulators should be more involved in IASB governance so that accounting can be used as a tool for financial stability. But accountants and business leaders – particularly in the US and Japan argue that accounts should not be subject to regulatory intervention. They should focus on providing an accurate snapshot of company's value. During an increasingly tense meeting on future funding for the IASB, Mr. Barnier argued, “the two issues of financing and governance can be linked; we want to see more issuers – more banks and more companies – and more prudential regulators represented on the governing board, e.g. IASB” (4).
The Commission argued that, it was “premature” to expect the EU to increase its annual ? 4,3 mln budget contribution for the IASB (the EU intends to reconsider its annual funding), which will bring the EU into conflict with the US and Asia and derail the convergence process. More than 110 countries, including most of Europe and Asia, use the International Financial Reporting Standards drawn up by the IASB. US companies continue to report under Generally Accepted Accounting Principles while regulators consider whether to endorse IFRS.
The accountancy has in fact a turbulent history and complicated present: ever since the 15 th century when Luca Pacioli, a wandering Franciscan monk and friend of Leonardo da Vinci, invented modern accounting in the Tuscan hills, there have been arguments about its meaning and purpose. It is still quite uncertain as to whether accounting is a social construct and just one way of looking at the world, or is it a quasi-science based on precise facts? (5)
Depending on how the rule-makers' investigations go, the US Securities and Exchange Commission, SEC intends to decide by that date whether all American companies should stop using US Generally Accepted Accounting Principles, the current national system, and move to the IASB's International Financial Reporting Standards , used in most of the rest of the world. Investors are mostly in favour of convergence but some worry that in the rush to meet the G-20 deadline mistakes could be made that would create future problems for company reporting. The most important thing for investors is that it is high-quality standards, and that they do meet the demands of shareholders and the wider investment community.
The SEC's expected decision might be crucial, as without support of the world's largest capital market, any global standard would be of no use. With the deadline in 2011, the inevitable cultural differences, disagreements and rivalries that come with a global enterprise on this scale – and that have plagued accounting debates for centuries – are threatening to disrupt the process. In spite of months of negotiations, the FASB and IASB have been unable to agree on pricing financial instruments.
The story of how accounting became a hotbed of acrimony that pitted regulators, accountants, investors and company executives against one another has its roots in the weeks before the Lehman Brothers collapse in September 2008. Late that August, the project to create a single global standard by bringing the US and the rest of the world closer together reached what is still its all-time high point.
Christopher Cox, then chairman of the SEC, announced a tentative deal that would switch all US companies to IFRS by 2014. Within weeks of Lehman's collapse, Mr Cox was replaced by Mary Schapiro as part of President Barack Obama 's incoming administration. During her confirmation hearings, Ms. Schapiro said she “would not be prepared to delegate standard-setting or oversight responsibility to the IASB” (6).
Sir David Tweedie, the former KPMG partner who heads the IASB, had his own problems to deal with across the Atlantic. EU pressure forced the publication in October 2008 of a rule that was widely considered as decreasing reporting quality; they may have saved some European banks from collapse.
Ambitions and perspectives
The changes enabled banks to reclassify whole portfolios, including complex structured products, and value them more favourably based on the cost of the loans and bonds that backed the securities. Sir David, whose desire for accounting precision has at times conflicted with continental European policymakers' traditional view of accounting as social construct and tool of economic stability – later said he nearly quit over the incident (7).
The FASB and IASB announced in July 2009, that they were unable to find a common approach on valuing financial instruments. Thus, the G-20 intervention followed raising hopes that convergence was back on track. The EU in November 2009 refused to consider adopting the first stage of IFRS-9, the IASB's standard related to valuing financial instruments (on the basis that it advocated too much use of “fair value”).
Sir David went ahead and published IFRS-9 for use in more than 110 countries that had adopted or were in the process of adopting IFRS, but without the backing of its main sponsor. Convergence has lurched ahead since then but with increasing interventions by regulators and policymakers, particularly in Europe.
Michel Barnier, the EU internal market commissioner suggested however, that the IASB's future funding depended on it bowing to pressure from Brussels to put more regulators on its board. The SEC has said IASB independence is necessary for it to consider moving US companies to IFRS.
IFRS and the EU
Most important issues are about enforcement of the accountants' rules, about the creation of a single international accounting standard and (once the world's top accountants have decided on a set of global rules) the institution to regulate them.
Presently, International Financial Reporting Standards have been adopted by about 110 countries, including all the European Union member states, Japan, Canada, China, India and even the US. At one of the IFRS meetings in London (2009), attended by leading accountants as well as national regulators and policymakers including Mary Schapiro, US Securities and Exchange Commission chairman, and Michel Barnier, EU's internal market commissioner, regulating international standards were the issues of primary importance. Among the ideas put forward was an enlarged role for the International Organization of Securities Commissions and the Committee of European Securities Regulators - for national and regional authorities. While foreign companies that raise capital in the US use IFRS, the SEC proposes bilateral arrangements. If the regulator has concerns over the interpretation of a particular standard, it can contact its opposite number in the company's home country to make sure that the standard is applied consistently.
Differences in accounting standards. Acording to the GAAP standards, the UK banks' assets would have been? 1,5 tril according to US GAAP standards in 2008 and ? 2,0 tril according to European IFRS (8).
European banks: specific path out of crisis. General opinion prevails that the EU authorities have been too slow “to clean up” the financial and banking sector. The EU banks were less exposed to the crisis and therefore did not take necessary measures to build their capital cushions or tackle debts loads. However, the situation has deteriorated in spring of 2010; it gives the impression that the financial crisis can take a new turn.
When the crisis started about two years ago, banks on both sides of the Atlantic were forced “to shore up their capital buffers” and hugely reduce their loan portfolios. However, the EU banks were less exposed to the crisis and therefore did not take necessary measures to build their capital cushions nor tackle debts loads. This situation is best reflected in the share prices in Europe: according to FTSE Eurofirst index, shares in the EU lost nearly half of their value (in the US banks, less than one-third). In May 2010 alone, the EU banks' stocks reduced by 18%, compared with 8% in the US.
Dire state of several EU member states' property market, to which the saving banks have been heavily exposed, produced a negative effect on the state of sovereign debts, in particular in the eurozone states. The signs of a new round of financial crisis in Europe have been visible already at the end of May-beginning of June. The interest rate premium on bank bonds over government debt has risen sharply, raising borrowing costs for many companies.
The situation did not change much (the banks' share prices continued to deteriorate) even after the EU finance ministers agreed on a bail-out for the Athens government in May while the financial sector's direct exposure to Greek sovereign debt remains severe.
Some blame the “contagious net” of the EU banks in Greek tragedy; e.g. France's BNP Paribas has revealed about € 5 bln in exposure to Greek sovereign debt. Banking executives insist that even if bondholders are forced to accept a partial forfeiture of repayments, known as a haircut, the hit would represent a tiny fraction of their earnings. BNP Paribas would lose about € 1 bln from a 20 per cent haircut on its holdings, less than 3 per cent of group revenues in 2009. General opinion is that the banking sector has lost much of its influence and activities, and is left to wait out troubled times.
Investors' concern. Investors are concerned about both the EU banks' exposure and about the interlinked nature of that exposure. Lending by the global banking sector, excluding domestic banks, to the public and private sectors in Greece, Spain, Portugal, Ireland and Italy – the five eurozone economies, which are still regarded (in June 2010) as the most troubled – was $ 4,000 bln at the end of 2009, according to the Basel-based Bank for International Settlements European banks' exposure accounted for three-quarters of this total, of which French banks made up nearly one-third and German banks almost a quarter.
Worries about the size, not to mention the quality, of banks' exposure to those economies are entwined with concerns about their ability to fund themselves. In the beginning of June 2010, the European Central Bank, in its financial stability review, said European banks would have to write off a further € 195 bln of bad debts by 2011. ECB pointed out that governments' needs to finance their large budget deficits would make it more difficult for banks to raise money in the bond markets. The main risks for the euro area financial system include concerns about the sustainability of public finances – even increasing – with an associated crowding-out of private investment (9).
Salvation scenarios
The predicaments are bouncing from the worst-case scenarios (e.g. default by a eurozone government or even the demise of the euro, which is regarded as probable) to efforts aimed at restoring banks' confidence. Quite certain, that the present challenges for the EU banks are exacerbated by the sector's structure, both in Spain, Italy, Greece, the UK and also in Germany, France, etc.
Something else contributed to the financial crisis, i.e. the banks' competition against each other to offer low-margin mortgage products; it hinders presently the resolution of the crisis. Local political support and a historical lack of transparency have permitted smaller banks to delay consolidation and escape restructuring.
For example, Germany's Landesbanken, a regional bank that make up about one-fifth of the country's banking assets, have been a weak spot for years. In 2008, the sector lost nearly € 10 bln, the consequence of years of cheap financing being unwisely invested in a range of securities – including US subprime mortgages – that then went bust. In 2009 the four most troubled – HSH Nordbank, WestLB, Landesbank Baden-Wurttemberg and BayernLB – made a combined € 5,3 bln net losses (10).
There is a widespread belief in Germany that the scale of writedowns still to be taken has been underestimated; besides, the federal government has failed to force even the “bad banks” to restructure (only WestLB agreed to carve out a portfolio of assets).
In Spain, the leading banks, e.g. Santander and BBVA survived the financial crisis relatively well. However, the smaller savings banks are long overdue for a restructuring. Simply merging or combining the weaker financial institutions will not eliminate the sector's woes; only a far more drastic restructuring process will deliver the required cost cuts and efficiency savings.
Another problem is that European banks still have huge capital requirements. Their core “tier one” capital ratios – essentially shareholders' equity plus retained earnings – vary from country to country. Nevertheless, they are generally well below what the financial market is likely to demand according to the Basel Committee on Banking Supervision (to formulate supervisory standards and guidelines for the global banking industry). The Basel proposals on liquidity include a new “net stable funding ratio” that requires banks to keep a minimum level of long-term funding relative to their assets. Some argue that this would leave European banks with a funding shortfall of as much as € 3,000 bln (adding to the hundreds of billions of euros in bank debt that will fall due by 2012).
Indebted European financial institutions
Various EU institutions have taken out more than € 800 bln in loans from the European Central Bank, the amount that is an all-time high. While US and UK banks are increasingly funding themselves in the private markets as governments wind down their exceptional liquidity programmes, European banks have actually become more reliant on central bank credit.
Concerns over the European banks' stability are interacting with broader worries over the pace of economic recovery and the adequacy of the political reaction to the continuing crisis. The austerity programmes put in place across the southern eurozone lack coherence in the policy response from governments and regulators.
Evidence of that came in May 2010 when Germany made the surprising unilateral move to ban so-called “naked” short-selling – the process of selling a financial instrument that is neither owned nor borrowed by the vendor – in bank shares, government bonds and credit default swaps. This triggered outrage among senior European bankers accusing the German chancellor of playing politics with already jittery markets. At the same time, there are few signs of any emerging regulatory consensus on critical issues ranging from a bank levy or the separation of riskier investment banking activities from banks' more pedestrian retail banking operations, to hedge fund supervision and the clearing of derivatives (11).
All that ended up in sharp falls for the European banking stocks, however the decline could be managable: some banks, particularly the stronger ones, are able to fund their operations, exposure to the Greek sovereign debt crisis looks manageable and Spain's financial authorities are forcing needed reforms.
But at least one lesson from the crisis seems presently valid: central bankers and policymakers have been constantly wrong in predicting possible downfalls.
Banks waiting for new regulations
The banking sector faces the biggest regulatory overhaul in its history; some bankers in the EU say that they could not even predict the impact of the numerous proposals. For example, the Basel Committee on Banking Supervision intends to adopt a new set of capital and liquidity rules by the beginning of 2011 while the EU authorities are drafting rules for derivatives (and some members, e.g. the UK has already created a commission to investigate whether some big financial institutions should be broken up) and the G-20 leaders are discussing global bank taxes.
No wonder that many senior bankers turned to heavy lobbyism in an attempt to avoid potentially damaging for the sector reforms, sharply reducing banks' lending abilities and other sources of revenues. For example, analysts at Barclays Capital observed that under one of the proposals for bank capital requirements (Basel committee's draft), Credit Agricole's “core” capital ratio – based on its level of shareholders' equity and retained earnings – would fall from about 8 per cent to zero, which would put France's largest bank out of business (unless a special “opt out” procedure is adopted). General opinion in France was that the banking sector lost much of its influence and activities, and was left to wait out troubled times.
Different approaches to crisis can be seen in Europe (as well as in other parts of the world): on one side, are bankers, politicians and bureaucrats who believe – generally – that bad debts do not need to be written down (12). The latest (November 2010) offer to Irish government from the EU officials and ECB was to sustain the Irish banks' solvency under all circumstances. Although, everybody knows that the troubled debtors could survive only with correct mix of modest inflation, rapid growth and fiscal tightening.
So far the ECB's funding for “bad banks” in four troubled eurozone states were the following (in bln of euros, from August to October 2010): Portugal – from 49,1 to 40; Spain –from 119,7 to 71,9; Greece – from 95,9 to 92,4; Ireland – from 95,1 to 130 (13).
The strategy to revive people and investors' confidence in fading banks, as well as structural changes in financial sector as a whole is for the new type of politicians to resolve. This message has been already explored by the leading British financial daily, which made a unique analysis of the societal aspects in financial sector (14).
Banks in Europe, according to Basel III regulation, which is about to take effect in 2011, will be required to hold top quality “tier one capital” equal to 7% of their total assets, adjusted for risks (compared to 2% before the financial crisis). Basel III also included 2 new liquidity rules: the liquidity coverage ratio (requiring banks to hold enough cash to survive a 30 day crisis) and the net stable funding ratio (which will force banks to hold more long-term funding).
Out of all Baltic countries, only Poland treated both the crisis' reasons and consequences in a positive manner. Whereas such countries as, e.g. Latvia was forced to turn to the EU and IMF, as well as other European states for financial assistance.
The crisis did not hit Poland hard; even in 2009 it was the only country in the EU to register economic growth. Poland's real GDP growth of 1,7 per cent contrasted with an average EU decline of 4,2 per cent, and contractions of about 5 per cent in Germany, Britain and Italy. In 2010, when Europe has been plagued by concern over excessive debts in Spain, Greece, etc., Polish economy projected to grow by 2,7 per cent, accelerating to 3 per cent in 2011, according to the International Monetary Fund. “The one-time problem state of central Europe stands out as a success story in a worrisome European landscape” (15).
One important reason for this is that, Poland has been able to profit from flexibility of the zloty exchange rate in a way that has helped growth and lowered the current account deficit without importing inflation. That would be impossible if the country had been a member of the eurozone. Poland is, of course (as all other new EU member states) committed eventually to entering the single currency but recent problems in the eurozone make Polish leaders question whether to submit (sooner, than later!) to a rigid exchange rate regime as a vital pre-condition for entry.
The decade-long story of peripheral euro members drastically losing competitiveness has been a salutary lesson. Still another conclusion from the Greek crisis is that there is no substitute for countries' own efforts to improve competitiveness, to boost fiscal discipline and increase labour and product market flexibility; these requirements are valid regardless of whether or not the countries are in the eurozone. Interest rates on 10-year government debt issued in zloty are 5,6 per cent in 2010, compared with about 7 per cent on 10-year Greek debt.
In the immediate aftermath of the 2007 subprime mortgage upheaval, Poland – like other central and eastern European countries – was hit by capital flight and fears of economic depredation. The period 2007-2008 was tough for all EU countries; but a combination of a propitious domestic economic structure and appropriate fiscal and monetary measures could yield favourable salvation, argued former Central Bank chef. With 38m people, Poland gained from having a relatively large and self-sufficient economy, and a financial system that is well capitalised, profitable and resisted the temptation to diversify into “exotic products”.
Because Poland's currency is not bound by the ERM-II (Exchange Rate Mechanism, 2 nd stage), Poland was able to adjust zloty's value according to national needs. Thus, between 2008 and 2009, Poland's real effective exchange rate, allowing for differences in unit labour costs, fell by nearly 20 per cent – a significant factor behind the narrowing of the current account deficit. During this process, the country increased the GDP per capita share (presently, at 60 per cent of the EU average compared with 49 per cent in 2004 when Poland joined the EU).
In the recent turbulence it has been widely recognised that a strong and independent central bank is in the best interests of the economy. Hence, the bank increased the scale and lowered the cost of central bank lending. Foreign exchange reserves rose to more than $ 85bn, from $ 65,7bn in 2007, underlining foreign confidence.
The government in 2008 correctly decided to relax fiscal policy and allowed the automatic stabilisers to function, with tax income falling and social security payments rising during the economic slowdown. But fiscal expansion has now gone too far. Given the relative buoyancy of the economy, the public deficit (7 per cent of GDP in 2010, up from 2 per cent in 2007) is regarded as too high (16).
Polish government expects that the necessary structural reforms will in the long run improve country's ability to meet euro criteria. However, Central Bank's representatives argue that Poland must temper the wish to adopt the euro with necessary prudence and not tie itself to timetables that may prove counterproductive.
The reasonable outcome is within solid economic growth and sensible policies on debt and deficits, which is possible both within and outside the eurozone. Nations in a hurry to join the euro may end up missing their overriding objectives; as it happened with Greece, for example. Countries like Poland that do not rush into obligations, do their homework and take time may end up with a more sustainable economic structure that will make them better equipped for the euro in the long run.
Saving eurozone and EU's economy
Financial facilities, of course, can help a lot in critical times; €440 bln emergency rescue fund (officially approved in February by the European Council) is one of the means in this direction.
However, the EU officials have come in January 2010 with additional reform pack, this time of a completely radical approach, i.e. economic planning. As part of the "European Semester", which was announced in the EU-2020 Strategy, the Commission, starting from 2011, would assess each year the main economic challenges for the EU and identify priority actions. These priorities will be included into the "Annual Growth Survey" that will serve as a guiding instrument for all member states including the Baltic States. The latter would adapt the social-economic priorities according to these policy guidelines.
European Union has elaborated a comprehensive plan to address the crisis and to speed up European economic development. The Commission will focus on coordinated efforts: “ A new phase of European integration begins. We are setting out to break new ground and to decisively improve the way in which we manage and coordinate our interdependent economies in the European Union. This is our economic governance in action, a coherent and comprehensive plan to return Europe to growth and higher employment”, argued the Commission's President (17).
The Annual Growth Survey is the start of the first "European Semester" which changes the way governments shape their economic and fiscal policies. Once agreed by the European Council, member states will reflect these recommendations in both their policies and national budgets. For the first time ever, EU member states and the Commission will jointly discuss macro-economic stability, structural reforms and boosting growth measures in a comprehensive way.
Planning steps
The first Annual Growth Survey marks the start of a new cycle of economic governance in the EU. It brings together the different actions which are essential to strengthen the recovery in the short-term, to keep pace with the European main competitors and prepare the Union to move towards its EU-2020 Strategy's objectives.
The Commission's Communication focuses on an integrated approach to recovery concentrating on key measures in the context of the EU-2020 Strategy and encompassing the following main areas:
• The need for rigorous fiscal consolidation for enhancing macroeconomic stability. The directions in this area will include financial sector, regulations in monetary policies and banks, other fiscal measures;
• Structural reforms for higher employment. This direction will be aimed at coordinated structural reforms to create jobs, to increase productivity and stipulate balanced budgets. Priority areas are: services, energy, intellectual property, pension system, knowledge and innovation;
• Banking sector: the priority is towards a new stress test for banks in 2011;
• Growth enhancing measures, which will be aimed at fundamental reforms in economic governance both in the EU and the member states.
This first Annual Growth Survey is designed to apply to the EU-27 countries as a whole and it will be tailored to the specific social-economic situation in each member state.
Ten priority actions
The Commission highlighted ten actions grouped under the three main areas (formulations are taken from the Commission's communication):
I. Fundamental Prerequisites for Growth, with three priorities: 1. Implementing a rigorous fiscal consolidation, 2. Correcting macro economic imbalances, and 3. Ensuring stability of the financial sector.
II. Mobilising Labour Markets, Creating Job Opportunities, with four priorities: 1. Making work more attractive, 2. Reforming pensions systems, 3. Getting the unemployed back to work, and 4. Balancing security and flexibility.
III. Frontloading Growth with three priorities: 1. Tapping the potential of the Single Market, 2. Attracting private capital to finance growth, and 3. Creating cost-effective access to energy (18).
The Strategy will review the situation regarding the EU headline targets, the draft national plans and the reform paths envisaged by the EU member states. The ambitious program, though, will be finalised in April.
Eugene ETERIS, European Correspondent
References:
1. See: IMF urges stress tests on European banks // Financial Times, 12 May 2009.
2. The report can be seen at:
3. See speeches: Internal market commissioner, Michel Barnier (22.04.2010).
4. Sanderson R. Accounting convergence threatened by EU drive // Financial Times, 20 April 2010.
5. See: Sanderson R. and Hughes J. Accounting: Carried forward // FT, 19.04.2010.
6. Sanderson R. and Hughes J. Op. cit.
7. Ibidem.
8. Croft J. Negligence actions against auditors rise // Financial Times, 29 March 2010. In the Bank of England Report, the difference is about 30 per cent!
9. See: Gordon S., Murphy M. Leaning lenders // Financial Times, 4 June 2010. - P. 9.
10. See: Financial Times, 4 June 2010. – P. 9.
11. Barber T., Wiesmann G. Berlin makes shock move without allies // Financial Times, 19 May 2010. - P. 9.
12. Eurozone debt. In: Financial Times, 18 November 2010. – P. 14.
13. Jenkins P., Goff S., Brown J.M. Ireland feels the pressure // Financial Times, 18 November 2010. – P. 1.
14. Masters B. New rules will change the game / Banking & Society, Special Section // Financial Times, 18 November 2010. – P. 2.
15. Skrzypek S. Poland should not rush to sign up to the euro // Financial Times, 12 April 2010. (The author, former president of the National Bank of Poland, wrote the article some days before he died in the Smolensk air crash in April 2010).
16. See: Cienski J. Poles hold fast amid economic storm in Warsaw // Financial Times, 21 February 2010.
17. Commission's Press release, Brussels, 12 January 2011, IP/11/22 and Rehn O. New reforms can break Europe's debt cycle // Finacial Times, 12 January 2011. P. 9.
18. Additional information on the yearly (2011) Growth Strategy, see:
№2(52), 2011