The fiscal and regulatory vacuum at the heart of the European Union

1. Willem H. Buiter CBE, FBA Professor of European Political Economy London School of Economics and Political Science The fiscal and regulatory vacuum at the heart of the European Union

2. These are extraordinary times • The financial crisis of the north-Atlantic region that started in 2007 is, by most metrics, the biggest financial crisis ever • The global contraction of real economic activity that followed it will undoubtedly be the deepest and longest downturn since the Great Depression • If policy makers screw up, it could still become worse than the Great Depression • I don’t consider that likely

3. Main lessons for US and Europe come from developing countries & EMs • Today’s advance industrial country financial crisis are rather like the EM crises of the 1970s, 1980s and 1990s. • Dysfunctional banking and financial systems • Frozen impaired financial markets • Lack of fiscal spare capacity • Convergence of public sector & banking sector credit ratings (in a crisis, all debt is public) • risk of ‘sudden stop’ • Double crisis : banks and sovereign debt • Triple crisis: banks, sovereign debt & currency • Main difference from EMs: global reserve currency status of US & Eurozone

4. Lessons • Pay special attention to the inconsistent quartet • Small country • Large internationally exposed banking sector • Own non-global reserve currency • Limited fiscal spare capacity • Iceland, Switzerland, Sweden, UK, Ireland (3 out of 4)

5. Key open question (determining whether this becomes the Great Depression Mark 2) • After the banking crisis and the (private sector) financial crisis are we entering a period of sovereign debt crises and currency crises? • If so, will it be restricted to EMs and small countries (especially in CEE), or will it involve larger countries, including the UK & the US?

6. How has EU/Eurozone performed in financial crisis & economic downturn? • Financial excesses (credit booms, asset bubbles) as bad in Eurozone as in US and UK • Positive exceptions: • Spain’s dynamic provisioning • Italy’s stay-at-home conservatism (except for UniCredit & IntesaSanpaolo ) • Negative exceptions: • Spain’s wild construction boom/bubble • Ireland’s wild construction boom/bubble • Ireland’s banking bubble • Germany’s Landesbanken • Lending to CEE & Balkans • Lack of transparency of Euro Area banks; failure to recognise losses & start recapitalisation • Euro Area behind US, UK and Switzerland in recognising bank losses and addressing recapitalisation

7. How has EU/Eurozone performed in financial crisis & economic downturn? • Real economy downturn at least as deep in Euro Area as in US & UK.

8. Have EU & EU institutions made a difference? • Positive: • Euro Area: Common Currency, LLR, MMLR • European Commission (Competition Directorate) attempts to preserve competition in banking despite egregious state aid & new banking Darwinism (survival of the fattest and the politically best-connected) • Less protectionism among EU members towards each other

9. Have EU & EU institutions made a difference? • Negative • No common policy on deposit insurance • No common policy on unsecured creditors of banks • No common special resolution regime (SRR) with structured early intervention (SEI) & prompt corrective action (PCA) • No common policy towards recapitalising banks • No common policy towards guaranteeing assets or liabilities, new lending or new borrowing • No common fiscal stabilisation measures, modulated according to ‘fiscal spare capacity’ • Strong protectionism in financial and ‘posted workers’ areas.

10. There is no such thing as a safe bank ... even if it is sound – something most crossborder north-Atlantic banks are not, but for past, present and anticipated future government financial support • Banks need: the Holy Trinity of financial stability • Liquidity support (central bank as lender of last resort & market maker of last resort) • Solvency support (Treasury as recapitaliser of last resort) • Because of 1. and 2. • Banks get regulation & supervision

11. Holy Trinity necessary only for banks severally or jointly too big to fail Reasons banks become too big, too interconnected, too complex and too international to fail: • Economies of scale • Economies of scope • Monopoly power (scale in a given activity) • Conflict-of-interest synergies (bundling many activities) • Lobbying power/political clout • Tax arbitrage • Regulatory arbitrage • Desire to become too big, too interconnected, too complex & too international to fail

12. Too big to fail • Too big to fail means too big to be private • Public ownership of very large institutions • Smaller private banks and other financial institutions • capital ratio requirements increasing in size of bank • More aggressive anti-trust & competition policy (European Commission) • Separate investment banking from commercial banking • Prevent conflicts of interests within investment banks and commercial banks by ‘unbundling’ further (Glass-Steagall on steroids) • No public (listed) companies in investment banking • No economic efficiency problems: • economies of scale in banking exhausted before $100 bn balance sheet. • Economies of scope non-existent (span of control and lack of focus problems). In the short term, fewer and larger banks In the medium term, more and smaller banks

13. The myth of too big to fail • Classic example of market discipline undermined by political economy considerations • Too big to fail is a financial stability myth, but a powerful political economy reality • Orderly resolutions of bankruptcy/defaults/insolvencies of even the largest banks and financial institutions are easy

14. Let’s put banks into insolvency! • Requires • Special Resolution Regime with Structured Early Intervention and Prompt Corrective Action – pre-empting Chapter 11 & Chapter 7: regulatory insolvency joins balance-sheet insolvency and liquidity insolvency . • Ability to ring-fence payment, settlement, clearing, custodial activities of banks (& possibly counterparties of banks also). • (Possibly) counterparties (CDS holders) senior to unsecured creditors • Clarity on the exact seniority ordering of all claimants • Political strength to resist pressure from unsecured creditors (pension funds, insurance companies, other banks) and other lobbyists

16. Failure of governance of border-crossing markets • Central banks, Treasuries and regulators/supervisors are national • No more cross-border branches regulated & supervised by home country (Icesave) • EU principle of mutual recognition, single passport RIP • Only independently capitalised subsidiaries, with own assets & liquidity; managed at arm’s length from parent & regulated & supervised by host country • Home country Treasury cannot be expected to bail out foreign subsidiaries of national banks Repatriation of cross-border banking

17. Failure of governance of border-crossing markets • Special problems of the EMU • One central bank for 16 countries • No fiscal Europe • No European regulator-supervisor for border-crossing systemically important financial institutions. • Because of 2., credit easing by ECB/Eurosystem problematic: who recapitalises the ECB?

18. Can central banks go broke? • Central bank’s conventional equity, W, need not be positive, but its comprehensive net worth, • V = W + S – E – T , must be positive, lest it either is at risk of failing to meet its financial obligations, or will have to raise S and thus future inflation to restore solvency. • Restoring solvency even through seigniorage may be impossible if the exposure of the central bank is to foreign currency assets or index-linked assets. • In that case only a low or negative realisation of T can restore central bank solvency

19. Conventional and comprehensive balance sheets of the ECB/Eurosystem look • ECB itself small and irrelevant • Eurosystem (ECB + 16 Euro Area NCBs) large and relevant, but not fully integrated • NCBs share losses incurred as a result of Eurosystem monetary operations, liquidity operations and credit-enhancing operations • NCBs do not share losses incurred by NCB acting as quasi-fiscal agent for national Treasury • NCBs do no pool capital.

20. Eurosystem Assets, 08/-5/2009

21. Eurosystem Liabilities, 08-05-2009

22. Can the Eurosystem go broke? • Consolidated financial statement of the Eurosystem as at 8 May 2009: • Bad news: Eurosystem has only €74 bn of capital and reserves & €1,795 bn worth of assets, i.e. 24.6 times leverage • Good news: Eurosystem’s balance sheet is 20% of Euro Area annual GDP & monetary base (€1 trillion, 75% currency) is about 11% of GDP (€9.2 trillion)

23. Can the Eurosystem go broke? • With 4 % trend nominal GDP growth a reasonable seigniorage benchmark is 0.33% of GDP each year (currently €32bn)( required reserves are remunerated). • If long-term safe interest rate exceeds long-term growth rate of GDP by one percent, capitalised value of seigniorage is 33% of GDP, more than 1.5 times the balance sheet of the Eurosystem. • Safe but beware: • growth of balance sheet of Eurosystem • Financial development and crime-fighting could reduce seigniorage revenue

24. The systemic financial stability role of the ECB • Is the ECB too independent to play a Euro-Area- or EU-wide role as regards macro-prudential supervision & regulation? • ECB may have to chose: independence and irrelevance or less independence and greater relevance.