Discipline and risk-sharing of the essence in the euro area

Daniel Daianu is Member of the Board of the National Bank of Romania, former Finance Minister of Romania and Trustee of Friends of Europe

While a significant economic recovery in the euro area has been underway in recent years, major challenges still remain as the banking union ‒ established to ensure that EU banks are stronger and better supervised ‒ is incomplete.

Corrections of imbalances have been made by implementing belt-tightening programmes in the economies in distress. These efforts to restore equilibrium, however, have come at the cost of an upsurge in unemployment and added pressure on the social fabric and the political domestic setups. Banks, in general, are now better capitalised, but the size of overall debt afflicts their balance-sheets. We should not be fooled by the current positive trend in economy, as it is largely reliant on the European Central Bank’s (ECB) non-standard policies, such as very low interest rates and asset purchases. If no adequate policy arrangements are put in place, new economic downturn will be quite painful.

There are two approaches to reform the euro area. The first, which focuses on financial discipline and rules essentially boils down to balanced budget executions throughout the business cycle. In a broader sense, it implies rules that would not allow public and private imbalances to get out of control. But the financial crisis that erupted a decade ago has revealed vulnerabilities that cannot be attributed to soft budget/financial constraints alone: resource allocation in a monetary union which features large development gaps among member states comes strongly into play.

This links to the second approach, which focuses on “risk sharing”. The euro area members’ uneven capacity to absorb shocks along with the non-existence of key policy tools, such as autonomous monetary policy, is problematic. With the exception of Greece, it was private indebtedness that primarily caused wide imbalances in some euro area countries. A risk sharing measure ‒ a collective deposit insurance system ‒ in the banking sector does make sense. This measure looks like the key missing link in the banking union’s architecture.

One can imagine a diversification of banks’ loan portfolio that would diminish the threats posed to their balance-sheets by activities in weaker economies. However, a complete decoupling of banks from weaker member states’ economies is not realistic and not welcome, and contagion effects can still be significant. Indeed, it can be inferred that, unless economic divergence among member states is mitigated, peripheral economies would become even more fragile once non-zero risk bonds come into being. The non-existence of proper risk-sharing schemes would only strengthen such perilous dynamics.

A concern of creditor nations is that certain euro area reforms would lead to systematic income transfers between the countries. This kind of “transfer union” would call into question the political legitimacy of such arrangements. But a key distinction should be made in this respect: systematic transfers that would stick the “financially assisted” label to some economies should be distinguished from transfers that help cushion asymmetric shocks and narrow performance gaps.
The need to reduce the bank-sovereign “doom loop” as much as possible lies at the root of attempts to come up with a European safe asset. For years now, Eurobonds have been mentioned as risk-pooling assets that would make the euro area more robust. However, mutualisation of risks is rejected by creditor nations, which do not accept the idea of a “transfer union” described above. As a result, the idea of sovereign bond-backed securities (SBBS) came up: this financial asset divided into three tranches – senior, mezzanine and junior – is intended to be attractive for banks and other financial institutions, and it should replace many of the current sovereign bond holdings.

But SBBS are not problem-free: the supply of senior tranches depends fundamentally on the demand for junior tranches, and this demand is likely to fall dramatically during periods of market stress, when some member states’ market access may be severely impaired. In those instances, the demand would swiftly shift towards other safe assets while the periphery bonds would plummet. Sure, one can envisage a variation of the composition of SBBSs as a function of member states’ market access, but this would make the whole scheme extremely cumbersome to implement. The fact is that, unless market access is secured for all member states, the unreliable supply of SBBSs makes them a non-workable asset. The volume of SBBSs would also be too small to make much of a difference in financial institutions’ balance-sheets, for the foreseeable future at least.

However, the introduction of SBBS should be judged in conjunction with a package of euro area policy redesign measures. The package should include at least liquidity assistance available during times of market stress; schemes, such as an unemployment benefit scheme, to cushion asymmetric shocks; sovereign debt restructuring that is not automatically triggered due to its potential to cause panic and more fragmentation; rules for adjusting imbalances that are not pro-cyclical; the macroeconomic imbalance procedure that operates symmetrically; a euro-area-wide macroeconomic policy that is reflected in the fiscal policy stance over the business cycle; investment programmes that foster economic convergence; and no de-reregulation of finance.

Euro area reform proposals must also consider the transition to a steady state. A smooth transition can be hampered if reform measures disregard correlations among them. Problems arise if, for instance, the introduction of SBBS or of other suitable measures does not take into account the side-effects of setting non-zero risk weights for member states’ bonds.

When it comes to financial integration in the euro area, establishing a banking union with a collective deposit insurance scheme raises a fundamental issue: can the banking union overcome market fragmentation and economic divergence in the absence of fiscal arrangements that would enable accommodation of asymmetric shocks and foster economic convergence? Some argue that a complete banking union would dispense the need of fiscal integration in the euro area. But is it sufficient for a robust economic and monetary union that risk sharing applies to banks only? And would private risk sharing be sufficient to cope with systemic risks in financial markets?

It is not clear that a collective deposit insurance scheme would involve private money only, under any circumstances ‒ some fiscal risk sharing may be needed in worst case scenarios. What if economic divergence persists, or even deepens, since banks may discriminate among economies not least due to perceived risks that originate in bailing-in schemes and other vulnerabilities? A disconnect between a banking union, in which “risk sharing” operates, and real economies is hard to imagine. If economies would continue to diverge and risk sharing would not be applied to them too, that would undermine the euro area further.

The biggest hurdle to overcome in the euro area is, arguably, fiscal integration, as it calls for more than institutional cooperation; it involves institutional integration and a significant euro area budget to share the risks. But the latter leads to a huge political conundrum, facing strong political and constitutional constraints. And here lies the cross-cutting vulnerability in the design of the euro area: there can hardly be integration in cohabitation with autonomous economic policy and democratic accountability at national level; something must be given up, more or less. It is fair to argue that this dilemma simplifies things and that compromises can be found.

The progress for both the euro area and the banking union requires reconciliation between rules and discipline on one hand, and private and public risk sharing on the other. Risk sharing must be designed in such a way, however, that it reduces moral hazard while simultaneously taking into account asymmetric shocks as well as different strengths of national budgets and of member states’ economies.

Private risk sharing schemes alone would not make the euro area more robust. Financial markets are too fickle, and they produce systemic risks recurrently. Past examples, such as the Great Recession, demonstrate that public intervention is needed at times to, ultimately, avoid a catastrophe.

Without adequate risk sharing schemes, the euro area will continue to be rigid and prone to experience tensions and crises recurrently. And without the necessary policy arrangements and mechanisms to combat growing divergence between member states, the functioning of the euro area is jeopardised. In the end, it is excessive divergence that feeds into the social fabric of countries, fuelling extremism, populism and Euroscepticism on its way.

This text presents personal views and should not be interpreted necessarily as the official position of the National Bank of Romania.