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Table of contents
The objective of setting up a single European banking supervisor is to have an independent and powerful institution supervising European banks. The arguments in favour of such a supervisor are the same as for an independent central bank. Banks, like money, should escape from the political sphere to be entrusted to experts. Banking supervision by an independent supranational authority prevents national or political factors to influence decisions and strengthens the credibility of strict rules Rochet, An independent supervisor will be credible when asserting that not all banks will be necessarily bailed out in the event of bankruptcy, which will encourage banks to reduce their risks.
This will reduce the moral hazard of banks otherwise encouraged to take risks under the insurance of being bailed out by their State. Independence also ensures shorter delays for the implementation of bankruptcy procedures, delays that are detrimental to the effectiveness of the adopted resolution procedure and create the possibility of lobbying actions limiting the credibility of the overall scheme.
The supervisor should be able to monitor banks in trouble before they become a threat to financial sector stability. Speculation on bank failures which has fed the crisis, would be substantially reduced. Confidence depends strongly on the quality of supervision. Uncertainties about the quality of the banking sector, on its capitalisation, on the amount of bad debts caused difficulties for banks to refinance themselves on the interbank market.
The European banking supervisor should facilitate the implementation of the common scheme of crisis resolution, by acting both in normal times and in times of crises for the resolution of bankruptcy procedures. Finally, it will monitor the implementation of the new Basel III standards. Five months later, this deficit was 23 billion. Moreover, the EBA has no national correspondents; it is based in London, and has authority on the British system while the United Kingdom does not wish to be part of the banking union.
The ECB lobbied to be entrusted with this task. Financial stability is already an objective of national central banks and the latter already had a role in the banking sector supervision. In France, for example, the Prudential Supervisory Authority is responsible for the agreement and supervision of banks and insurance institutions; it an independent authority, but remains backed by the Bank of France.
The European Commission estimated that the ECB has an established reputation of political independence. It will ensure the implementation of standards for the degree of leverage, of liquidity, of own funds and it may, in coordination with the national authorities, impose the constitution of capital buffer or the introduction of corrective measures as deemed necessary.
It will be the relevant authority to approve credit institutions. It will ensure the coherent application of the EBA single rulebook. It will monitor the supervision of other banks which will be conducted by national supervisory authorities, who will be accountable to the ECB. The ECB may decide, at any time, to supervise any credit institution. The SSM will benefit from the expertise of national supervisory authorities.
The ECB shall have access to all the information available to national supervisors. As the ECB is an EU institution, it will be possible to appeal a decision according to the principles defined in the European treaties. But currently this Council does not have any power. A fair distribution of powers between euro and non-euro area countries on European banking supervision is going to be very delicate within the ECB, this institution being primarily the Central Bank of euro area countries. So the European Parliament decided that all countries participating to the SSM are entitled to the same representativeness within the Council who will lead the supervision tasks of the ECB.
A Supervisory Board SB and fully independent services will have to be created within the ECB to avoid conflict with the monetary policy objective. The SB would have six members from the ECB the Chair, the Vice-Chair and four other members and representatives of each national supervisor which may be the national central bank or a separate authority. However the Board of Governors will have a right of veto on all decisions. The supervisory power of the ECB voted on 12 September will be fully effective in November , one year after the entry into force of the texts.
It should also provide the texts of laws that will govern the management of banking crises in the euro area. It should ensure regular stress tests on European banks. The EBA may make decisions on the double majority group of countries subject to the SSM, group of countries not subject to it , which in practice gives a right of veto to the UK.
It is not yet certain that this committee will have an effective role, in the absence of any established doctrine and of any strong will. The risk is great that entrusting these issues to the ECB is a new step towards the de-politicisation of Europe. Certainly, the European authorities claim that the ECB will be subject to enhanced transparency and democratic accountability requirements.
Although a Monitoring Committee is created, the Governing Council will remain responsible for banking supervision and monetary policy decisions. Will the ECB be able to account for European banks diversity? The European Parliament says that it will be one of its duties but it does not explain how financial institutions diversity will be preserved Committee on Economic and Monetary Affairs, European Parliament, The single rulebook on which the EBA works and which must serve as a code of conduct for the ECB advocates a uniform regulation for all European banks.
However, should governance or the capital ratio be the same for a small German retail bank and a large European banking institution? One should have considered a dual system: However, national regulators are facing today unequal risks: A dual system would have risked accelerating the withdrawal of deposits from medium-size banks in Southern countries. The main point is the objective for the European banking system: Banks are encouraged to diversify internationally to reduce their risks. But the crisis showed the dangers of diversification on foreign markets where banks are not familiar with.
Banks lose contact with domestic firms, which deteriorate the quality of credit. Local authorities would no longer have dedicated banks. Governments will lose their ability to influence bank credit supply, which, for many people, is desirable no political influence on credit supply , but is dangerous in our opinion: For instance, in the case of the Dexia bank, the opposition between on the one hand the European Commission and on the other hand France, Belgium and Luxembourg, has for a long time blocked the plan to dismantle the bank.
On fair competition grounds, Brussels questioned the financing of local authorities by such a bank because Dexia received public aid for its dismantling plan. This threatens the continuity of the financing of local French authorities, could block their projects and especially forbid France to provide specific and secure mechanisms to finance local projects by local savings. Is this compatible with a banking union?
This bank should provide credit according to specific criteria, linked with the French industrial policy. The question of the compatibility of such a public institution with the banking union will arise. European banks will have to account for different national regulations on interest income taxation, special deposits regulation or financing circuit organisation. Is this compatible with the banking union or does convergence need to be organised?
And who will decide about it? In any case, the SSM does not address the question of how to ensure similar credit conditions in different countries sharing the same currency but in different economic situations. In the recent past, equal nominal interest rates encouraged rising debt in countries with strong growth and inflation. Today, interest rates are strongly influenced by risk premia imposed by markets, with no link to the macroeconomic situation.
It is difficult to assess if there will be and if there should be a Chinese wall between bank supervision and monetary policy see Beck and Gros, , for a discussion. The two functions are closely correlated when the Central Banks provide liquidity to banks, especially in times of crisis. But this problem is not specific to the SSM implementation; it is always a concern for monetary policy that a strong interest rise deteriorates the balance sheet of some financial agents.
One could imagine that the ECB implements diversified macro-prudential policies imposing higher capital ratios to banks in countries in economic expansion and lower ratios for countries in difficulty. But this raises three questions: Will the ECB punish a country running a too expansionary policy according to the Bank views by imposing strong capital ratios to its banks? In , for instance, a MS like France may want domestic banks to increase credit supply to French firms to support an industrial recovery, but the ECB may consider this is a dangerous strategy for French banks financial stability.
Diversified macroprudential policies would require a MS-well-defined coordination of European monetary policy, country-specific monetary measures and domestic fiscal policies which is not on the European agenda today. A common vision on the banking system regulation is a prerequisite to European supervision. An agreement needs to be reached on crucial questions such as: Should banks be prevented to intervene on financial markets for their own profit? Should we promote the development of public, mutual, or regional banks or on the contrary the development of internationalised banks?
Should we encourage banks to supply credit primarily to households, businesses and governments of their countries of origin or on the contrary to diversify? Will macro-prudential rules be national or European? Of course, in theory, it would be easier and more legitimate to rescue banks under a single supervision. But this prospect is hardly useful in the current crisis, where the problem is to help banking systems already in trouble in Spain, Cyprus, Ireland, or Slovenia. In our view there is a major risk that euro area countries agree in emergency to enter a dangerous path, and that the banking union is as badly analysed ex-ante as were the single currency, the Stability and Growth Pact, the Fiscal treaty.
The Cypriot crisis has highlighted the difficulties of a European supervision. The European banking system is currently highly heterogeneous. In some countries, banks have a significant share of deposits from non-residents. Does the SSM need to make national systems converge or can it accommodate their diversity? The risk is that the banking union leads to conflicting situations between national strategies on banking and financial matters and the ECB, either because some countries may wish to keep certain public or regional features in their banking system, or because some others will want to maintain their predatory features to attract foreign deposits.
Economic issues will also arise: In November , ECB undertook a comprehensive assessment of the euro area banking system before assuming its supervisory tasks in November Common methodologies will be developed in these three areas. Capital shortfalls for viable banks should be provided by private capital or, if private capital is insufficient, by public backstops. After this exercise, the ECB will have a clear view of the situation of the European banks and will be able to take the responsibility to supervise them. The limitation or maybe the strength of this exercise is that the ECB is both judge and party.
The ECB must assess the riskiness of MS public debts, which depends on its willingness to guarantee them or to respond to speculative attacks. So, the ECB evaluation is not neutral; it can be seen as a commitment to rescue the banks proclaimed healthy. In the US, banking supervision is dual: The Federal Reserve membership is mandatory for national banks and optional for State banks. In the event of joining, banks must subscribe to their regional reserve Bank and deposit the corresponding reserves. The Fed is independent of the government as it is ultimately accountable to the Congress which establishes the key macroeconomic objectives for monetary policy and as members of the Board of Governors and the Chairman are confirmed by the Congress.
It sets the level of mandatory reserves. The FDIC is an independent agency of the federal government and receives no Congressional appropriations. The five members of its Board of Directors are appointed by the President and confirmed by the Senate. It is responsible for the supervision of State banks that are not members of the Federal Reserve System. It is also responsible for bank bankruptcy procedures resolutions and ensures the continuum of prudential policy and resolutions procedures. Until now, within the European Union, the legal provisions governing bank failures were country-specific.
In some countries, like the UK, banks are submitted to the general code of firms bankruptcy and thus to a judicial procedure. Other countries, such as France have mixed regimes: The scheme has five pillars. The first one is to improve prevention by requiring banks to establish wills , i. The second gives the European banking authorities the power to intervene to implement recovery plans and to change bank managers if the bank does not meet the capital requirements. The bail-in tool will give resolution authorities the power to write down the claims of unsecured creditors of a failing institution and to convert debt claims to equity.
In the event of a bank failure, shareholders will be affected first, then subordinated claims and, if necessary, claims of higher categories. These claims could be transferred in equity. Some liabilities are permanently protected: Others deposits from individuals or SMEs could have a specific treatment. National resolution authorities could also exclude liabilities to avoid contagion or value destruction in some creditors.
The fund would provide temporary support to institutions under resolution. But the share of losses between ordinary creditors, privileged creditors and the resolution fund remains uncertain. According to the fifth, Member States shall ensure that the institutions maintain, at all times, a sufficient aggregate amount of own funds and eligible liabilities expressed as a percentage of the total liabilities of the institution European Commission, to absorb losses. So, in principle, taxpayers would not have pay for the creditors of insolvent banks. The EBA will have to set out the legislative framework for these instruments of resolution.
The administrative body responsible for the resolution at the national level is left to the discretion of each country: Central Bank, finance ministry or a specific institution. The SRB would propose a resolution procedure, which would be formally decided by the Commission as the SRB has no constitutional existence and implemented by the relevant country under the SRB control. If a national resolution authority does not comply with the decision of the Board, the latter could address executive orders to the bank in trouble. National resolution funds would be replaced by a Single Bank Resolution Fund.
Due to the reluctance of some MS, particularly Germany, the draft adopted by the Council on 18 December states that the pooling of national resolution funds will be carried out gradually in 10 years, from to It is only at this horizon that banks financing or recapitalisation funds will be provided at the European level. The decision to place a bank under the resolution procedure will depend on the Resolution Fund Board, where sit MS representatives and not of the Commission or the ECB. The restructuring projects will be developed by the Fund Board, submitted to the Commission and then to the Council this procedure is not credible, taking into account the short delay required.
A MS will not be required to provide funds without the approval of its Parliament. The Fund will be organised by an intra-government agreement, i. This project faces the reluctance of the European Parliament, which would have preferred the immediate introduction of the Single Resolution Fund at the EU level, so that the MS have no more power in this matter. But, in our view an EU organization cannot impose expenditures to MS public finances without their agreement, and MS cannot accept to lose any power on their national banks restructuring. The ESM will borrow on financial markets at low rates it aims to be AAA rated and will be able to provide financial assistance to the European countries in difficulty through a European assistance under a Memorandum of Understanding.
It will buy public debt bonds on primary and secondary markets and will thus contribute to lower interest rates. It will be able to mobilize billion euros with 80 billion euros being effectively paid-up capital, the rest remaining available if needed. According to the Treaty establishing the ESM, the latter will have a status of senior creditor for public debts. When the European supervisor is in place, the ESM will have the possibility to recapitalise directly euro area banks in difficulty and, in this case, it will intervene without the senior creditor status.
Here also, this leaves open the question of the potential intervention of the ESM for banks currently in difficulty. A choice needs to be made between two strategies: If this mechanism works effectively, if the ESM supports, recapitalises and restructures all European banks in difficulty, it will be a shareholder in a large number of banks. This would raise the issue of the management of such participations. Is it the role of the ESM? The system introduced remains complicated, with the intervention of the ECB via the SSM , of the ESM, of the national authorities of resolution and possibly of the deposit guarantee fund.
This European crisis resolution scheme belongs to early corrective action policies which already exist in other countries. In the United States, following the savings and loans crisis in the eighties, the Federal Deposit Insurance Corporation Improvement Act was adopted in This text establishes a resolution framework structured in two pillars: Banking supervision and monitoring are done through two tools: When banks fall below established in advance levels of funds, pre-defined corrective measures are applied.
The codification of the sanctions makes predictable the choice of regulator and prevents arrangements between the bank and its regulator. The second pillar means that the method of resolution chosen for a bank in difficulty shall be the one which minimizes the cost of liquidation for FDIC.
According to Finance Watch , it is not sure that these dispositions could avoid a full taxpayer protection, if banks remain interconnected and too big. If a systemic bank is in financial difficulty, it would be difficult to report its losses on other credit institutions without creating a contagion effect. However, Basel III standards require banks to link their credit distribution to their own funds. The risk is that banks are weakened and that credit supply is reduced, contributing to maintain the zone in recession. We would prefer a clear separation between banks playing a quasi-public role management of deposits, loans to households, enterprises, public authorities and banks with financial market activities, the first would benefit from a public guarantee directly by their State and indirectly by the ECB , the others not.
The SRM project deprives the national authorities from all powers. They would be obliged to obey the Single Resolution Board instructions. The losses of a bank would be supported by all countries belonging to the banking union, thereby justifying a single control. According to the project, the Commission and the SRB would be able to decide to impose a resolution plan to a bank, without the agreement of the relevant governments. It is an important step toward European Federalism, which has not yet been accepted by Germany, for instance, which claimed for more political union though a constitutional reform before this hidden step.
The implementation of the guidelines of this new authority may be problematic. A banking group in difficulty may be requested to sell its shares of large national groups. But will national governments agree to expose a national champion to a foreign control?
As shown in the case of Dexia, the terms of a bank restructuring can have serious consequences for the countries where it was operating. Are governments and citizens willing to lose all power in this area? We cannot agree with the Finance Watch Report , which writes: Following the decisions of the 29 June Summit, Spain could be the first country where banks would be directly recapitalised by the ESM. However, this would not occur before ; the modalities of such a procedure and the impact of the ESM support on the governance of recapitalised banks still have to be specified.
The assistance to Spain agreed in summer foreshadows what could the European procedure for banking failure resolution be. On 25 June , the Spanish government requested assistance from Europe to restructure and recapitalise its banking sector. The required conditions have been specified in a Memorandum agreed by the European Council. The document points out the weaknesses of the Spanish economy: The assistance programme has three steps: But the aid is awarded according to two sets of conditions, the first one concerning banks, the second one Spanish governance.
The Commission, the EBA and the ECB can examine the banks having received European aid and may choose to liquidate an institution they consider too fragile. The independence of the Central Bank of Spain and its supervisory power should be strengthened. The Spanish authorities must encourage disintermediation and financing through markets.
Finally, the Spanish Government must reduce public and external deficits and undertake the structural reforms recommended in the context of the European semester. The aid was spread into two parts: All Spanish banks have run stress tests that assessed their recapitalisation needs; their results were published in September. Banks were then classified into four groups. Other Spanish banks are either in Group 2 for those unable to recapitalise on their own or in Group 3 for those which obtained a delay until June to raise capital by themselves. This institution, created on 1 December , will be able to buy assets up to 90 billion euros.
According to Fernando Restoy, the FROB president, haircuts applied to the loans transferred to the bad bank will be Junior and hybrid debts will be converted into equity or will be redeemed with a high discount.
Forthcoming issues
Spanish banks received the second part of 1. The Commission report from March see, European Commission, is optimistic about the recovery of the sector and does not expect other recapitalizations for the moment. Spanish banks soundness is tested via stress tests. Besides, this project monitoring is extremely complex. In the absence of a European supervisor, Spanish public authorities are responsible for the resolution: The difficulty of coordination of such an organisation diminishes the credibility of the project.
The drastic recapitalisation that Spanish banks will have to perform may decrease credit availability, which will deepen recession in Spain. Spain has benefited from a substantial drop in the interest rate it has to pay: In order to set the bases of the future European banking union, the European banking crisis management could extend to all European banks balance sheets the withdrawal of bad loans to an Asset Management Company. Troubled Asset Relief Program, which was intended to clean the financial sector from its toxic assets.
In , the Credit Lyonnais, owned by the French State, was split into a healthy entity pursuing the bank activity and a bad bank responsible to sell all non-performing assets and activities of the Credit Lyonnais Blic, However the pooling of assets within this bad bank generated a global fall in the value of transferred assets, the sale of which was an additional cost for taxpayers. The Cypriot crisis led to the first implementation of the new method of banking crises resolution.
European institutions refused to go beyond an aid of 10 billion euros to Cyprus, considering that this would have induced an unsustainable debt. They refused to help directly a banking system they judge oversized for the country, badly managed, specialized in money laundering and securing dubious Russian assets.
Thus, the new method has been implemented: Shareholders and creditors of Laiki, the second bank of Cyprus, which will be closed down, lose all their assets. The amounts of less than The amount of deposits in excess of However, this implementation of the new European scheme of crisis resolution revealed its weaknesses: Capital flows controls had to be introduced when banks reopened.
Frozen assets and losses for large deposits have affected SMEs and some households doing real estate transaction, having just received an inheritance or saving for their retirement. Above all, Jeroen Dijsselbloem, the Eurogroup President, who said that the model applied in Cyprus corresponded to the future practice of the banking union, had to step back and pretend that the case of Cyprus was unique. The Eurogroup and several leaders of the ECB made similar statements, in full contradiction with on-going projects, thus weakening the choice of bail-in as the method of resolution.
The banking union should include a European deposit guarantee scheme. A deposit guarantee system protects savers in case of bank failure by refunding their deposits up to a certain ceiling. It is one of the sovereign tasks of the State to provide citizens with a risk free instrument of payment and saving. On the other hand, in a banking crisis, information asymmetries between depositors and towards banks strengthen the contagion of panic and cause a rush of investors seeking to withdraw their deposits massively.
Then liquidity crises turn into solvency crises threatening to spillover to the entire banking system. However, it is necessary to distinguish between relatively small deposit amounts, with interest rates incorporating no risk premium, which must be guaranteed and other deposits, with interest rates incorporating risk premia for, deposits that should rightfully bear the risk of losses.
So a government deposit insurance which guarantees that the promised return will be paid to all who withdraw their funds, has a key social benefit because it allows banks to follow a desirable asset liquidation policy, separated from the cash-flow constraint imposed by the panic of depositors. The harmonisation of the deposit guarantee level in Europe would avoid that some countries attract deposits from their neighbours by offering a full guarantee of deposits, a strategy implemented by Ireland during the crisis, knowing that this full guarantee may have heavy consequences for the population of the country concerned.
On the other hand, given the differences in standards of living, the share of guaranteed deposits would widely differ from one country to another. There were, in , 40 different deposit guarantee regimes in the 27 EU countries European Commission, Depending on countries, these schemes are managed by the government, by banks or by both. A group of banks may decide to create a common private fund to guarantee their deposits according to specific rules of their choice. EU lawmakers have developed the deposit guarantee via several directives: The minimum level of guarantee was raised to In , the European Commission put forward the idea of a pan-European deposit guarantee system by [European Commission, ].
It called for a networking of existing systems by proposing the establishment of a mutual borrowing facility between all funds and a gradual harmonisation of procedures. But the European Parliament and the Council disagreed on how to harmonise the systems. The Member States wanted to reduce the financing rate of funds paid by banks, while MEPs wanted to make risky banks contribute more significantly via a system of risk premium.
An agreement was reached in December The target fund level must be reached within a year period. In case of insufficient ex ante funds, DGS will collect immediate ex post contributions from the banking sector, and, as a last resort, they will have access to alternative funding arrangements such as loans from public or private third parties. Bank contributions to DGS will reflect individual risk profiles. The Commission wishes now to launch discussions on the establishment of a pan-European guarantee scheme.
It is necessary for the Scheme to guarantee all European banks because if it covered initially only the strongest large transnational banks, depositors would rush to guaranteed banks and this would immediately increase the risk of a euro area break-up. Under the assumption of a Compared to when regulations in Europe requested a guarantee of The crisis has shown the contradiction between the more and more internationalised structure of European banks and the deposit guarantee which remained at the national level. The problem turned out to be especially acute for countries like Ireland or Cyprus where banking systems were oversized.
This can be prevented in two ways: The first solution is preferred in Europe today. But the Cypriot crisis will perhaps reopen the debate. The Spanish banking crisis recalled the need to protect public finances in the event of bank failure, but in , two issues remain problematic. As the risk of a euro zone exit of a MS has not entirely disappeared, the question is: A European guarantee on deposits in euros is needed to prevent the capital flight away from countries believed to be likely to leave the euro area.
But in the current situation, given the risk that such a guarantee would have to apply for some countries Cyprus, Greece, Portugal or even Spain , it is difficult to implement due to the opposition of Northern countries. The European Commission has not chosen between a uniform rate of contribution to the guarantee scheme and a variable rate depending on the risk level of guaranteed institutions.
UCITS and other collective funds are not insured. Deposits are covered up to an individual amount of It also intervenes to limit bank failures: It has means of resolutions of failures; the most common means is the sale of deposits and credits to another institution. The FDIC resources come from premiums by banking institutions and insured savings, and from the certificates of association signed by the members at their membership and from earnings on investment in US Treasury bills.
Since , the premium of credit institutions is based on their risk level Morel and Nakamura, Thus, until late , the premium of institutions to the guarantee fund varied between 0.
In the period, banks went bankrupt in the US, which divided by three from The current reserve fund represents 0. The FDIC plans to return to its long-term target, a reserve of 1. The European Commission has worked for several years on the networking of European Union banking schemes. This new strategy, the Brady Plan, recognized that the debt overhang could only be eliminated through deep debt reduction, conducted in a manner similar to bankruptcy reorganization.
To implement the plan, multilateral institutions provided substantial sums, on a long-term basis, to finance discounted debt buybacks or financial enticements e. This lending was done on the condition that a definitive settlement with all creditor banks could be simultaneously. The external official sector facilitated bilateral debt restructuring between countries and creditor banks, arguably to the benefit of all involved parties.
Nevertheless, the external official sector protected its own interest by providing financing conditioned on seniority, as in bankruptcy arrangements. It also cajoled leading commercial banks into coordinating their negotiations and preventing free riding, so as to preclude them from unduly benefiting from overall debt reduction.
To effectively leverage the new opportunity for economic recovery offered by eliminating the debt overhang, it was imperative that the policy framework be geared toward encouraging investment, including both the promotion of high-return, domestic investment opportunities and securing the necessary savings from abroad to finance them.
Countries became eligible for the Brady Plan only after meeting these investment readiness requirements. Beginning in and working one country at a time, debt in Latin America was eventually restructured within a few years. Despite increased senior multilateral debt, the programme of debt reduction was sufficiently substantial to facilitate additional market financing.
Hence, market-friendly restructuring, along with official international support, paved the way for renewed access to external market finance Figure 1. In contrast to the debt crises of the s, which the muddle-through strategy of the Baker Plan failed to resolve, these crises could be remedied by the provision of external liquidity. In this instance, although high debt was a complicating factor, the problem did not require debt reduction. In both cases, liquidity provided by the international community in the form of bridge loans or lines of credit helped minimize the risk of debt crisis.
Other cases of liquidity or contagion distress were triggered by international credit shortages, as in the aftermath of the Russian economic crisis when institutions holding high-risk Latin American bonds suffered funding shortfalls. These temporary financial disruptions led to a spike in sovereign risk spread throughout the region.
Unfortunately, at the time, the international liquidity mechanisms that today serve to offset financial stress were poorly developed, and countries suffered various degrees of damage, with some experiencing a debt crisis. While these multilateral arrangements have been extremely successful, they are limited in scale and sustained on the premise of their senior creditor status. This creditor status has been enforced to the point that no shareholder has ever lost money, with the exception of funds diverted through the concessional window available only to the poorest countries.
Similarly, the region has experience with cooperative arrangements within states, in the form of fiscal federalism but such initiatives have faced significant enforcement problems. Firstly, the Latin American experience suggests that correct diagnosis of the nature of the financial crisis in the affected country is crucial.
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Otherwise, if the crisis is not counteracted with external liquidity sufficient to cover temporary dislocations in financial markets and prevent deteriorating fundamentals from validating a market run as in the traditional bank run paradigm , the panic will cause real damage, potentially leading to a full-fledged debt crisis. How are policy makers to know whether external liquidity provision is enough? In the Latin American experience, liquidity stress has typically been associated with identifiable shortcomings in international financial markets, while financial distress stemming from flawed fundamentals has been associated with excessive debt and low-growth prospects in particular domestic economies.
Financial distress of the first type is often alleviated by sufficient liquidity support, but is largely unresponsive in the second. It is essential to discern the factors behind the extreme financial distress, and heretofore resistance to liquidity support, in affected European countries. This persistence of financial distress despite liquidity support is sufficient reason to seriously consider the potential impact of debt overhang and debt restructuring as a policy alternative.
If fiscal profligacy is the root cause of the crisis, fiscal adjustment may be insufficient to right the economy, and likely actively counterproductive if it is not. The adverse effects of debt overhang, fiscal contraction, and worsening capital accounts tend to compound in depressing economic activity, making it difficult to find a growth-positive solution to the debt problem, even with liquidity support and a commitment to fiscal discipline.
While a first attempt to stabilize the economy utilizing liquidity support and fiscal austerity may be given the benefit of the doubt, a vicious cycle of low growth and prohibitive market financing costs should not be allowed to go unchecked, as it did during the Lost Decade. Elimination of the debt overhang through restructuring should be considered as soon as it becomes reasonably clear that excessive debt cannot be reduced by prudent fiscal adjustment and expected growth.
Liquidity provision to avoid disorderly debt default makes is a logical stopgap measure but, if the debt is unsustainable, will only worsen the problem over time. Furthermore, liquidity provision compromises the provider, which is increasingly exposed to credit risk, thus entertaining the possibility of being unable to offer financial support when debt restructuring becomes unavoidable. Experience indicates that recognizing debt restructuring must be part of the solution is a difficult decision, and one that is often excessively delayed Sturzenegger and Zettelmeyer, The involved parties involved usually have incentives to postpone the required restructuring for far too long, as creditors benefit from any economic improvement and, perhaps, debtors wish to avoid accepting political responsibility for an unpopular policy.
In this regard, the cooperative institutions of the eurozone such as the ECB compare favourably with the past support provided to Latin American by the IMF and other extra-regional multilateral institutions. As exemplified by the restructuring of the Greek debt, the European institutions have the ability to cajole private participation in debt reduction schemes despite the absence of over-arching global institutions mandated with the task.
The preconditions and conditionality attached to multilateral lending help ensure that growth recovery will result from debt restructuring. It is this overall efficiency gain that makes debt restructuring a winning proposition for all parties. Debt reduction without growth recovery is obviously contentious and, ultimately, futile. When justified by fundamentals and certified by multilateral institutions following the logic of bankruptcy proceedings, debt restructuring has not had negative consequences for regaining market access. This has occurred, moreover, despite the increase in official senior debt inherent to the restructuring.
In the case of Latin America, the conditionalities imposed by supranational entities such as IMF to constrain imprudent policy behaviour could perhaps be justified on the basis of domestic governance distortions, but not moral hazard. The risk of moral hazard may be relevant to the European contest in so far as its external financing is more generous and its repayment enforcement more lax than that of multilateral senior lending to Latin America. This is especially relevant in the case of pari passu official lending to European crisis countries.
While senior official lending may fail in its objective by discouraging future junior private lending, pari passu official lending may induce moral hazard. Of these, it is of particular interest to analyse banking crises linked to public debt crises, which often go hand-in-hand, reinforcing each other and underlying the high incidence of twin banking and debt crises in the region. However, the banks — loaded with sovereign debt, either as a result of financial repression or their own choice — end up inheriting the risk of a debt crisis.
Conversely, deeper financial systems may yield a substantial growth dividend, but at the expense of increasing the costs of resolving banking crises when they occur. More specifically, the resolution of banking crises stemming from unsustainable expansions usually draws fresh resources from the public sector, thus creating a substantial jump in public debt.
If liquidity risks appear to be at play in a situation of bank distress, experience indicates that it is paramount to swiftly provide ample liquidity, in accordance with the traditional Bagehot doctrine, rather than wait to confirm whether the treatment is necessary and will be effective. Nevertheless, the principle of minimizing entanglement between banking crisis resolution and sovereign debt still applies. In a situation of fragile public debt, it is better to err on the side of resolution mechanisms that economize public resources.
In the case of Argentina in , for instance, many provincial banks were privatized, while insolvent banks were closed—or reorganized to shed their unviable aspects—rather than recapitalized. This helped minimize the burden of resolving the banking crisis borne by the public sector. At the outset, increasing sovereign risk contributed to the bank runs of Subsequent attempts at crisis resolution compounded the attendant risks by penalizing bank assets through the conduct of currency conversion i. This arrangement failed to inspire confidence in depositors, who were prevented from further running only through the enactment of highly punitive controls.
For those institutions unable to address their problems themselves, all available external resources were pooled to ring-fence and fully secure the payment system, while the maturity dates of time deposits were gradually stretched by legal fiat to help stabilize the system utilizing its existing resources.
In parallel, public debt was restructured separately with bondholders at large, a tactic that also followed the minimalist approach of stretching maturities and restoring pre-crisis interest rates. This balkanization strategy was successful in diffusing the financial crisis and promoting subsequent normalization. Foreign banks, as discussed, were not drawn into the problem, thus simplifying resolution of the crisis.
First and foremost, entangling banking crisis risks with sovereign debt crisis risks is a recipe for disaster. There is, however, a high premium on keeping these risks separate. Depending on the circumstances, this general principle may take different forms. If, due to contagion or panic, liquidity conditions are at work, it is essential to swiftly provide ample liquidity rather than wait for greater clarity, regardless of the fact that some resources may be put at risk.
The spread of banking risk to sovereign risk may constitute a point of no return. On the other hand, if banking problems are more fundamental e. In the Latin American experience, this problem was addressed utilizing some combination of: This last approach involves freeing healthy generally foreign banks from interference and concentrating resources on key banking functions, such as the payment system. As the ECB can provide unlimited bank support in euros, this complication is obviously absent in eurozone countries.
Nevertheless, ECB decisions are mediated by a cooperative arrangement requiring the agreement of all involved parties, in contrast to falling under the sovereign control of a single state. In any event, the protection of the sovereign is, of course, maximized when external financial resources are used to support the banking system. In the European context, their own EU institutions not just the IMF may support bank liquidity and provide the credit lines required to implement the much-needed bank support.
It is clear that for the purpose of minimizing entanglement, these resources, ideally, should not be sovereign-guaranteed. While this was an unthinkable luxury in the case of Latin America, it may be feasible in the context of supranational EU entities such as the banking union, to the great advantage of peripheral states. As financial integration resumed in the s, the region became increasingly exposed to sudden stops in capital flows. Regardless of how they materialize, sudden stops affect the financing of the overall balance of payments.
As a result, affected countries that were previously running current account deficits are forced to close them abruptly. This is usually done through large real exchange rate depreciations. Moreover, sudden stops in the region usually coincided with banking crises and, in the case of countries with fixed exchange rates, currency crises as well Calvo, Izquierdo and Talvi, Some of these currency crises were forced by speculative attacks against local currencies pegged to the dollar, wherein a surge in uncertainty led to an increase in the demand for hard currency, depleting the reserves of the Central Bank and creating a currency crash.
Fortunately for Europe, eurozone countries in crisis, as they lack a local currency, are not vulnerable to destabilizing speculative attacks. Systemic Banking Crisis dates in the region from Laeven and Valencia The main manifestation of this domestic savings shortfall is the incursion of large current account deficits as a percentage of GDP. In this respect, the situation in peripheral European countries today is even more troubling than that of Latin America in the mids Figure 3. Latin America and Europe: Saving, Investment and Current Account.
Any external financing shortfall imposed by the crisis on peripheral economies not offset by liquidity support from external sources must be accommodated; adjustment therefore remains a problem. While the ability of the ECB to provide the balance of payments support needed to control financial stress compares favourably with that of the IMF to help offset sudden stops in Latin American countries, if the underlying economic fundamentals call for adjustment, it cannot resolve the crisis.
If adjustment is required, then the Latin American experience with sudden stops may be useful to contemporary Europe. Although European countries are open economies with large tradable sectors, the currency union severely restricts the scope for engineering the adjustment through real exchange rate depreciation and may thus induce a recessionary adjustment to dampen domestic demand. On the cyclical front, the challenge for governments is to transition the adjustment into a tighter external financing constraint while avoiding spillovers into the banking system.
In a review of policy responses to sudden stops in Latin America, Cavallo and Izquierdo document the lates crisis resolution mechanisms of eight Latin American countries. They conclude that successful crisis resolution is more likely when countries are able to use expansionary macroeconomic policies to stimulate the economy during the external credit crunch. Nevertheless, the authors caution that, in the absence of large sums of largely unconditional money provided by the international community to bridge a protracted fiscal gap, successful crisis resolution requires that each country finance its own stimulus by saving during prosperous times.
Raccourcis
Given that countries in distress are rarely able to fiscally fend for themselves, the lesson of primary relevance from the Latin American experience is that external financial packages are crucial to smoothing the post-sudden stop adjustment. This explains, for example, why Mexico recovered fairly quickly after the Tequila Crisis of , having received a USD 50 billion package partially financed by the U. That said, while individual countries may lack the tools to implement countercyclical policies, such tools do exist at the eurozone level.
Of course, using those tools would inevitably entail a reallocation of resources within the European Union, from more creditworthy countries to less creditworthy ones. Such support is reminiscent of a standard external financial package, and would thus carry similar moral hazard risks, to the extent that it is given as a transfer or lent with credit risk. In the late s, when the effects of the Asian and Russian financial crises began to be felt in Latin America, much confusion persisted regarding the nature of the shock and its possible implications.
The region had only recently recovered from the contagion effects of the Tequila banking crisis, and for a time it was believed that the crisis would be similar — that is, that the credit crunch would be short-lived and contagion would ultimately be contained. Reality, however, proved to be quite different, as three years into the crisis, capital flows had not yet returned to the region at normal levels. Assessing the damage caused by liquidity stress, and the point at which liquidity problems are no longer temporary, is critical to effective policymaking. In the case of Argentina, for example, more than three years into the credit crunch, the authorities were still working under the assumption that liquidity could be restored, resulting in their pursuit of an ill-advised debt swap that pushed obligations forward in time.
By the time the government finally switched strategies in late , launching an orderly restructuring program to reduce the debt burden to sustainable levels, the IMF had also changed strategies, withdrawing its financial support due to disagreements with authorities over the macroeconomic framework. From a cyclical standpoint, expansionary macroeconomic policies may help smooth the adjustment. If, as is often the case, countries are not able to finance the stimulus themselves, external official assistance is needed.
In such cases, unconditional external financial assistance would serve only to delay an otherwise unavoidable adjustment in favour of permanently tighter financing constraints. Countercyclical policies financed with external financial assistance may allow time for economies to adjust, but are no substitute for structural reforms aimed at reducing underlying vulnerabilities and restoring long-term growth. Correspondingly, Troika financial support would not be a solution in and of itself. External support ought to be conditional on the country remedying its structural weaknesses. In this instance, debt reduction was implemented concurrently with structural reforms, giving credibility to fiscal discipline and allowing for the productive use of renewed investment.
Immediately after the Brady Plan restructuring of the s, growth-oriented reforms enabled external market financing to include new instruments like portfolio debt and equity. Debt reduction alone was not enough to stem the crisis and spur recovery. Following Lora and Panizza , we focus on five areas of reform: The central focus of the reforms, first adopted in the late s, was market liberalization and the removal of controls on the allocation of productive resources. During that period, the structural reform process in Latin America was incomplete and quite uneven, across both countries and areas of reform.
The greatest advances occurred in the early s in the areas of trade liberalization and financial market reforms aimed at avoiding financial repression. Labour reform is the only area in which progress has been quite limited, both in degree and the comparatively small number of countries pursuing it.
Firstly, the reforms were observed to have significant but transient effects on growth. Growth accelerated, on average, by more than 1 percentage point in the aftermath of the strongest wave of structural reforms, but the growth effect abated as the reform impetus waned. Secondly, the growth-enhancing effect of reforms was higher in countries with better institutional environments, generally measured as strong rule-of-law.
Interpreting the lessons from the Latin American experience in this area too broadly is unwarranted.
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In the areas in which Latin America underwent the greatest change in the s, namely trade openness and financial market reform, most European countries, arguably, do not need reform.