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---

### Executive summary — overview
- Selected issues paper accompanies the staff report and discusses:
  - bank lending constraints (¶1 and Box 1 of the staff report),
  - fiscal governance (Section VI.A of the staff report),
  - governance of structural reforms (Section VI.B of the staff report),
  - financial reform challenges (Section VI.C of the staff report).

### Chapter I — Euro Area: A Bank Credit Crunch?
- Core findings on bank lending and corporate financing:
  - Recent divergence in external debt financing patterns of corporations suggests bank lending constraints are binding.
  - Since early 2009, corporate credit costs have declined and net issuance of corporate debt has soared, while bank lending growth to non-financial companies has fallen sharply.
  - Survey results and disaggregated bank loan data indicate bank loan supply constraints are driving this divergence rather than differences in firms’ risk profiles between large companies and SMEs.
  - The substitution of debt securities for bank loans by non-financial corporations is unprecedented in the available period and points to supply-side constraints.
  - Disaggregated data show a relatively stable ratio of large to total bank loans; large corporations shifted to capital markets while bank loans to large corporations fell at similar rates as total loans.
  - ECB SME survey (2009) found deterioration in availability of bank loans: net percentage reporting deterioration was 28 percent for large firms and 32 percent for SMEs.
- Quantitative impact estimates (VAR results and interpretation):
  - A simple VAR model (variables: real GDP q-o-q growth, overnight interest rate, real bank loans q-o-q growth, difference in annual growth rates of bank loans and debt securities; sample/data periods noted in text) indicates:
    - The loans supply shock experienced in 2009 could lower GDP by about 2 percentage points during 2010-11.
    - A 20 percentage point increase in the growth difference (bonds minus bank loans) would reduce GDP by about 2 percent over the next two years.
    - A 100 basis point increase in interest rates lowers GDP by about 1.2 percent after two years.
  - Alternative framing in the text: constrained bank loan supply could shave about 1 percentage point off growth in both 2010/11.
- Mechanisms and distributional effects:
  - Large corporations often access capital markets; bank-dependent firms (mostly SMEs) face binding credit constraints.
  - SMEs account for 60 percent of value added and 70 percent of employment in the euro area.
- Supporting evidence and caveats:
  - Aggregate credit-to-GDP ratios are non-stationary and do not clearly indicate causality between credit and output; pockets of credit rationing likely exist.
  - Demand factors played a key role: weak corporate demand (investment, working capital, inventories) contributed to weak bank lending growth.
  - Identification of loan supply shocks can be confounded by benign developments (capital market innovation or financial deepening); results corroborated by cross-country and analytical studies showing financial-crisis-induced recessions are deeper and longer-lasting and “creditless” recoveries average about two percentage points lower growth.
- Data notes:
  - Sample/data periods referenced in the text include 1990:1–2009:4; 1995:1–2009:4; 1999–2001 (euro adoption dummy discussed).
  - Staff calculations underpin GDP impulse responses (VAR with 3 lags) to one standard deviation shocks in the endogenous variables.

### Chapter II — Gaps in the Euro Area Fiscal Framework: Options for a New Fiscal Contract
- Main diagnosis:
  - The existing euro area fiscal framework has main gaps; reforms should improve enforcement and crisis management capacity.
  - For the second time in less than 10 years, the euro area’s fiscal framework is under severe stress; failure to encourage fiscal discipline in good times was key.
- Long-standing flaws identified:
  - (a) The preventive arm of the SGP failed to encourage buildup of sufficient buffers in good times; exclusive reliance on soft law in the preventive arm is partly to blame.
  - (b) Weak governance aggravated structural flaws; surveillance focused narrowly on procedural aspects and formal deficit limits; EDP enforcement was tainted by political considerations in the Council.
  - (c) The fiscal framework lacked centralized crisis management and resolution capacities, increasing risk of ad-hoc bailouts.
- Broad reform options:
  - Create a central fiscal agency, or
  - Perfect the existing framework within the boundaries of the Treaty or with only minor amendments.
- Central agencies — independent fiscal agency:
  - Two categories: fiscal authorities (policy prerogatives) and fiscal councils (technical/advisory/monitoring).
  - Design principles: (i) simple and transparent mandate; (ii) instruments to constrain or incentivize national governments; (iii) independence from political constraints; (iv) accountability.
  - Advantages: strengthen fiscal discipline, improve balance between credibility of rules and policy flexibility.
  - Practical considerations: fiscal authorities could set binding constraints or mandate across-the-board spending cuts; fiscal councils could provide independent monitoring and public assessments and form basis for judicial enforcement via the European Court of Justice (proposal noted).
- Central agencies — an EMU bond:
  - Centralizing public debt issuance via a single European bond could limit contagious sovereign crises, use terms of access as incentive devices, lower average borrowing costs, and create a deep sovereign bond market.
  - Institutional and legal challenges: extensive pooling may conflict with Treaty Art. 125 (“no-bail-out”); EFSF creates precedent of resource pooling.
  - Key operational issues for an independent issuer: address moral hazard via on-lending conditions/pricing tied to numerical limits, provide transparent mechanisms to deal with members facing financing difficulties.
- Strengthening the existing framework (less transformative options):
  - Ambitious reforms within current Treaty boundaries could close gaps considerably.
  - Ensure all member states have strong budget procedures and institutions; use binding legal instruments (e.g., a Directive pursuant to Article 136) to foster convergence toward high standards.
- Enforcement and governance — specific proposals:
  - Modify the role of the Council in implementing the EDP, broaden sanctions, and create formal accountability for national governments.
  - Possible actions:
    - (i) introduce greater automaticity in moving up steps in the EDP during benign times, while giving stronger discretionary powers to the Commission when sanctions must be decided;
    - (ii) establish non-pecuniary sanctions to avoid undermining adjustment efforts;
    - (iii) adopt measures that maximize reputational and political costs for offenders.
  - Details:
    - Automaticity would rebalance the 2005 reform; in benign times steps could be fully automatic and accelerated in well-defined circumstances (e.g., misreporting, high and rising debt).
    - Imposition of sanctions should remain discretionary based on sound economic judgment; to strengthen decision-making the Commission could be given the decision to impose sanctions with only a veto right for the Council, or the Council could be required to publicly justify deviations.
    - Pecuniary sanctions in bad times lack credibility and should be imposed only in good times; non-pecuniary sanctions (e.g., voting rights) could be considered.
- Strengthening accountability and national integration of stability programs:
  - National governments should face formal accountability requirements beyond ex-ante peer reviews.
  - Possible measures: public hearings with the Council or ECFIN committee to explain deviations; better integration of stability programs in national budget processes.
- Expanding surveillance and early warning triggers:
  - Allow activation of an EDP regardless of the deficit trigger if clear risks to public debt dynamics are detected.
  - Base fiscal surveillance on a broad set of indicators signaling imbalances with potential severe, durable budgetary impact.
  - Emphasize monitoring expenditures via medium-term expenditure ceilings and focus on debt sustainability.
- Using public debt level as an explicit EDP trigger:
  - Options include EDPs for countries where public debt is above 60 percent of GDP could only be abrogated when they reach a structurally balanced position (or medium-term objective).
  - Commission proposal (May 12, 2010 Communication): activate EDP regardless of deficit trigger if decline in public debt toward 60 percent is insufficient; recommendation to focus on medium-term trend implied by unchanged policies.
- Symmetric incentives: safeguards in bad times and tightening in good times:
  - Proposals:
    - Give greater role to cyclical considerations and revenue buoyancy; re-define reference value in Treaty Protocol No 12 as the upper-bound of a nominal deficit range consistent with structural balance.
    - Incentivize “rainy day funds” or higher balances in good times by giving credit during bad times for overperformance; alternative: a fictitious “compensation account” centrally run (no real money).
    - Introduce hard-law elements in the preventive arm (e.g., mandatory interest-bearing deposits if progress toward MTO insufficient).
    - Automatically adjust certain tax and expenditure items to cyclical developments to complement automatic stabilizers.
- A third way: binding through harmonized national frameworks:
  - Encourage member states to transpose common fiscal-responsibility objectives into national frameworks.
  - Harmonization guided by (i) rules compatible with spirit of SGP (at least structural balance); (ii) credible national enforcement procedures adapted to each member state.
  - Proposal: create non-partisan national fiscal councils to monitor, analyze, advise on preventive action, and ideally trigger judicial procedures activating sanctions.
  - European System of Fiscal Responsibility Council (ESFRC) could work with the Commission to improve fiscal surveillance and ex-ante peer review of budgets.
- Crisis management: conditional financing and strengthened escalation:
  - Create a conditional financing mechanism to avert market disruptions paired with enhanced high-frequency monitoring.
  - Immediately escalate the EDP to Article 126-9 to request specific measures within a pre-defined time frame under threat of sanctions (would likely require amendment to Art. 126).
  - In extreme stress, consider transfer system in form of highly-concessional loans with extensive grace periods.
  - Moral-hazard concerns reinforce case for improved surveillance and stricter enforcement.

### Chapter III — Narrowing the Gap Between an Optimal Currency Area and EMU: Integrating the Labor Market
- Core message:
  - Deepening structural reforms yields substantial benefits for euro area countries and makes monetary union more effective and sustainable.
- Reform priorities:
  - Establish a common set of regulations on labor contracts for all workers without constraining job turnover.
  - Further activate tax and benefit systems.
  - Seek employment-friendly wage bargaining.
  - Fully liberalize services sectors and renew the Single Market Program.
- Expected returns and channels:
  - Raise employment rates to meet fiscal strains from population ageing and crisis-support measures.
  - Countries with strict employment rules display lower turnover and face marked increases in structural unemployment after downturns.
  - Generous but time-limited unemployment benefits contingent on activation and training shorten unemployment spells and preserve skills.
  - Activating female and older workers via tax and pension reforms increases labor supply; policy levers include actuarially neutral pension systems and tax incentives for second earners.
  - Single Market liberalization in services amplifies employment returns; product market competition fosters reallocation, scale economies, and innovation.
  - Harmonized labor-market institutions reduce asymmetric consequences of common shocks and ease adjustment.
- Delivering structural reforms — supranational instruments:
  - Treat properly functioning labor markets as an EMU public good; apply heightened coordination/surveillance to labor taxation, unemployment benefits, employment protection legislation, and aspects of collective bargaining.
  - Strong Eurogroup commitment: upgrade peer review of fundamental structural reforms (art. 136).
  - Integrate surveillance of structural reforms with the Stability and Growth Pact to analyze policy interactions.
  - Monitor both performance and policy indicators; give Commission more power to issue warnings (art. 121.2).
  - Use sanctions and incentives: channel financial incentives through a reformed EU budget with disbursements linked to reform implementation; consider reallocating budget toward regional competitiveness and employment objectives.

### Chapter IV — Financial Sector Reform in the EU: The Current State of Play
- State of play and challenges:
  - Agreement in principle exists on creating a European supervisory structure comprising the European Systemic Risk Board (ESRB) and European Supervisory Authorities (ESAs), but important details remain to be worked out and will determine effectiveness.
  - The Commission plans steps to strengthen national resolution tools; a pan-European resolution fund and resolution authority can further strengthen stability.
- Banking-sector assessment and recommended actions:
  - Further bank recapitalization, restructuring and consolidation are crucial to restore credit flow and stability.
  - Weaker banks need to:
    - raise additional capital,
    - clean up balance sheets,
    - present a convincing business model with sound governance,
    - or face restructuring, divesture or takeover.
  - Long-term public ownership stakes are questionable as they may hamper restructuring and consolidation.
  - Regulatory reform decisions should be made soon to reduce uncertainty.
- ESRB role and challenges:
  - ESRB envisaged to conduct macro-prudential supervision but "will not have binding powers" and will issue risk warnings and recommendations with a "comply or explain" follow-up.
  - Proposed ESRB agenda: (i) risks from largest/interconnected institutions; (ii) increases in financial imbalances and asset bubbles; (iii) structural and technological changes increasing systemic risk.
  - Operational challenges: ensure strong action on emerging risks and ensure ESRB analysis informs regulators and supervisors at all levels.
- Systemically important institutions and macro-financial imbalances:
  - Crisis showed some institutions are "too large, too interconnected, or too important to the real economy to be allowed to fail under standard bankruptcy proceedings."
  - Measures discussed: robust bank-specific resolution mechanisms; capital surcharges for systemic contribution; structural interventions including break-up where necessary.
  - EU-wide calibration: capital requirements and countercyclical provisioning should reflect location- and sector-specific risks; ESRB should guide such calibration.
- Microprudential supervision and ESAs:
  - ESFS will bring together national supervisors with three sectoral ESAs and a Joint Committee; ESAs tasked with a single rule book, harmonized supervisory practices, and binding powers to mediate disputes.
  - Political negotiations have tightened fiscal safeguard provisions and voting procedures, weakening ESAs’ powers relative to Commission proposals; European Parliament seeks stronger bodies and complementary institutions.
  - Staff priorities: strengthen ESAs’ binding powers and roles in colleges for largest groups; establish time-efficient rule-making procedures; limit fiscal safeguard clause to cases with direct, identifiable, sizable fiscal costs; acceptable to delay implementation to secure a solid agreement.
- Crisis management and resolution — proposals:
  - Staff cornerstone: European Resolution Authority (ERA) with mandate and tools to deal with failing cross-border banks; industry-financed European Deposit Insurance and Resolution Fund (EDIRF); fiscal backstop.
  - Interim steps: enhanced national resolution regimes, Crisis Management Groups (CMGs) or Cross-Border Stability Groups (CBSGs), Recovery and Resolution Plans (RRPs), ex-ante burden-sharing preparations.
  - Deposit Guarantee Schemes reform should be consistent with crisis resolution plans; EU-level DGS must be matched with strong European supervision and resolution framework.
  - Immediate improvements: EFC ad hoc working group proposals include strengthening ECOFIN role, creating EFC crisis coordination cell, and requiring RRPs; recommend ESAs representation in CMGs/CBSGs.
- Regulatory reform and macroprudential scope:
  - Basel-based reforms underpin EU regulatory reform (CRD IV consultation): common liquidity standards, tightening capital quality, leverage ratio, measures to counter procyclicality, counterparty credit risk emphasis.
  - Concerns: cumulative impact on cost of financial intermediation; need robust calibration and consideration of timing.
  - Regulatory reform should provide scope for macro-prudential policies (e.g., capital surcharges for systemically important institutions; buffers responsive to buildup of financial imbalances); consider framework directive approach to allow modular calibration by European authorities.
- Market infrastructures and derivatives:
  - Challenge: extent to which framework mandates central clearing by CCPs; mandation may create single-point-of-failure risks for illiquid contracts.
  - Pragmatic solution: mandate clearing for sufficiently standardized and liquid contracts; for others, use capital framework to penalize bilateral clearing and incentivize CCP use.
- Operational and data recommendations:
  - Establish single rulebook via harmonized legislation and ESAs rule-making scope; consider centralized prudential databases managed by ESAs with direct reporting by banks.
  - Increase qualitative information sharing and reassess confidentiality; publish selected non-sensitive prudential data to increase market transparency.
  - ESAs and ESRB must avoid supervisory gaps given the set-up complexity.
- Funding, levies and pan-European arrangements:
  - EC proposed risk-based levy to feed financial stability funds; advantages of dedicated fund: quick mobilization, aiding resolution of systemic institutions, enabling early intervention.
  - Moral hazard mitigated by effective resolution framework ensuring losses borne by shareholders and creditors first.
  - Pan-European Financial Stability Fund and ERA offer advantages when countries are fiscally constrained but require preclusion of moral hazard, strong governance, and quick decision-making.

### Policy recommendations and operational guidance (summary)
- Banking sector and credit supply:
  - Prioritize further bank recapitalization, restructuring and consolidation.
  - Ensure adequate credit provision to sound SMEs through channels other than commercial banks where appropriate.
  - Supervisors should avoid unduly limiting credit availability to sound SMEs, recognizing banks’ relative cost-efficiency in assessing SME creditworthiness when bank–SME relationships exist.
  - Facilitate SMEs’ access to financing as part of the EU response to the crisis; prior measures had limited uptake.
- Fiscal governance:
  - Strengthen enforcement mechanisms at EU level (automaticity in EDP steps, increased Commission powers, non-pecuniary sanctions) or reinforce national frameworks via non-partisan fiscal councils.
  - Consider central fiscal authority or EMU bond proposals while addressing legal and moral-hazard implications.
  - Expand surveillance, use public debt level as an explicit EDP trigger where appropriate, and create symmetric incentives for tightening in good times and safeguards in bad times.
- Structural reform implementation:
  - Advance common labor market regulations, service liberalization, activation of tax and benefit systems, and integrate structural reform monitoring with the SGP.
  - Use Eurogroup commitment, integrated surveillance, and Commission warnings to enhance traction.
  - Channel financial incentives through a reformed EU budget linked to reform implementation.
- Financial sector reform implementation:
  - Clarify the details of European supervisory architecture; strengthen ESAs’ powers and ESRB effectiveness.
  - Develop stronger national and pan-European resolution tools, including consideration of a European Resolution Authority and an industry-financed European Deposit Insurance and Resolution Fund, with fiscal backstop arrangements.
  - Harmonize crisis management frameworks, improve deposit guarantee schemes consistent with resolution framework, and create time-efficient rule-making and data-sharing arrangements.

### Key quantitative and survey statistics extracted from the text
- SMEs: 60 percent of value added and 70 percent of employment in the euro area.
- ECB SME survey (2009): net percentage reporting deterioration in availability of bank loans — 28 percent for large firms and 32 percent for SMEs.
- VAR model effects:
  - Loans supply shock experienced in 2009 could lower GDP by about 2 percentage points during 2010-11.
  - A 20 percentage point increase in the bonds vs. bank-loans growth difference would reduce GDP by about 2 percent over the next two years.
  - A 100 basis point increase in interest rates lowers GDP by about 1.2 percent after two years.
- Sample/data periods and notations retained from the text where relevant: 1990:1–2009:4; 1995:1–2009:4; 1999–2001 (euro adoption dummy discussed).

*Prepared by Xavier Debrun (chapter content and staff calculations as presented).*
*IMF staff analysis and recommendations as presented in the source PDF.*

### EXECUTIVE SUMMARY

### EXECUTIVE SUMMARY

### Overview
- The selected issues paper accompanying the staff report discusses:
  - bank lending constraints (¶1 and Box 1 of the staff report),
  - fiscal governance (Section VI.A of the staff report),
  - governance of structural reforms (Section VI.B of the staff report),
  - financial reform challenges (Section VI.C of the staff report).

### Chapter I — Euro Area: A Bank Credit Crunch?
- Core findings:
  - Recent divergence in external debt financing patterns of corporations suggests bank lending constraints are binding.
  - Since early 2009, corporate credit costs have declined and net issuance of corporate debt has soared, while bank lending growth to non-financial companies has fallen sharply.
  - Survey results and disaggregated bank loan data indicate bank loan supply constraints are driving this divergence rather than differences in firms’ risk profiles between large companies and SMEs.
  - The substitution of debt securities for bank loans by non-financial corporations is unprecedented in the available period and points to supply-side constraints.
  - Disaggregated data show a relatively stable ratio of large to total bank loans, implying large corporations shifted to capital markets while bank loans to large corporations fell at similar rates as total loans.
  - ECB SME survey (2009) found deterioration in availability of bank loans: net percentage reporting deterioration was 28 percent for large firms and 32 percent for SMEs.
- Quantitative impact estimates:
  - A simple VAR model (variables: real GDP q-o-q growth, overnight interest rate, real bank loans q-o-q growth, difference in annual growth rates of bank loans and debt securities; sample and data sources detailed in text) indicates:
    - The loans supply shock experienced in 2009 could lower GDP by about 2 percentage points during 2010-11.
    - A 20 percentage point increase in the growth difference (bonds minus bank loans) would reduce GDP by about 2 percent over the next two years.
    - A 100 basis point increase in interest rates lowers GDP by about 1.2 percent after two years.
  - The analysis also notes that constrained bank loan supply could shave about 1 percentage point off growth in both 2010/11 (alternative framing reported in the text).
- Mechanisms and distributional effects:
  - Large corporations often access capital markets; bank-dependent firms (mostly SMEs) face binding credit constraints.
  - SMEs account for 60 percent of value added and 70 percent of employment in the euro area.
- Supporting evidence and caveats:
  - Aggregate credit-to-GDP ratios are non-stationary and do not clearly indicate causality between credit and output; pockets of credit rationing likely exist.
  - Demand factors played a key role: weak corporate demand (investment, working capital, inventories) contributed to weak bank lending growth.
  - Identification of loan supply shocks can be confounded by benign developments (capital market innovation or financial deepening); results are corroborated by cross-country and analytical studies showing financial-crisis-induced recessions are deeper and longer-lasting and “creditless” recoveries average about two percentage points lower growth.

### Chapter II — Gaps in the Euro Area Fiscal Framework: Options for a New Fiscal Contract
- Main argument:
  - The existing euro area fiscal framework has main gaps; reforms should improve enforcement.
- Key reform ingredients suggested:
  - Consider a paradigm shift toward a central fiscal authority empowered to define and enforce deficit limits (noting that reopening the Treaty would take time).
  - Much of the benefit of a central authority could be achieved by strengthening enforcement of the Stability and Growth Pact (SGP):
    - Greater automaticity in moving up steps in the Excessive Deficit Procedure (EDP) during benign times.
    - Stronger discretionary powers for the Commission when sanctions must be imposed.
    - Use of non-pecuniary sanctions to avoid undermining adjustment efforts.
  - Alternatively, enforce SGP-compatible deficit limits through coordinated reforms of national fiscal frameworks:
    - Non-partisan fiscal councils at the national level could help enforce rules reflecting the spirit of the SGP.

### Chapter III — Narrowing the Gap Between an Optimal Currency Area and EMU: Integrating the Labor Market
- Core message:
  - Deepening structural reforms yields substantial benefits for euro area countries and makes monetary union more effective and sustainable.
- Recommended reform focus:
  - Establish a common set of regulations on labor contracts for all workers without constraining job turnover.
  - Further activate tax and benefit systems.
  - Seek employment-friendly wage bargaining.
  - Fully liberalize services sectors.
- Supranational actions to strengthen reform traction:
  - Strong commitment by the Eurogroup to structural reform.
  - Integrated surveillance with the Stability and Growth Pact with clearly defined targets.
  - More power for the Commission to issue warnings.

### Chapter IV — Financial Sector Reform in the EU: The Current State of Play
- State of play and challenges:
  - Agreement in principle exists on setting up a new European supervisory structure comprising a new European Systemic Risk Board (ESRB) and European Supervisory Authorities (ESAs), but important details remain to be worked out and will determine effectiveness.
  - The Commission is planning steps to strengthen resolution tools at the national level.
  - A pan-European resolution fund and resolution authority can further strengthen overall stability in a financially integrated region such as the EU.

### Policy Recommendations and Operational Guidance
- Priority actions to address bank lending constraints and support recovery:
  - Fixing the banking sector is crucial to alleviate loan supply constraints and support growth.
  - Ensure adequate credit provision to sound SMEs through channels other than commercial banks where appropriate.
  - Supervisors should ensure their actions do not unduly limit availability of bank credit to sound SMEs, recognizing banks’ relative cost-efficiency in assessing SME creditworthiness when bank–SME relationships exist.
  - Facilitate SMEs’ access to financing as part of the EU response to the crisis, noting prior measures had limited uptake.
- Fiscal governance reforms:
  - Strengthen enforcement mechanisms at EU level (automaticity, Commission powers, non-pecuniary sanctions) or reinforce national frameworks via non-partisan fiscal councils.
- Structural reform implementation:
  - Advance common labor market regulations and service liberalization, and integrate structural reform monitoring with the SGP.
- Financial sector reform implementation:
  - Clarify the details of the European supervisory architecture and develop stronger national and pan-European resolution tools, including consideration of a pan-European resolution fund and authority.

### Key Quantitative and Survey Statistics Extracted from the Text
- SME contribution: 60 percent of value added and 70 percent of employment in the euro area.
- ECB SME survey (2009): net percentage reporting deterioration in availability of bank loans — 28 percent for large firms and 32 percent for SMEs.
- VAR model effects:
  - Loans supply shock experienced in 2009 could lower GDP by about 2 percentage points during 2010-11.
  - A 20 percentage point increase in the bonds vs. bank-loans growth difference would reduce GDP by about 2 percent over the next two years.
  - A 100 basis point increase in interest rates lowers GDP by about 1.2 percent after two years.
- Sample/data periods and notations retained from the text where relevant: 1990:1–2009:4; 1995:1–2009:4; 1999–2001 (euro adoption dummy discussed).

*EXECUTIVE SUMMARY*

### 13.      More important though are further bank recapitalization, restructuring and

### 13.      More important though are further bank recapitalization, restructuring and 

### Banking-sector assessment and recommended actions
- Further bank recapitalization, restructuring and consolidation of the banking sector are more important than other measures to restore credit flow and stability.
- Especially weaker banks need to:
  - raise additional capital,
  - clean up their balance sheets,
  - put forward a convincing business model embedded in a sound governance structure,
  - or face restructuring, divesture or takeover.
- The desirability of long-term public ownership stakes is questionable as they may rather hamper than accelerate restructuring and consolidation of the European banking sector, especially across national borders.
- Regulatory reform decisions need to be made soon to reduce uncertainty.

### Empirical and survey evidence (notes from figures)
- Data on bank loans to non-financial corporations and securities other than shares issued by non-financial corporations are from the ECB and nominal GDP data are from Eurostat.
- The ECB Bank Lending Survey (2003Q1-2010Q1) reports net percentages of banks reporting tightening credit standards; the net percentage is calculated as the difference between reported “increases” and “decreases.”
- The ECB Bank Lending Survey documents effects of capital costs on lending across 2009Q3, 2009Q4, and 2010Q1, categorizing responses from “Considerable impact on both capital and lending” to “Basically no impact on capital.”
- Data on BBB (corporate euro bonds) minus German Bund yields are from DataStream.
- Large loans are defined as corporate loans exceeding 1 million euro. Data are from the ECB.
- The ECB SME Survey reports net percentages of respondents on changes in availability of external financing over July-December 2009 (categories: Bank Loans; Trade credit; Equity investment; Debt security; Other). The net percentage is calculated as the difference between reported “increases” and “decreases.”
- Staff calculations underpin GDP impulse responses (VAR with 3 lags) to one standard deviation shocks in the endogenous variables.

### Fiscal framework: identified gaps
- For the second time in less than 10 years, the euro area’s fiscal framework is under severe stress; failure to encourage fiscal discipline in good times was key.
- Long-standing flaws that need urgent attention:
  - a. The preventive arm of the SGP has failed to encourage the buildup of sufficient buffers in good (boom) times, slowing down the decline in public debts and limiting countercyclical firepower in bad (bust) times. Exclusive reliance on soft law in the preventive arm of the SGP is partly to blame.
  - b. Weak governance aggravated the structural flaws of the SGP. Regular fiscal surveillance focused narrowly on procedural aspects and formal deficit limits; enforcement of the EDP was tainted by political considerations inherent to the Council’s ultimate responsibility in implementing the Procedure. Result: insufficient room for sound economic judgment and insufficient analysis of fiscal risks.
  - c. The fiscal framework lacked centralized crisis management and resolution capacities, increasing the risk of ad-hoc bailouts. A conditional credit facility accessible to euro area members facing financing stress was conceived only under panic on sovereign debt markets.

### A new fiscal contract: broad reform options
- Two broad classes of reforms:
  - create a central fiscal agency, or
  - perfect the existing framework within the boundaries of the Treaty or with only minor amendments to it.

### Central agencies — independent fiscal agency
- Two categories proposed: fiscal authorities (akin to central banks, with policy prerogatives) and fiscal councils (technical, advisory, monitoring roles).
- All independent fiscal agencies build on:
  - (i) a simple and transparent mandate,
  - (ii) instruments that the agency can freely use to constrain or incentivize national governments to act in a way consistent with agency’s mandate,
  - (iii) independence from political constraints, and
  - (iv) accountability (Debrun, Hauner and Kumar, 2009).
- Advantages:
  - Strengthen fiscal discipline by fostering—or in some cases imposing—better use of policy discretion rather than relying solely on numerical limits.
  - Help strike a better balance between credibility brought by binding rules and flexibility required by changing circumstances due to insulation from pressures that nourish indiscipline.
- Practical considerations in the EU context:
  - Fiscal authorities could receive power to set binding constraints on budgetary aggregates, change selected policy instruments within pre-set limits, or mandate across-the-board spending cuts.
  - Fiscal councils could provide independent monitoring and public assessments of governments’ commitments under the SGP, raising reputational or political costs of reneging and promoting better pricing of risk in financial markets.
  - The fiscal council’s assessment could form the basis for a judicial enforcement mechanism through the European Court of Justice (proposal noted).

### Central agencies — an EMU bond
- Centralizing public debt issuance via a single European bond could:
  - limit the risk of contagious sovereign debt crises and high-debt traps in fiscally vulnerable countries,
  - use terms of access to the common pool of financing (price or quantities) as an incentive device to encourage compliance with the rules-based fiscal framework,
  - lower average borrowing costs—lower risk and liquidity premiums,
  - create a deep sovereign bond market comparable in size to the US treasury bond market.
- Operational complexities remain and are beyond the scope of the paper.
- Important institutional and legal considerations:
  - Extensive pooling of resources would represent a paradigm shift and, if common debt were joint and several liabilities, would arguably turn the “no-bail-out” clause of the Treaty (Art. 125) on its head.
  - The European Financial Stability Facility (EFSF) adopted in response to extreme market stress creates an important precedent of resource pooling that could clear the way for a permanent mechanism along the lines of euro bond proposals.
- Two key issues requiring an independent institution to manage:
  - Address moral hazard in assistance schemes: on-lending of proceeds of a common EU bond will need to be on conditions that discipline member states; pricing formulae could explicitly reflect numerical limits on debts and deficits enshrined in the Treaty or deviations from the medium-term objectives for the structural balance.
  - Provide a mechanism available to deal in a comprehensive and transparent way with individual euro area members facing financing difficulties.
- Such disciplining mechanisms could:
  - provide smoother and more predictable pricing of risk than fragmented debt markets,
  - virtually eliminate the possibility of a sudden cut-off from market financing,
  - explicitly reward and penalize countries based on contribution to the scheme’s creditworthiness, providing the most creditworthy countries with an incentive to join.

### Strengthening the existing framework (less transformative options)
- Even if appetite for paradigm shift is low, ambitious reforms within current Treaty boundaries could close gaps considerably.
- A starting point: ensure all member states have the strong budget procedures and institutions required for national and EU-wide fiscal rules to be effective.
- Binding legal instruments (e.g., a Directive pursuant to Article 136) could be used to foster convergence towards the highest standards of fiscal governance at the national level.

### Enforcement and governance: specific proposals
- Credible enforcement of the pact requires modifying the role of the Council in implementing the EDP, broadening the range of sanctions, and formal mechanisms to hold national governments accountable for fiscal commitments. Possible actions include:
  - (i) introducing greater automaticity in moving up steps in the EDP during benign times, while giving stronger discretionary powers to the Commission when sanctions ultimately have to be decided;
  - (ii) establishing non-pecuniary sanctions to avoid undermining adjustment efforts;
  - (iii) adopting measures that maximize reputational and political costs faced by offenders.
- Details on automaticity and sanctions:
  - Greater automaticity in the EDP would rebalance the 2005 reform of the Pact, which allowed for longer delays in adverse circumstances and was widely seen as weakening the SGP. In benign times, steps in the EDP could be made fully automatic and, in well-defined circumstances—such as misreporting, and high and rising debt levels—could even be accelerated.
  - The imposition of sanctions should remain the outcome of a discretionary decision based on sound economic judgment because automaticity increases the risk of counterproductive outcomes where abandoning the procedure could be preferable.
  - To strengthen decision-making, the role of the Commission could be increased by placing the decision to impose sanctions directly in its hands, with only a veto right from the Council decided at qualified majority or unanimity. Alternatively, the Council could have to publicly justify (for instance before the European Parliament) why it deviates from a Commission’s recommendation.
  - A broader set of sanctions should be envisaged. Pecuniary sanctions in bad times lack credibility because they complicate adjustment and therefore should be imposed only in good times, while non-pecuniary sanctions (e.g., related to voting rights in the eurogroup) could be considered.

*Prepared by Xavier Debrun (chapter content and staff calculations as presented).*

### 18.      National governments should face formal accountability requirements. At the

### _cr10222 - 18.      National governments should face formal accountability requirements. At the

### Strengthening accountability and national integration of stability programs
- National governments should face formal accountability requirements beyond ex-ante peer reviews of budgets.
- Possible measures:
  - Countries could be required to explain in a public hearing with the Council or the ECFIN committee of the European Parliament why they deviated from previous recommendations.
  - Better integration of stability programs in national budget processes could increase accountability at the national level.

### Expanding surveillance and early warning triggers
- Surveillance should be expanded to allow activation of an EDP regardless of the deficit trigger if clear risks to public debt dynamics are detected.
- Fiscal surveillance should be based on a broad set of indicators signaling imbalances whose unwinding could have a severe and durable budgetary impact.
- Signs of such imbalances could trigger early warnings.
- A greater role should be given to monitoring of expenditures:
  - Mapping deficit targets into medium-term expenditure ceilings (to be adjusted for tax expenditure) would make it easier to assess the extent to which revenue windfalls are spent.
- Emphasis: more attention to debt sustainability and a Pact that binds in good times.

### Using public debt level as an explicit EDP trigger
- The SGP should allow for the debt level to be used as an explicit trigger in the EDP. Options include:
  - EDPs concerning countries where public debt is above 60 percent of GDP could only be abrogated when they reach a structurally balanced position (or their medium-term objective). Expected effects: strengthen budget balances on average and reinforce the preventive arm for countries exiting excessive deficits.
  - As proposed by the Commission in its May 12, 2010 Communication, the EDP could be activated regardless of the deficit trigger if the decline in public debt towards the 60 percent reference value is deemed insufficient.
    - Caveat: changes in public debt can reflect many non-policy factors, including “below-the-line” financial operations without lasting impact.
    - Recommendation: focus on the medium-term trend in public debt implied by unchanged policies.

### Symmetric incentives: safeguards in bad times and tightening in good times
- Safeguards for fiscal stabilization in bad times should be matched by symmetric incentives to tighten in good times.
- Proposals:
  - Give greater role to cyclical considerations and revenue buoyancy developments in assessment of budgetary positions; re-define the reference value in Treaty Protocol No 12 as the upper-bound of a nominal deficit range consistent with structural balance. The range would allow for uncertainty in real-time cyclical estimation.
  - Incentivize member states to create “rainy day funds” or to run higher balances in good times by giving credit during bad times for overperforming on fiscal commitments in stability programs.
    - Alternative: a fictitious “compensation account,” as in Switzerland, allowing deficit ceiling adjustments to the extent they do not exceed accumulated overperformance; overdrafts beyond a threshold would tighten the deficit ceiling and trigger the EDP. This could be centrally run (no real money) to avoid misuse.
    - “Rainy day funds” could be mandated through a Directive pursuant to Article 136.
  - Introduce hard-law elements in the preventive arm of the SGP; the Commission’s recent Communication proposes mandatory interest-bearing deposits in case of insufficient progress towards the Medium-Term Objectives.
  - Automatically adjust certain tax and expenditure items to cyclical developments, complementing automatic stabilizers (Blanchard and others, 2010). Article 136 could be used to leverage domestic reforms. Alternative: make part of EU transfers to member states contingent on country-specific cyclical conditions.

### A third way: binding through harmonized national frameworks
- Increase national ownership by encouraging euro-area members to transpose the common objective of fiscal responsibility into national fiscal frameworks.
  - So far, harmonization of national rules around common objectives has largely been left to members’ discretion.
  - National fiscal rules have risen since the SGP inception (Debrun and others, 2008); leadership by large EMU members could deliver greater harmonization.
  - If needed, more explicit coordination could be envisaged in the euro area on the basis of Article 136 of the Treaty.
- Harmonization guided by two principles:
  - (i) Rules compatible with the spirit of the SGP: at least structural balance, close to balance or in surplus.
  - (ii) A credible national enforcement procedure adapted to each member state's decentralization, form of government, and legal tradition.
- Proposal: create non-partisan national fiscal councils with mandates to:
  - Monitor fiscal performance continuously.
  - Analyze contribution of policies to underlying fiscal developments.
  - Advise on early preventive action in case slippages are detected.
  - Ideally trigger a judicial procedure activating sanctions.
- The creation of harmonized national fiscal responsibility councils could lead to a European System of Fiscal Responsibility Council (ESFRC):
  - Work closely with the Commission to improve fiscal surveillance, enhance analysis underlying EDPs, and strengthen horizontal coordination.
  - Serve as a specialized vehicle for ex-ante peer review of national budgets proposed by the European Commission.

### Crisis management: conditional financing and strengthened escalation
- Because debt crises are triggered by liquidity problems, a conditional financing mechanism should be created to avert market disruptions (credit rationing and excessive risk premiums).
- To minimize moral hazard and maximize credibility:
  - Pair the facility with enhanced high-frequency monitoring at the center.
  - Immediately escalate the Excessive Deficit Procedure to Article 126-9, whereby the Council has full authority to request specific measures within a pre-defined time frame against the threat of sanctions. (This would likely require an amendment to Art. 126.)
- In extreme stress, an option is a transfer system in the form of highly-concessional loans with extensive grace periods.
- Moral-hazard concerns and weaker ex-ante market discipline from assistance schemes strengthen the case for improved surveillance and stricter enforcement mechanisms described above.

### Concluding assessment and institutional implications
- Extreme sovereign market stress demonstrated that fiscal discipline is a collective responsibility needing more solid institutional underpinning.
- The Commission issued recommendations addressing SGP operation: greater focus on debt sustainability in the EDP, more binding preventive instruments, broader risk analysis, and ex-ante peer review of budget proposals.
- The flawed enforcement procedure of the SGP needs repair, which almost inevitably implies amending the Treaty; expanding sanctions without making them inevitable will be ineffective.
- A central fiscal authority with power to impose legally binding deficit limits could provide a durable solution; however, many benefits could be achieved by tightly coordinated reforms of national fiscal frameworks.
- Article 136 offers a basis to set up a European System of Fiscal Councils:
  - Non-partisan fiscal councils would help enforce national rules reflecting the spirit of the SGP (structural budget balance or surplus), coordinated by the Commission to improve fiscal surveillance and strengthen national ownership of common rules.

*IMF staff analysis and recommendations as presented in the source PDF.*

### 6.      EU driven reforms have succeeded when accompanied with clear powers, but

### _cr10222 - 6.      EU driven reforms have succeeded when accompanied with clear powers, but

### Lisbon Strategy outcomes and limits of soft coordination
- The Lisbon Strategy combined product market reform at the EU level with labor market and social policy reform at the national level.
- Top-down approach toward product markets was considered appropriate; labor market and social model preferences were deemed country-specific.
- Expectations that product-market reform would generate national incentives for labor market reform were not met. Key observed failings:
  - "The absence of immediate pressure on exchange rates and the illusion of unlimited external financing under EMU made reforms to sustain competitiveness less compelling."
  - "Advances in product market reform did not increase incentives to reform core labor market institutions enough to overcome the fierce resistance by large groups of insiders."
  - Learning spillovers were limited by political economy constraints; reforms were often piecemeal, involved direct compensation to losers, or used complex trade-offs between institutions.
  - Examples:
    - Spanish 1994 and 1997 labor market reforms struggled to ease incumbent regulation.
    - Germany's Hartz 2002-05 reforms and Italy's Treu 1997 and Biagi 2002 reforms used "two-tier reforms" to increase flexibility at the margin.
  - Collective bargaining responses varied; some countries internalized EMU effects on wage setting, while in others wage increases worsened competitiveness relative to productivity.
  - Political reluctance to reform partly reflected perceived electoral punishment, but evidence suggests reformist governments have the same likelihood of being re-elected as status-quo governments; governments with a clear mandate to reform tend to be re-elected (Williamson and Haggard, 1994; Buti et al., 2008).

### Revisiting the Case For Structural Reform in EMU — objectives and expected returns
- Reform agendas differ across countries but should focus on:
  - Establishing a common set of regulations on labor contracts for all workers without constraining job turnover.
  - Further activating tax and benefit systems.
  - Seeking employment-friendly wage bargaining.
  - Fully liberalizing services sectors and renewing the Single Market Program.
- Expected returns from a comprehensive reform package:
  - Ensuring sustainability of social models by raising employment rates to meet fiscal strains from population ageing and crisis-support measures.
  - Improved labor market dynamism:
    - "Countries where employment rules are strict display lower turnover and are likely to experience a marked increase in structural unemployment following downturns (Mourougane and Furceri, 2009, OECD 2009)."
    - Boosting labor flows will require relaxation of regulation on labor contracts.
  - Unemployment benefits reform:
    - "Generous but limited-in-time unemployment benefits contingent on tightened activation and combined with effective training" shorten unemployment spells and preserve skills. Past reforms cited: Denmark during the 90s; Hartz reforms in Germany 2002–05.
  - Activating female and older workers:
    - Labor supply of women and older workers is "highly elastic to tax treatment and out-of-work benefits (OECD, 2005)."
    - Policy levers: make pension systems actuarially neutral; provide tax incentives for second earners.
  - Single Market liberalization in services amplifies employment returns of labor reform; liberal product markets reinforce employment gains and reduce persistence of unemployment after downturns (Annet, 2007; Guichard and Rusticelli, 2010).
  - Improved equity:
    - Continental and Nordic countries show stronger equity due to higher taxes and redistribution.
    - Adequate unemployment support conditional on strict job acceptance, indirect-tax-biased tax mix, and responsible wage formation preserve incentives in Scandinavian countries; an efficiency-equity trade-off remains in Continental economies.
    - Mediterranean countries would benefit from better education and reduced labor market dualism to improve social inclusion.
  - Enhanced productivity:
    - Competition in product markets fosters resource reallocation, economies of scale exploitation, and innovation. Regulation that restrains competition reduces innovation (Bassanini and Ernst, 2002; Jaumotte and Pain, 2005b).
    - Productivity-enhancing environment particularly needed in Southern countries.
  - Reduced impact of asymmetric shocks:
    - More harmonized labor market institutions would reduce asymmetric consequences of common shocks and ease adjustment, making monetary policy more effective and reducing strain on national budgets.
  - Higher labor mobility:
    - Barriers identified: strict employment protection, limited portability of pensions, long-lasting passive unemployment benefits, and weak active labor market policies (Wasmer and Janiak, 2008).
  - Facilitating rebalancing of regional growth:
    - Stringent product and labor market regulations can cause persistent deviations of wages from productivity, especially where collective bargaining is dominated by sheltered sectors (Berger and Nitsch, 2010; European Commission, 2008).
    - Regaining cost competitiveness via labor market reform is important for deficit countries specialized in low-technology goods; surplus countries can pursue labor and services market reforms to invigorate domestic investment and demand.

### Delivering Structural Reforms — supranational actions and instruments
- A simultaneous, comprehensive approach across euro-area countries can generate synergies and help overcome political resistance.
- Key recommended actions at the supranational level:
  - Pursuit of a more integrated labor market:
    - "Properly functioning labor markets should be seen as an EMU public good" and harmonization is consistent with "arts. 151 and 156 of the TFEU."
    - Features affecting price and wage formation—labor taxation, unemployment benefits, employment protection legislation, and some aspects of collective bargaining—should be subject to heightened coordination and surveillance.
  - Strong commitment by the Eurogroup to structural reform:
    - Upgrade peer review of fundamental structural reforms within the Eurogroup (based on art. 136 of the TFEU) to act as a collective body, provide systematic assessments, and communicate benefits of reforms and costs of the status quo from a euro-area perspective.
  - Integrated surveillance with the Stability and Growth Pact:
    - Align surveillance over structural reforms with fiscal policies and external imbalances to analyze policy interactions (effects of structural reforms on budgetary positions, implications for fiscal consolidation, and role of budget composition in supporting growth).
  - Surveillance over targets and policies:
    - Monitor both performance indicators (e.g., employment growth) and policy indicators (e.g., labor market institutions), recognizing reforms take time and may be masked by external economic changes.
  - More power to issue warnings:
    - The Commission should reaffirm independence vis-à-vis the Council by issuing policy warnings (art. 121.2) when economic developments risk jeopardizing proper functioning of EMU.
  - Sanctions and incentives to foster reform:
    - Channel financial incentives through a reformed EU budget, with disbursements closely linked to reform implementation.
    - Observation: "Common Agricultural Policy and Structural Funds, whose disbursement is contingent on very weak conditionality, absorb more than 70 percent of the budget."
    - Proposals: allocate a larger proportion of resources to strengthen market adaptability (regional competitiveness and employment objective; European Global Adjustment Fund) or modulate access to financing through a common EU bond based on compliance with reform implementation.

### Financial sector reform in the EU — state of play and macroprudential supervision
- Financial sector reform is proceeding rapidly along multiple tracks:
  - Institutional reforms: frameworks for macroprudential supervision; better integrated cross-border microprudential supervision; streamlined rule-making.
  - Crisis management and resolution: improving and harmonizing national frameworks.
  - Regulatory reform of capital and liquidity standards aligned with global reform efforts.
  - Areas needing more time for global consistency: hedge fund regulation, rating agencies, credit derivatives.
- Challenges and opportunities:
  - The sovereign phase of the crisis highlighted financial interconnectedness among EU member states and between governments and banks.
  - Common policy initiatives and integrated financial markets can mitigate crisis impact; robust financial stability and resolution frameworks with strong European and cross-border elements are needed to reduce banks–governments ties.
- European Systemic Risk Board (ESRB):
  - The ESRB is envisaged to conduct macro-prudential supervision but "will not have binding powers" and will issue risk warnings and recommendations with a "comply or explain" follow-up.
  - Main counterparts likely: ECOFIN and the envisaged European System of Financial Supervisors (ESFS).
  - Central banks will occupy a large majority of voting seats; supervisors will be represented as well. Organizationally, it will be closely linked to the ECB and not a separate legal entity.
- Proposed ESRB agenda items (staff view):
  - (i) Risks posed by the largest and most interconnected financial institutions.
  - (ii) Increases in financial imbalances, such as credit-fuelled asset bubbles, both at the aggregate level and for particular countries or sectors.
  - (iii) Changes in the structure and technology of the financial system that contribute to systemic risk build-up.
- Key operational challenges for the ESRB:
  - Ensure sufficiently strong action is taken to address emerging build-up of risks.
  - Ensure that ESRB macroprudential analysis permeates work of financial regulators and supervisors at all levels.

*Source: IMF staff chapter titled "EU driven reforms have succeeded when accompanied with clear powers, but" (excerpts provided).*

### 5.      A prime function of the ESRB will be to formulate policies and measures to

### 5.      A prime function of the ESRB will be to formulate policies and measures to

### Systemically important institutions
- The crisis demonstrated that certain institutions are "too large, too interconnected, or too important to the real economy to be allowed to fail under standard bankruptcy proceedings."
- Measures discussed:
  - Robust, bank-specific resolution mechanisms.
  - Capital surcharges commensurate with an institution’s contribution to systemic risk (approach considered by the Basel Committee).
  - Structural interventions (as envisaged in the United States) including breaking up large and complex institutions when systemic risk cannot otherwise be controlled.
- In a highly integrated financial market (such as the EU), failures need assessment at the European, rather than national, level.
- Roles for the ESRB:
  - Calibration of measures.
  - Providing guidance on the use of structural intervention.
  - Coordination with national supervisory authorities where implementation powers remain national.

### Macro-financial imbalances
- The crisis showed build-up of aggregate risks can be concentrated in particular countries and sectors, notably when trade imbalances lead to strong capital inflows (Merrouche and Nier, forthcoming).
- National policies may be insufficient in a financially integrated region; European rules, tools, and policies are needed.
- Policy recommendations:
  - Calibrate capital requirements and countercyclical provisioning EU-wide to uniformly reflect riskiness of exposures, including risks related to sector and location (which may reflect country-specific systemic risks).
  - Use the ESRB to guide such EU-wide calibration.

### Monitoring structural change and innovations
- The ESRB must monitor systemic risk implications of changes in the financial system prompted by innovation and regulatory arbitrage.
- Macroprudential monitoring should encompass:
  - (i) changes in the way services are offered across sectoral lines (insurance, banking and securities), including notably the provision of credit by non-banks;
  - (ii) the robustness of the infrastructure supporting rapidly growing markets;
  - (iii) innovations in products and business models.

### Microprudential supervision and rule-making
- The European System of Financial Supervisors (ESFS) will bring together national supervisors with three sectoral European Supervisory Authorities (ESAs) and a cross-sectoral Joint Committee.
  - ESAs charged with building a single rule book, harmonizing supervisory practices, and having binding powers to mediate and settle disputes between supervisors.
  - Cross-border groups to be supervised by standardized colleges of national supervisors.
- Political negotiations:
  - ECOFIN compromise largely follows Commission proposals but reinforced fiscal safeguard provisions and tightened voting procedures, weakening ESAs’ powers.
  - European Parliament seeks strengthened bodies, streamlined governance, limitations on the fiscal safeguard clause to situations impinging “directly and in a significant manner” on fiscal responsibilities, leading role for ESAs in supervisory colleges of the largest systemic institutions, colocation of three ESAs and the ESRB in Frankfurt, and complementary institutions (Banking Resolution Unit, European Deposit Guarantee Scheme, European Financial Stability Fund).
- Timing risk:
  - Significant risk of delays beyond the currently envisaged date of January 1, 2011.
- Staff views and priorities:
  - Focus on effectiveness of new architecture; minor delays acceptable for a solid agreement.
  - Strengthen ESAs’ binding powers and roles in colleges of biggest groups.
  - Establish sound, time-efficient rule-making procedures enabling ESAs to build a single rule book and deal with macroprudential risks on the basis of ESRB guidance.
  - Limit fiscal safeguard clause to cases with direct, identifiable, and sizable fiscal costs.
  - Agreement in principle that supervisory architecture will in the medium term be complemented with integrated crisis management and resolution arrangements.
- Operational challenges and recommendations:
  - Continued efforts to establish a single rulebook by harmonizing legislation and providing ESAs scope to establish technical rules; consider turning the CRD into a framework directive with significant rule-making scope for the European Banking Authority.
  - Achieve desirable information sharing with fair automatic and instant access for entitled parties; consider centralized prudential databases managed by ESAs with direct reporting by banks.
  - Increase sharing of qualitative information through intensive contacts at all levels.
  - Reassess confidentiality levels and publish a selected subset of non-sensitive prudential data to increase market transparency.
  - ESAs and the ESRB must avoid supervisory gaps given the complexity of the set-up.

### Crisis management and resolution
- The EU single banking market requires an integrated framework for crisis management and resolution.
- Commission intentions:
  - Seek EU-wide harmonized early intervention tools, bank resolution regimes and deposit guarantee schemes.
  - Probe political support for medium-term reforms to establish an integrated framework for cross-border banks.
- Staff proposal cornerstone:
  - European Resolution Authority (ERA) with mandate and tools to deal cost-effectively with failing cross-border banks.
  - Industry-financed European Deposit Insurance and Resolution Fund (EDIRF).
  - Fiscal backstop.
- Interim steps and tools:
  - Enhanced national resolution regimes and safeguards to improve cross-border coordination.
  - Common toolset could include powers to set up a bridge bank, effect sale to a private bidder, and partial sale of assets and liabilities.
  - Remove legal obstacles from European and national law (including company and insolvency law) that impede resolution actions while safeguarding stakeholder interests through judicial review.
  - Legal requirements for national authorities to consider consequences of resolution actions on other member states and enshrine principles for burden sharing in law.
- Funding and levies:
  - EC proposed a risk-based levy on the banking system to feed financial stability funds, which will require a fiscal backstop.
  - Advantages of a dedicated fund: can be mobilized quickly, aid resolution of systemic institutions (fund bridge banks, assist sales), enable early intervention (force sale of bad assets including cross-border exposures).
  - Fiscal position: no difference to public sector finances whether levy accrues to general revenues or to a fund that invests in government assets.
  - Moral hazard risk can be mitigated by an effective resolution framework that circumscribes fund use and ensures losses borne by existing shareholders and creditors first.
- Pan-European arrangements:
  - A pan-European Financial Stability Fund and European Resolution Authority offer advantages, particularly when individual countries are fiscally constrained.
  - Debates on how to back-stop a European stress test and alternatives to the ECB’s securities market program (SMP) point to potential benefits of a pan-European fund.
  - Such a fund needs sound mechanisms: preclude moral hazard, ensure good governance, enable quick decision-making.
  - Staff’s proposed combination of an ERA and EDIRF would achieve these objectives.
- Deposit Guarantee Schemes (DGS) reform:
  - Pending DGS reform should be consistent with plans on crisis resolution.
  - Commission’s proposals expected to include significant harmonization and possibly an EU-level deposit guarantee scheme.
  - Any such scheme must be matched with strong European supervision and a resolution framework that constrains national strategies and avoids tilting incentives toward socializing losses.
  - Ideally, should lead to establishment of EDIRF as part of comprehensive crisis resolution reform.
- Immediate improvements:
  - EFC ad hoc working group proposals include: strengthen ECOFIN role, create an EFC crisis coordination cell, establish Crisis Management Group (CMG) or Cross-Border Stability Group (CBSG) for each large cross-border group, require Recovery and Resolution Plans (RRPs), and make ex-ante preparations for ex-post burden sharing.
  - Recommend ESAs be represented in CMGs and CBSGs with mandate to mediate and monitor adherence to 2007 crisis management principles and relevant MoUs.
  - ESRB cannot be given immediate legal power to declare an emergency, but could be consulted before an emergency is declared and use recommendations to achieve greater coordination across sectors (banking, insurance and securities).

### Regulatory reform
- Basel proposals form the basis for EU regulatory reform in banking.
- Commission public consultation on modifications to the capital requirements directive ("CRD IV") to reflect Basel Committee proposals of December last year.
- Key elements of proposed reforms:
  - Common liquidity standards.
  - Tightening of the quality of capital.
  - Introduction of a leverage ratio.
  - Measures to counter procyclicality.
  - Greater emphasis on counterparty credit risk, including risks related to derivatives exposures.
- Potential benefits and concern:
  - These proposals could significantly strengthen resilience of the European financial system to future shocks.
  - Area of concern: cumulative impact on the cost of financial intermediation in Europe; solution may require robust calibration and consideration of timing and pace of introduction.
- Macroprudential scope in regulatory reform:
  - Regulatory reform needs to provide scope for effective macro-prudential policies.
  - Current reform proposals leave limited room for supervisory discretion and do not explicitly envisage ESRB providing guidance or detailed calibration.
  - Consider issuing standards as a framework directive to open scope for modular calibration by European authorities.
  - Examples: capital surcharges for systemically important institutions; capital requirements and buffers responsive to buildup of financial imbalances in aggregate and in particular countries and segments.
- Alternative Investment Funds Managers (AIFM) Directive:
  - Final shape uncertain with strong member-state differences.
  - Concerns from the United States and United Kingdom about treatment of funds and asset managers located outside the EU.
  - Preferable to foster a global debate toward international consensus on appropriate regulation.
- Derivatives and market infrastructures:
  - Key challenge: extent to which framework mandates central clearing by CCPs.
  - Concern: mandation may force CCPs to clear illiquid contracts or contracts with risk-management challenges, creating single-point-of-failure risks.
  - Pragmatic solution: mandate clearing for sufficiently standardized and liquid contracts; for other contracts use capital framework to penalize bilateral clearing and incentivize (rather than mandate) use of CCPs.
  - Legislative proposals expected in the first half of this year should reflect progress in the United States where similar issues are debated.

_Italic: IMF staff chapter content from the provided PDF._

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10222.pdf_