March 19, 2010
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As Prepared for Delivery
Introduction
I would like to thank the Commission for offering me the opportunity to address this important conference. Sound cross-border crisis management arrangements in the European Union (EU) are so important that today’s conference has the potential to shape the financial and economic future of the EU. If the EU proceeds boldly in this area, it would be one of its most important economic policy initiatives since the Maastricht Treaty.
What kind of banking system for Europe?
I am convinced that the EU needs an integrated banking system and that this in turn requires an integrated framework for crisis prevention, management and resolution.
The public’s feelings toward the banking sector are understandably ambivalent these days Nonetheless, the banking system remains essential for the recovery and for long-term prosperity. We have no choice but to make it function properly.
For the EU the stakes are especially high. The crisis has challenged its financial integration project. Yet, to grow out of this crisis Europe needs financing for viable businesses, new opportunities, and healthy financial institutions. An integrated financial market offers the best assurance of continuous access to a variety of sources of financing, regardless of local circumstances.
Such a system requires banks to be able to compete and realize economies of scale across the EU, choosing freely whether to do so through cross-border transactions, branches, or subsidiaries. The single banking passport—in the sense of the freedom for banks to operate across borders—is essential for this. Yet, the single passport is being questioned based on some of the bank failures during the crisis. We all agree that an Icelandic-style banking crisis cannot be allowed to recur. But this tragic case was less a result of the single passport in itself, than of the prudential framework for it, namely the principle of home country control.
The problems with home country control are many, especially when this control is not matched by credible and viable mechanisms for joint accountability. We have observed that it does not necessarily foster cooperative behavior in crisis situations—on all sides—and that it exacerbates the “too-big-to-save” problem. Home country control also has often resulted in ineffective oversight of cross-border operations. And before the crisis, many countries in Central and Eastern Europe with a large foreign bank presence found that it limited their ability to deal with the buildup of systemic risk in their economy.
Yet, there are also positive stories to be told. In countries such as Estonia, Hungary, and Latvia, the crisis has induced home and host authorities to work much closer together, to their mutual benefit. Examples range from official bridge loans and precautionary swap lines to the European Bank Coordination Initiative, which brought foreign banks together with their home and host authorities with the assistance of the IMF, and helped ensure that those banks collectively maintained their credit lines to the region. Europe needs to build on these experiences, and establish a system in which such close cooperation becomes a permanent and automatic feature.
To underpin the single financial market, what is needed is a financial stability framework that makes countries feel secure in the knowledge that risks to their financial stability are well managed, that their interests are being looked after, and that their concerns and views influence decisions that affect them.
What elements are needed for an EU banking stability framework?
One of the biggest steps forward that mankind ever achieved was control over fire. Fire can be both very dangerous and hugely beneficial when properly controlled. To derive the benefits from fire, we had to build comprehensive systems to exercise permanent control over it. These systems span a continuum, with a heavy focus on prevention, ubiquitous tools and mechanisms to extinguish fires as soon as they erupt, and fire brigades to intervene when things get out of hand.
Importantly, the risks from fire are a matter of common concern. Because fire is so contagious and damaging, we all have an interest in our neighbors’ and our neighborhood’s fire safety arrangements.
Financial services are similar. They are hugely beneficial to us, but can be very dangerous. Risk-taking is the essence of banking. We cannot eliminate all risk unless we are prepared to forego financial services. We have all been burnt by the financial crisis, just like our predecessors many thousands of years ago when they attempted to harness the power of fire. But, as then, the right response is to build comprehensive systems to contain the risks while enjoying the benefits. As then, safety is a shared concern requiring joint responses.
The first responsibility for a safe banking system lies with the banks themselves. They need to be exercise sound judgment, avoid excessive risks, provide sound incentives to their staff, eliminate conflicts of interest, engage in contingency planning, and buy insurance proportionate to the risks they run.
But self-discipline is not enough. Preventive systems are needed that ensure that banks indeed behave responsibly. That is why we need good regulation and supervision. Europe is taking historic steps in this direction, based on the recommendations of the De Larosière Group. What is needed now is a timely compromise between the proposals of the Council and the amendments being considered by the Parliament, so that the EU can go ahead and finally establish a fully effective regulatory and supervisory framework.
And in order for that framework to work, the EU also needs a new supervisory culture, in various respects. First, supervisors need to adopt a European rather than a national mindset. They need to worry no less about the neighborhood than about their own house. Second, the burden of proof of safe behavior should fall on the banks, not on supervisors. And third, supervisors need to be able to deal with financial institutions from a position of strength, confidence, and systemic insight.
Fire damage can best be contained when the fire is detected and extinguished early. Hence, the new supervisory system needs the means to detect problems early on, notably extensive and automatic sharing of data and qualitative information. It also needs strong tools to intervene at an early stage so as to resolve or contain problems while they are still manageable.
But even the best fire prevention system needs a fire brigade. Let me challenge you here. As much as I see the EU making efforts to tackle the issues of cross-border regulation and supervision, I do not sense the same momentum in the area of crisis management and resolution. The existing arrangements have proven to be inadequate, making both national and cross-border bank failures difficult to handle effectively and more costly then they need to be. Ireland faces a fiscal crisis partly as a by-product of its banking crisis, whereas conversely Greek banks are suffering partly due to the Greek fiscal crisis. The difficulty of finding agreement across borders led to a likely costly break-up of Fortis along national lines. And taxpayers in many countries are paying the price for crisis management and resolution frameworks that insufficiently protected their interests.
Concretely, what I think is needed is a European Resolution Authority, armed with the mandate and the tools to deal cost-effectively with failing cross-border banks—an ex ante solution to the problems that currently hamper cooperation in crisis situations, rather than an ex post one. It should be part of an integrated system of crisis prevention, crisis management, crisis resolution, and depositor protection. It should cover at least the major cross-border banking groups, as well as all banks running large-scale cross-border operations under the single passport. The system’s overriding objective ought to be cost-effectiveness, in a broad sense—minimizing contagion, collateral damage to the economy, losses to depositors, and costs to government budgets. To achieve this, it should make sure that losses are borne in the first place by shareholders and holders of equity-like instruments, and in the second place by uninsured creditors. As much as possible, the system should be pre-financed by the industry—including through deposit insurance fees and any levies on the relevant financial institutions.
To be robust, such a system needs access to financing and a fiscal back-up mechanism for any net resolution costs. EU member states have already agreed to the principle of burden sharing for such costs, but have yet to make it operational and binding. Of course agreement on burden-sharing will be difficult under any circumstances, but the system I propose should make it easier, because it is geared toward cost-minimization and reassures all stakeholders that they will be involved throughout.
Conclusions
The crisis has hit ordinary people very hard. Their trust in the financial system and the financial stability framework has to be restored, and they need reassurance that the lessons from the crisis have been learned and applied. Modest reforms that maintain a pretense of progress but continue business as usual are not sufficient.
Europe needs a fundamental overhaul of its financial stability architecture that allows its citizens to enjoy the benefits of financial integration and protects them against the kind of twin fiscal-financial crises that are currently afflicting several member states. The reform of the supervisory and regulatory framework that is currently before the European Parliament is very important, but takes us only half the way. It needs to be matched by an integrated EU crisis management and resolution framework.
Politicians need to rise to the challenge. They need to give the many able technocrats in this room the green light to move ahead with a holistic solution, much as what happened for EMU. The opportunity should not be squandered or deferred.
