Resuming Virtuous Financial IntegrationJosé Viñals, Financial Counsellor and Director,
International Monetary Fund
Launch of the IMF-Staff Book “From Fragmentation to Financial Integration in Europe”
Center for Financial Studies, Frankfurt, Germany, December 11, 2013
Ladies and Gentlemen,
It is a great pleasure to be here today at the Center for Financial Studies in Frankfurt, which has been one of the most influential forums for discussions of issues of financial stability in the European Union.
Financial stability: a core concern of the IMF
The global crisis has taught us that preserving financial stability should be a top priority. It has shown that the health of a country’s financial sector has far-reaching implications for the health of its economy and that of other countries.
Financial stability has been a core concern of the IMF, exemplified by the fact that the IMF has been conducting financial stability assessments at the country-level since 1999, through the so-called FSAPs.
These FSAPs are part of the IMF’s financial sector surveillance and serve to detect vulnerabilities and systemic risks, and to help countries adjust their policies and institutional frameworks to prevent and manage financial crises.
To date, about 140 countries have undergone such a financial system stability assessment and many of them did so more than once. In the European Union, all countries have participated.
It is clear that financial stability assessments at the individual country-level are not sufficient for members of the European Union. The single market in financial services means that a bank incorporated in, say, Luxembourg could sell mortgages to Italian households from a branch in Poland. Several financial institutions operate in 10 EU countries or more. And for the euro area, core markets such as the money market do not have national borders.
Recognizing this cross-border feature of their financial systems, the authorities in the European Union decided to build supranational bodies and frameworks to coordinate regulation and supervision at the level of the single market in financial services. So it made sense to conduct a financial stability assessment at the level of the European Union. And now that a banking union is in the offing, taking a cross-border perspective will become even more relevant.
The new book that we are launching today grew out of one of those assessments – the first European Union-wide Financial Stability Assessment Program (FSAP) by the IMF. It reflects an ongoing dialogue between the IMF and the European Union Institutions, which started in June 2011. The global financial crisis hit the European at a time when the European institutional architecture to safeguard financial stability was still being built. Thus, the EU FSAP focused on the effectiveness of the EU institutions and the contributions of proposed EU-wide institutional reforms, including the banking union, to financial stability. We are glad to see that the discussions we had in the context of the EU FSAP helped shape the current reform agenda at this critical juncture for Europe.
Fragmented we fail
As suggested by the title of the book that we are publishing today, “From Fragmentation to Financial Integration in Europe”, one of the key lessons from our EU-wide assessment is that robust supranational institutions are essential to ensure safe financial integration.
During good times the role of such supranational institutions should be to guard against excesses and imbalances that build up at the regional level but are not so visible to national authorities.
During not so good times, supranational institutions need to deliver robust crisis management: when financial institutions are allowed to operate across borders, national authorities cannot handle trouble on their own.
When cross-border arrangements for regulation, supervision, and backstops are not robust, there will be a tendency to ring-fence behind national borders. This fragmentation is exactly what we have been observing since the outbreak of the crisis. But this is an inefficient outcome. While this problem is more acute in the euro area, other members from the European Union are not immune. Let me elaborate:
Financial integration in the EU began under the impetus of the single market project and took off after the inception of the euro. Between 2000 and 2008 total intra-EU exposures increased from about euro 3 trillion to about euro 8 trillion, mostly accounted for by flows from the core of the euro area and the United Kingdom to the periphery and to the emerging economies of the European Union.
Financial integration led to financial convergence, but it did not lead to economic convergence. On the contrary, countries’ competitiveness drifted apart, allowing imbalances to build up. By 2009, net foreign liabilities of Greece, Ireland, Portugal, and Spain exceeded these countries’ GDP. Underlying fiscal positions also diverged.
The financial tide turned quickly when the global crisis morphed into the euro area sovereign debt crisis. Private financial exposures to countries in difficulties were cut in half between 2008 and end 2012. Capital kept flowing to countries with current account deficit, but official flows replaced private ones, as reflected in the extraordinary rise in Target 2 imbalances.
More recently, policy actions at both the European and national levels succeeded in partially reversing the tide of financial fragmentation and promoting economic convergence. Competitiveness has been strengthening in the stressed countries and the current account deficits have been practically eliminated. Target 2 imbalances have come down notably and sovereign funding conditions and debt markets have much improved. But the nexus between sovereigns and banks has further intensified: the share of sovereign debt held by banks in stressed economies has overall doubled between May 2012 and September 2013. And the easing in sovereign stress has not yet filtered through to bank lending conditions. Households and firms continue to face very different financial conditions depending on where they are.
Imagine a baker in Frankfurt borrowing at a yield spread of 1.5 percent, while similar bakers are paying 3 percent in Berlin, 4 percent in Bonn, and 5 percent in Munich. Clearly, something would be wrong with this picture. But this is exactly what is happening to bakers in Rome, Ljubljana, and Lisbon, even though they are in the same business, transact in the same currency, and operate in a single market for financial services. Granted, credit risks differ across the euro area, but calculations in the IMF’s October 2013 GFSR show that these could explain only about a 1-1.5 percentage point of the lending rate difference.
Financial fragmentation implies that monetary transmission is not working well, which in turn perpetuates fragmentation. Countries facing the highest stress are also those that benefit the least from the ECB’s very accommodative stance. These countries face higher borrowing costs and high debt. Hence there is little room to support the domestic economy, which in turn weakens the banking system. Weak banks are ultimately a potential liability to the sovereign, which perpetuates the adverse feedback loop between them.
High unemployment, combined with slow nominal income growth and corporate debt overhangs, could negatively affect the economic outlook. This, in turn, would affect the quality of assets held by banks in stressed economies. The IMF’s latest Global Financial Stability Report (GFSR) estimated that the share of the corporate sector that is unable to cover interest expenses out of earnings amounts to almost 50 percent of debt in Portugal, 40 percent in Spain, and about 30 percent in Italy. It disproportionately affects small and medium-sized enterprises.
Without improvements in the outlook, we estimate that losses resulting from strains in the corporate sector would be adequately covered by provisions in the Spanish banking system, but would use up the provisions made on corporate loans and consume most of the profits in the next two years in the Portuguese and Italian banking systems.
Integrated we stand
The key challenge facing the EU and the euro area in particular is to secure a strong recovery and reignite a virtuous circle of financial integration and growth. More growth will reduce the stress on the financial system and improve the scope for cross-border investing. A stronger financial system will enhance monetary transmission, which in turn will benefit countries under stress and reduce fragmentation.
So what is ahead on the policy agenda?
Recent policy actions have reduced tail risks and stabilized financial markets. OMT has been particularly effective in this context. The path to sustained growth now requires sustained and smart policy actions on various fronts. Monetary policy has played and will have to continue to play a key role to support price stability and thus the recovery in Europe. Fiscal policy will need to remain anchored in a medium-term framework to ensure debt sustainability while taking into account cyclical conditions. These policies need to be complemented by much needed structural reforms to boost potential growth.
In addition, we need put the financial system on a totally sound footing. To accomplish this, at least three actions are essential:
First, the clean-up of the banking system must be finished. As noted in the book, banks have made considerable progress in the recent past in improving their regulatory capital ratios and most large banks in the EU should be able to meet the Basel III solvency standards. However, the job is not completed. Some banks still have a large portfolio of non-performing loans and the profitability of the large European banks has been comparatively weak and declining. Falling operating income and rising loan loss provisions are the main culprits. Concerns about asset quality are further compounded by uncertainty about the extent and nature of lender forbearance. All this is reflected in market valuations of banks well below book values.
For these reasons we at the IMF fully agree that it is essential to diligently, rigorously, and credibly carry out the planned comprehensive assessment of the 128 banks that will be covered by the single supervisory mechanism (SSM). The upcoming assessment can help restart the virtuous circle of financial integration and growth. It should give a boost to investor confidence in European banks with positive effects on the economy. In particular, it should lead to more clarity about the quality of bank assets; better capitalization by those banks which need it; lower cost of funding for all economic agents in stressed economies; and foster credit supply.
Experience has shown that asset quality reviews can be very effective especially when they are accompanied by stress tests, and provided that some fundamental credibility requirements are met.
For example, the analysis must be unbiased and consistent across countries: this can be achieved by fully disclosing the methodologies and parameters of the exercise and by bringing in independent third-party expertise, as demonstrated in countries that already undertook asset quality reviews, such as Ireland and Spain. It is good news that this is what the ECB is planning to undertake.
Another credibility requirement is the availability of adequate capital backstops. Without it suspicions may arise about the design of the exercise, and there may be uncertainty about the ability of banks to meet capital needs. It is important that any identified capital shortfalls are covered in the first instance by new private capital. But there should also be clarity about the availability of public resources, should they be needed. And given the fragility of some sovereigns in the euro area, recapitalization from common sources, such as the ESM, should be on the table. There should also be clarity on the time horizon over which banks should achieve the desired recapitalization, and whether it would differ whether capital needs are identified in the baseline, or through stress tests.
Should private capital fall short and public funds be needed, the understanding is that the new state aid regime will apply. This regime stipulates that subordinated debt holders contribute to the maximum extent possible to recapitalization, except if there were financial stability or proportionality reasons not to do so. To avoid moral hazard and uncertainty on junior debt’s loss absorbing role, the rules of the game should be well understood. How will systemic risk exceptions be defined? How to ensure they are evenly applied across countries? Moreover, bailing in senior debt as a rule is in my view not appropriate in the context of the forthcoming comprehensive assessment, as it is likely to have destabilizing contagion effects, putting ill-timed funding pressure on otherwise sound banks. Nonetheless, once bank health is restored following this assessment, senior debt bail-in should be part of the resolution kit as envisaged in the Bank Recovery and Resolution Directive, but after a proper transition period. These issues should be clarified as soon as possible.
Clarity on the rules of the recapitalization game will provide further incentives for banks to strengthen their balance sheets ahead of the results of the asset quality review and stress tests, and integrate them into their existing capital plans. It is encouraging that several banks are already raising capital, reclassifying non-performing loans to default category and raising provisions accordingly.
The second urgent action in Europe’s financial system is the completion of the banking union:
Establishing effective supervision of the highest quality in a cross-border context, as the SSM aims at, is a vital but daunting task. The ECB will need to have a complete supervisory toolkit and will need to be able to attract the best talent. It will need to work effectively with national supervisors and under various national legislations. The ECB must be able to rely on full information and ensure that its regulations are binding everywhere.
Effective supervision requires resolution frameworks that have teeth. Without an adequately backstopped common resolution regime single supervision is not likely to be as effective as it should be and would not go far enough in breaking the vicious sovereign-bank links. A single resolution mechanism (SRM) is a necessary complement. The EC proposal for an SRM is a positive step. Strong independent powers are needed to resolve banks. While strengthening of national resolution frameworks should help, a common backstop would nonetheless need to be in place. Moreover, as it will take time to build up a resolution fund, assessed on the industry, the resolution arrangements at the national and common levels need to have access to backup funding. The permanent resources of the resolution fund should be adequate. In the U.S., for example, the FDIC aims to have resources on hand equivalent to 2 percent of insured deposits.
But the banking union goes beyond the euro area. As explained in the book we are publishing today, other members of the European Union will also benefit from a robust banking union. Some can do so directly by becoming member of the banking union, while those who do not join will benefit from improved regional financial stability.
The banking union also does not diminish, but rather increase the relevance of other pan-European institutions. Links to financial centers such as London which may remain outside the banking union are critical for effective supervision of financial institutions throughout the single market. And the banking union will cover only banks. Hence the book argues for a strengthening of the European Supervisory Authorities and the European Systemic Risk Board to ensure stable channels of non-bank intermediation.
This brings me to the third needed action, which is to promote capital market-based financial integration.
Europe’s financial system remains dominated by banks. In several countries, banking system assets are a multiple of GDP. For the European Union as a whole, bank assets are nearly three times E.U. GDP. And they are about 2.7 times euro area GDP. By contrast, bank assets amount to just about 70 percent of U.S. GDP, reflecting much more reliance on capital markets.
With banks so large, Europe must ensure that they are safe. It will be important that any gaps in intermediation get filled by more dynamic capital markets. Achieving a better balance between bank and capital markets-based intermediation over time will make Europe’s economy more resilient. Restarting and expanding securitization would create room for banks to fund small and medium-sized enterprises. The history of securitization in continental Europe is relatively favorable: very few of these products which originated there turned sour in the aftermath of the crisis. Similarly, cross-border holdings of equity can be encouraged by removing constraints on institutional investors and developing alternative retail finance products.
Europe created a single market in financial services because it was a natural component of the economic integration it pursued. Some countries went further and adopted a single currency.
Financial markets celebrated these achievements by integrating rapidly. But the institutions and frameworks to support this integration were unable to keep up. As a result the sovereign debt crisis led to a much more fragmented market than anyone could have imagined.
Yet the crisis also served as a wake-up call. Unprecedented policy actions are being taken to avoid such crises in the future.
Let’s complete the job with speed and panache: finish the banking sector clean-up once and for all, equip the banking union with teeth, and balance it with stronger and deeper capital markets.
Adapting to Europe a phrase that originated during the American Revolution in 1768 would read as follows; “Then join hand in hand, brave Europeans all! By integrating we stand, by fragmenting we fail!”