Blog Post

Eurocrisis lessons from banking regulation: create collateral in return for support

The similarities between banks and countries in a monetary union are striking. First, like banks, countries in a monetary union can face a self-fulfilling run resulting in sudden stops. Second, just as one banks’ risk taking increases other banks’ probability of default because of contagion, as the current crisis in the eurozone shows, contagion is especially strong within a monetary union due to cross-border trade, impact on domestic banks, or investor beliefs on correlated risk (see e.g. the review in Pericoli and Sbracia, 2003). Third, just like banks considered to be sound turned to be insolvent in the 2007-2008 financial crisis, we are rediscovering that also in advanced economies debt levels can become unsustainable. And while a country with debt denominated in its own currency can not be forced into default by markets, this is not the case in a monetary union.

By: Date: August 14, 2012 Topic: European Macroeconomics & Governance

The similarities between banks and countries in a monetary union are striking. First, like banks, countries in a monetary union can face a self-fulfilling run resulting in sudden stops. Second, just as one banks’ risk taking increases other banks’ probability of default because of contagion, as the current crisis in the eurozone shows, contagion is especially strong within a monetary union due to cross-border trade, impact on domestic banks, or investor beliefs on correlated risk (see e.g. the review in Pericoli and Sbracia, 2003). Third, just like banks considered to be sound turned to be insolvent in the 2007-2008 financial crisis, we are rediscovering that also in advanced economies debt levels can become unsustainable. And while a country with debt denominated in its own currency can not be forced into default by markets, this is not the case in a monetary union.

Bank regulation

It is therefore natural to compare bank regulation with the governance of countries in a monetary union. Bank regulation has basically three elements summarized in table 1 below: insurance against liquidity problems, regulation of risk taking incentives, and a framework to address solvency problems.

To prevent bank runs, all developed countries now have deposit insurance. For banks with immediate funding problems, there exists a lender of last resort (the ECB for eurozone bank). In addition, for too-big-to-fail banks there is an implicit bail-out guarantee. The presence of such safety nets, however, creates incentives for excessive risk taking. To mitigate these incentives we regulate banks by imposing capital requirements, leverage restrictions, and liquidity requirements. To address externalities across banks (i.e. systemic risk see e.g. here for a review of the literature) we are developing macroprudential regulation – although nobody is still quite sure what this exactly means or how it should be implemented. In spite of these precautions, banks can and do get in trouble. For that we need element number three: the ability to deal with solvency problems through a restructing framework that tries to balance recapitalisation, restructuring and bankruptcy. In the US, the FDICIA already provides such a framework. All these three elements have been expanded and are in the process of being modified substantially as a result of lessons drawn from the 2007-2009 financial crisis.

Countries in a monetary union

For countries in a monetary union the same three elements can be distinguished. To prevent interest rates from reaching unsustainable levels, eurozone countries are constructing mechanisms to insure against such shocks. The EFSF / ESM constitutes a rudimentary safety net with a limited firepower that tries to provide insurance to countries against liquidity and solvency shocks. In addition, the ECB has the powerful potential of performing open market operations and buying individual countries debt in the secondary market, in principle with the aim of ensuring the transmission of monetary policy. But it could also be used to protect countries from runs, although primary market intervention might be more efficient. Other currently non-existent instruments that prevent self-fulfilling runs on individual countries are also possible, such as eurobonds (which insure countries against runs but also shield their interest rates from macro-economic shocks or the consequences of bad policy decisions) and allowing the ECB to buy bonds in primary markets.

Where banks are regulated to reduce the risk of bankruptcy, countries in the EMU are increasingly regulated to prevent government debt from becoming unsustainable. The six-pack includes a ceiling on public debt, limits on the general government deficit, and monitoring of macroeconomic imbalances, while the European semester offers additional policy recommendations. The justifications are similar to those in the case of banks. First, insurance prevents runs on a country that impose negative externalities on other countries, while regulation aims to prevents moral hazard and free riding on other countries’ prudent policies.

Finally, when Greece restructured its debt through private sector involvement (PSI) it was the first western-European country to default since the second world war. We are rediscovering that countries in a monetary union can go bankrupt. How can we deal with countries facing solvency problems (unsustainable debt levels)? Like banks, they can be recapitalized. Countries can be bailed out with the aid of other countries. The ESM / EFSF can be and has been used to do this, although under the assumption that loans would be fully paid back. In addition, countries may adjust through internal devaluation (i.e. a downward nominal adjustment in domestic wages and prices ) or fiscal devaluation, restructuring of private or public debt (the latter has been done through PSI in Greece while the former may be awaiting us for Spanish banks), or even restore exchange rate mechanisms by exiting the monetary union (this requires exit from the monetary union). Table 1 below summarizes this analogy between banks and countries in a monetary union.

Table 1: Similarities

 

Regulation

Safety net

Solvency problems

Banks
  • Capital requirements
  • Leverage restrictions
  • Liquidity requirements
  • Macro prudential regulation
  • Deposit insurance
  • Lender of Last resort
  • Implicit guarantees
  • Recapitalisation
  • Restructuring
  • Bankruptcy

 

 

 

 

Countries in a monetary union

  • Debt ceiling
  • Limits on government deficit
  • Limits on balance of payment deficit / surplus
  • Prescribed macroeconomic policy
  • ESM / EFSF
  • Eurobonds
  • Secondary market operations
  • Primary market operations
  • ESM / EFSF
  • Eurobonds
  • Internal devaluation
  • Debt restructuring
  • Transfers
  • Exit

Differences

Of course, there are important differences, summarized in table 2. The first difference concerns the enforceability of regulation. Banking regulators can withdraw a bank’s banking licence. It has the legal power to force banks to increase capital and take other measures. How might the European Commission enforce the six-pack? Access to structural funds can be withheld, countries can be excluded from negotiations, voting rights on ECB can be withdrawn (theoretically, as this is not possible under the current treaty), and fines may be imposed. But although there is some scope for disciplining measures, there is no analogy to the withdrawal of banking licenses.

A related issue is the independence of the regulator. Where a banking regulator is independent, countries in a monetary union in essence regulate themselves. This may be effective if there are ways for countries to commit themselves to certain rules. In a monetary union, however, rules and regulation are never set in stone and can always be renegotiated. This undermines the effectiveness of regulating countries debt levels, unless sovereignty is truly transferred to a supranational level.

Concerning the safety net, a central difference between countries and banks is the possibility for banks to post collateral. Banks that receive insurance in the form of liquidity support are required to pledge collateral. This is an important device to solve problems arising from asymmetric information. It insures the lender against moral hazard and can be used to separate good risks from bad risks. In contrast, it is difficult for countries to pledge collateral in return for support, as this would require committing to hand over future tax receipts or national resources. This point is well-known from the literature on sovereign debt, see e.g. Panizza, Sturzenegger and Zettelmeyer, who argue that creditors have limited recourse to government assets because ‘few sovereign assets (including future income streams) are located in foreign jurisdictions, and a sovereign cannot credibly commit to hand over assets within its borders in the event of a default. Second, there are legal principles that protect sovereign assets even when they are located in foreign jurisdictions.’

The final difference is in the possibility to address solvency problems. Outsiders can not recapitalise a country in return for an equity stake. In addition, sovereign countries can not be forced to enter into a program with the EFSF / ESM and relinquish control in return for bail-out loans. This latter difference is, however, smaller than it may seem, because in the 2007-2008 crisis some banks also resisted nationalisation.

Table 2: Differences

Regulation

Safety net

Solvency

  • Enforceability of regulation
  • Governance of the regulator
  • Ability to offer collateral
  • Equity stake in return for recapitalisation
  • Commitment to implement reforms by handing over control

Lessons

What lessons can we draw from this comparison? Eurozone countries are trying to stop an evolving liquidity and solvency crisis without resorting to all-out liquidity support, while at the same time limiting transfers and ruling out further integration as a way to improve control over policy and budgets. This is close to trying to regulate countries in the way we regulate banks. Important limitations of this approach lie in the ability to enforce regulation and to obtain collateral in return for liquidity or solvency support. Regarding the former, it might be possible to enhance the effectiveness of ex ante regulation by devising ways to better discipline individual countries. A more systematic approach would be possible that combines hard measures like withdrawal of structural funds, imposing monetary fines, and soft measures like imposing non-monetary institutional restriction (i.e. withholding voting right on certain topics).

More importantly, it may be feasible to strengthen the possibilities to give other countries some form of collateral in return for loans in order to facilitate liquidity provision and some form of recapitalisation of weak countries by healthy ones. This would help to solve the prisoners-dilemma that surplus and deficit countries seem to be stuck in right now. One possibility is to set-up semi-private funds that use public assets allocated by the government as backing obtain support from other eurozone countries. According the Financial Times, Italy is considering taking that route to try and obtain funds from private parties, but it could equally well serve as collateral for support from other eurozone countries. Imagine the ESM obtaining the effective rights to revenue flows from airports, railroads, or energy networks. A second possibility is to strengthen the legal possibilities of enforcing claims on collateral offered by eurozone governments. Europe has developed a common law system with supranational jurisdiction by the European Court of Justice, which might prove valuable in this respect.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.


Warning: Invalid argument supplied for foreach() in /home/bruegelo/public_html/wp-content/themes/bruegel/content.php on line 449
View comments
Read about event More on this topic

Live Event

Mar
26
12:30

Spitzenkandidaten series: Yanis Varoufakis

The first event in the The Road to Europe - Brussels Briefing Live: Spitzenkandidaten series. The series features the lead candidates for the European Elections of six parties and is jointly organised by Bruegel and the Financial Times in March and April 2019.

Speakers: Maria Demertzis, Martin Sandbu and Yanis Varoufakis Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Apr
2
12:30

Spitzenkandidaten series: Bas Eickhout

The second event in the The Road to Europe - Brussels Briefing Live: Spitzenkandidaten series. The series features the lead candidates for the European Elections of six parties and is jointly organised by Bruegel and the Financial Times in March and April 2019.

Speakers: Bas Eickhout, Guntram B. Wolff and Rochelle Toplensky Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Apr
3
12:30

Spitzenkandidaten series: ALDE

The third event in the The Road to Europe - Brussels Briefing Live: Spitzenkandidaten series. The series features the lead candidates for the European Elections of six parties and is jointly organised by Bruegel and the Financial Times in March and April 2019.

Speakers: Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Apr
4
08:30

Spitzenkandidaten series: Jan Zahradil

The fourth event in the The Road to Europe - Brussels Briefing Live: Spitzenkandidaten series. The series features the lead candidates for the European Elections of six parties and is jointly organised by Bruegel and the Financial Times in March and April 2019.

Speakers: Jim Brunsden, Maria Demertzis and Jan Zahradil Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Apr
9
12:30

Spitzenkandidaten series: Manfred Weber

The fifth event in the The Road to Europe - Brussels Briefing Live: Spitzenkandidaten series. The series features the lead candidates for the European Elections of six parties and is jointly organised by Bruegel and the Financial Times in March and April 2019.

Speakers: Anne-Sylvaine Chassany, Manfred Weber and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author

Blog Post

The shadow of Brexit: Guessing the economic damage to the UK

Under a set of assumptions, this post concludes that UK real income and investment would have been 4% and 6% larger respectively had it not been for the shock of the Brexit referendum result. With somewhat audacious assumptions, the damages already incurred can be scaled up to guess the negative macroeconomic consequence of each of the three possible Brexit outcomes: no-deal, deal or no Brexit.

By: Francesco Papadia Topic: European Macroeconomics & Governance Date: March 21, 2019
Read about event More on this topic

Upcoming Event

Apr
11
12:00

Spitzenkandidaten series: Frans Timmermans

The sixth event in the The Road to Europe - Brussels Briefing Live: Spitzenkandidaten series. The series features the lead candidates for the European Elections of six parties and is jointly organised by Bruegel and the Financial Times in March and April 2019.

Speakers: Frans Timmermans and André Sapir Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Apr
11
12:30

Can the euro area weather the next crisis?

Is the euro area strong enough to make it through another crisis? What reforms are still needed. Klaus Regling will join us for this roundtable event in Washington DC to discuss these questions.

Speakers: Masood Ahmed, Klaus Regling, Maria Demertzis and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: 2055 L Street NW, Washington DC 20036
Read article More on this topic

Blog Post

Talking about Europe: Le Monde 1944-2018

An ongoing research project is seeking to quantify and analyse national printed media discourses about Europe over the decades since the end of the second world war. A first snapshot screened more than 2.8 million articles in Le Monde, out of which 750,000 speak about “Europe”.

By: Enrico Bergamini, Emmanuel Mourlon-Druol, Francesco Papadia and Giuseppe Porcaro Topic: European Macroeconomics & Governance Date: March 20, 2019
Read article More by this author

Opinion

New EU industrial policy can only succeed with focus on completion of single market and public procurement

France and Germany recently unveiled a manifesto for a European industrial policy fit for the 21st century, sparking a lively debate across the continent. The fundamental idea underpinning the manifesto is a good one: Europe does need an industrial policy to ensure that EU companies remain highly competitive globally, notwithstanding strong competition from China and other big players. However, the Franco-German priorities are unsuitable for the pursuit of this goal.

By: Simone Tagliapietra Topic: European Macroeconomics & Governance, Innovation & Competition Policy Date: March 18, 2019
Read article Download PDF More on this topic

Policy Contribution

The European Union’s response to the trade crisis

The global trading system is under attack on various fronts. In this Policy Contribution, the authors examine the root causes of the current problems, develop good and bad scenarios for what could happen next, and provide recommendations for how the EU should respond.

By: Uri Dadush and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: March 14, 2019
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: The case for a legislative remedy for recessions

Bruegel's Maria Demertzis welcomes Yale Law School professor Yair Listokin to this Director's Cut of 'The Sound of Economics', to discuss how law might be deployed as a macroeconomic tool to counter financial crisis.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: March 12, 2019
Load more posts