The Eurozone and EU should not lose the opportunity to reform their missions and institutions now that there is growing optimism and a renewed sense of pride in the euro-area project and identity. The completion of the banking union, with a common deposit insurance scheme (EDIS), and the creation of a common backstop for future crisis resolutions are certainly critical components of a new architecture and governance of the region.
Even the creation of new safe assets for European banks (i.e. sovereign-bond-backed securities such as “ESBies”) are important tools to help break the vicious circle between bank failures and sovereign risk (state insolvency).
The use of the “ESBies” (European Safe Bonds), without joint liability (no risk mutualisation among Eurozone countries), could make Europe’s financial system safer in the event of a potential default of one of the member states or in the case of a “haircut” on sovereign debt.
As sovereign bonds tend to be more concentrated in the portfolios of domestic investors and banks, the recourse to well-diversified European Safe Bonds in banks’ portfolios might reduce in the future concentration risks for banks investing in sovereign bonds. In other words, if one country defaults on its sovereign debt or it is forced to restructure its debt, the financial system will remain solvent.
Regulation to Save the EU?
When Basel IV regulation is introduced, it will probably impose a risk weight higher than zero (Rwa) on sovereign bonds held in banks’ portfolios (i.e. no longer a risk-free asset). Thus, at that point banks will probably have no choice but either to significantly increase their capital to comply with the minimum capital requirements, or to substitute the domestic (national) sovereign bonds in their portfolios with other safer bonds (i.e. “ESBies”), if they do not want to penalize their profitability and dividend payouts.
Banks are also required to comply with Bank Recovery and Resolution Directive (BRRD), MREL, and TLAC requirements, and the new accounting regulation (IFRS 9). Therefore, they have to plan in advance the compliance to the new rules. Even the retroactive enforcement of the “Burden-sharing” and “Bail-in” rules (BRRD) in Europe has added more complexity to the bank crisis resolution events.
It seems that each country has been handling this challenge (BRRD regulation) in different ways, and with different timely solutions, either with stronger protections of senior bonds, or through the introduction of CoCo and Bail-in-able bonds, or through other solutions to protect investors, while most of the burden of bank failures generally remained on the holders of subordinated debentures and other stakeholders.
Elections a Turning Point
This seems to be a turning point for Europe, thanks to the recent results of the political elections. A unique opportunity to be brave and to make those additional and critical reforms to the EU framework and Eurozone institutions and rules that might assure a more stabilized Union in the years to come.
The new Merkel-Macron axis might be just the missing piece of the puzzle to allow the successful completion of the necessary reforms to relaunch Europe and its stronger integration. Chancellor Angela Merkel seems to be open to the discussion of some of President Macron’s proposals to relaunch Europe, namely the creation of a eurozone budget, investing in the European defense industry, facilitating a greater regulatory standardisation across many fragmented markets and perhaps even introducing the Eurobonds.
Currently, Germany is running a surplus of 8.1% of the GDP, while other countries in the region still have excessive budget deficits, thus increasing macroeconomic imbalances. Despite its impressive, globally competitive, and strong economic and social model, Germany maintains its commitment to trade surpluses and balanced budgets; a more favourable real exchange rate versus other eurozone currencies (amplified by the effects of the QE); and the benefit of the “salary moderation” reforms, introduced in the Country soon after joining the euro (thus increasing productivity proportionally more than wage growth per employee).
Since the post-crisis period, Germany has been advocating in favour of tough austerity measures for the other member states of the euro area. Consequently, low investments in capital-starved and debt-laden nations such as Italy, Greece, and Spain, in spite of some degree of flexibility on budget deficits in more recent times, have contributed to slow growth and a jobless recovery in the latter countries (but the late introduction of labour reforms in a number of peripheral European economies did not help either).
Germany and Austerity
The German view for reducing economic imbalances and achieving stabilization within the Eurozone in the past years, following the crisis, has been to progress with tough austerity and internal devaluations on prices and salaries, higher levels of primary balances, and other national adjustments, but this approach has also led to deflationary trends in some peripheral economies.
Furthermore, national adjustments alone have proved ineffective in spurring equally strong reflationary trends in all countries. Some levels of fiscal transfers (temporary or permanent) in the Eurozone will be necessary in the long run to improve the adjustments, reduce imbalances, and achieve a better harmonisation of the labour market regulation and corporate tax bases.
In the years after the global financial crisis, countries like the USA and UK have almost doubled their public debts as a percentage of the GDP in order to rescue their economies. In addition to the massive monetary stimuli from their central banks and the various runs of QE programs, these countries have also reached astonishing levels of budget deficits to revamp economic growth and to fights recession and deflationary pressures (USA reached budget deficit in excess of 12% in 2009 whereas the UK reached a budget deficit above 10% in the same year).