The Financial Times today published my analysis of what the bank restructuring in Cyprus and of Eurogroup President Jeroen Dijsselbloem’s much-commented interview earlier this week. I suggest that the EU must now find a more stable path between too extreme, harmful policy stances – excessive moral hazard (which I call the “Sanio Doctrine” based on the seminal decision to bail-out IKB in late July 2007), and denial of systemic risk (the “Mellon doctrine” with reference to ill-fated US policy before the inauguration of Franklin D. Roosevelt). This is an important debate for Europe and not least for future discussions on the banking union framework.
The late Mike Mussa of the Peterson Institute, a former Chief Economist of the International Monetary Fund (IMF), noted about some episodes of the late-1990s Asian financial turmoil that “there are three types of financial crises: crises of liquidity, crises of solvency, and crises of stupidity.” This quip comes to mind when considering the developments of the past few days around Cyprus.
The March 16 announcement of an agreement backed by most European leaders and institutions as well as the IMF, which called for a tax (or possibly an unfavorable cash-for-equity swap) on holders of bank deposits, no matter how small, was a policy blunder likely to cost the European Union (EU) dearly.
The sequence that led to this “Saturday-morning plan” is well known. Greece’s sovereign debt restructuring a year ago hit Cypriot banks that had bought Greek bonds, raising doubts about the Cypriot government’s own solvency. Negotiations on a possible bailout by the EU had been seen as inevitable as early as mid-2012. But discussions were frozen until a general election in Cyprus last month. Unfortunately, the delay pushed the timetable of negotiation into German election cycle territory, constraining the latitude of the euro group, in which Germany is now the unquestioned central actor. Driven by the domestic German political debate, European negotiators were intent on forcing losses on large (read Russia-linked) Cypriot deposits as an indispensable component of the package.
To the surprise of many, the recently elected Cypriot president, Nicos Anastasiades, added a further twist to the tangled situation by suggesting a hit to small depositors as well. According to some reports, he wanted to limit the losses imposed on large depositors in order to preserve the island’s future as an international financial center. All negotiators seem to have accepted this offer before realizing, too late, how damaging it might be to trust in the safety of bank deposits well beyond Cyprus.
No easy or painless option was available for Cyprus. However, some of the Saturday-morning plan’s flaws were avoidable.
First, the plan disregarded the lessons of financial history about the high importance of deposit safety, particularly for middle-class households (which is why there usually is an upper limit for explicit deposit insurance, harmonized at € 100,000 in the EU since 2009). Based on the experience of the early 1930s, it is virtually undisputed in the US that a breach of deposit insurance will primarily hurt the “little guys.” Sheila Bair, the respected former Chairman of the US Federal Deposit Insurance Corporation, has expressed this view with reference to Cyprus. Similar lessons arise from the record of many recent emerging-market crises.
If it is true, as alleged, that Cyprus’s own president was the one who recommended hurting small depositors, European negotiators were not justified in going along. After all, in November 2010 the Troika of the EU, the European Central Bank (ECB) and the IMF rebuffed the Irish authorities’ proposal to “burn” the holders of senior unsecured debt in failed banks. Their concern was to prevent damaging contagion in the rest of Europe. A similar argument was more straightforward and sensible for Cyprus than it had been for Ireland, and should have led them to oppose Mr Anastasiades’ proposal from the outset.
Second, the festival of finger-pointing in Brussels and across Europe following the Cyprus debacle shows that the negotiators had no “plan B” were the Cypriot Parliament to reject their initial scheme. One must wonder whether the EU is ready to handle the complex Russian side of the Cypriot equation, including the wisdom of depending on Russian goodwill for a solution to the current mess.
Third, the Saturday-morning plan raised profound questions about the democratic nature of EU decision-making. The problem is not that hard measures were to be imposed on the Cypriot population. A loss of autonomy, alas, is the inevitable consequence of the Cypriot state’s inability to meet all its commitments on its own, as Mr. Anastasiades had earlier acknowledged. Moreover, Cyprus has earned no sympathy by rejecting the United Nations plan for the island’s reunification ahead of its entry into the EU in 2004, and for harboring Russian and Russian-linked financial activities widely presumed to be connected with money-laundering.
The problem, rather, lies in the extent to which the European crisis management is now being held hostage by German electoral politics. This dynamic is not new in the euro-crisis, but has reached new heights as Chancellor Angela Merkel’s main opposition, the Social Democratic Party (SPD), has identified Cyprus earlier this year as a “wedge issue” on which it could challenge her. The SPD calculation was to paint Ms. Merkel as too lenient with shady Russian oligarchs and their “black money” held in Cypriot banks, while she would presumably be prevented from responding because of a fear of destabilizing Europe’s financial system. In effect, Ms. Merkel called the SPD’s bluff by risking the euro zone’s first bank run. No wonder that placards on Nicosia’s streets carry slogans such as “Europe is for its people and not for Germany,” or that Athanasios Orphanides, until recently the governor of the Cypriot central bank and a member of the European Central Bank (ECB)’s Governing Council, complains that “some European governments are essentially taking actions that are telling citizens of other member states that they are not equal under the law.”
It is too early to evaluate the lasting damage, but it is likely to be significant. The Saturday-morning decision-making process leaves an impression of incompetence and groupthink, tainting all of the participating actors, including all euro zone finance ministers, the European Commission, the ECB, and the IMF. The EU’s earlier sense of purpose by committing to a banking union last June and delivering on its first step (the Single Supervisory Mechanism) in December has now been battered. So has the aura of statesmanship and control developed by Ms. Merkel and the ECB. Possibly most damaging, even if the deposit tax is reversed or adjusted, the trust of middle-class households throughout the Eurozone in the safety of their banking system has eroded. Hopefully there will be no immediate deposit flight in other countries than Cyprus. But in future crisis episodes, households will behave in a destabilizing way, assuming Europe’s deposit insurance arrangements are not profoundly reformed. There is an apt parallel with the Deauville declaration by Ms. Merkel and French President Nicolas Sarkozy, endorsing losses for Greek sovereign bondholders in October 2010, which started an 18-months cycle of increasingly negative market expectations throughout Europe.
What now? A week ago, the challenge in Cyprus was to close the fiscal gap with a bailout package. Now it is to close the fiscal gap, and to restore a minimal level of trust in the banking system, without which the economy cannot operate. This raises the bar. The obvious risk is of massive deposit withdrawals whenever the Cypriot banks reopen. Now that the seal on deposit safety has been broken, depositors will do their best to avoid additional taxation or expropriation in a few weeks’ or months’ time, no matter how many promises are made that this is a unique and once-and-for-all occurrence. Cypriot authorities are likely to address this with a mix of capital controls and deposit freeze, perhaps in the form of conversion of deposits to interest-bearing certificates of deposits, as recently proposed by Lee Buchheit and Mitu Gulati. But “financial repression” or even incarceration can only last for a limited period of time given the freedoms guaranteed by the EU treaty.
Unlike in previous euro-crisis episodes, there is little the ECB can do alone. The problem is fiscal at the core and must be addressed by elected leaders. They may conclude that it is best to let Cyprus default, impose capital controls and leave the euro zone, an option that was reported to be explicitly considered in European policy circles. But such a move would violate the promise of European leaders to ensure the integrity of the euro zone, no matter what, and potentially set off a chain reaction, including possible bank runs in other euro zone member states, starting with the most fragile ones, such as Slovenia and of course Greece.
On the other hand, it is difficult to see how the risky scenario of a Cyprus exit could be avoided without further fiscal commitments by euro zone partners, including Germany. Their help could be in the form of additional direct transfers to Cyprus to plug the fiscal gap, or some form of guarantee of deposits that would come from the European rather than the national level. A quick but imperfect way to achieve the latter would be for a European entity, possibly the European Stability Mechanism, to provide an unconditional guarantee for a limited but sufficient period of time (say, 18 months) to all national deposit guarantee schemes in the euro zone, up to the € 100,000 European limit. Such “deposit reinsurance” has been rejected absolutely by European policymakers so far. It would constitute a major contingent financial commitment, even though the trust-enhancing effect would arguably result in an eventual net fiscal benefit for all. But it would be a powerful preemptive tool to make sure a scenario of retail bank run contagion does not materialize, and might also become the only option available to restore confidence if such a scenario were to become reality.
Assuming that the current situation is somehow brought under control, longer term questions beckon, beyond the geopolitical considerations related to Cyprus and its neighborhood. The breach of the deposit guarantee, materialization of the bank run threat, and probable consideration of capital controls will cast the euro zone debate on banking union in a new and starker light. Since mid-2012 and until now, the policy consensus in Europe had been to pretend that the question of supranational deposit insurance, with its direct links to the currently-frozen issue of fiscal union, was important but not urgent, and should be left out of the explicit banking union agenda. This convenient stance will be harder to hold given the Cypriot experience. More broadly, the episode will contribute to an overdue debate about the democratic (or otherwise) nature of European decision-making and the effectiveness of its crisis management, two challenges more tightly connected than many observers realized. A first step might be to recognize the plan of March 16 as a mistake, and to have an honest debate about how it could have been avoided.
Many commentators are puzzled by the general lack of negative financial market reaction to the fast-unfolding events in Cyprus. The most likely reason, to be tested in the next few days, is that investors have been sufficiently impressed by last year’s whatever-it-takes commitments, particularly those by Ms. Merkel and ECB President Mario Draghi. The markets’ baseline assumption remains that a last-minute solution will be found after all the brinkmanship. Longstanding observers of the Eastern Mediterranean tend to project a darker mood, as they recall that this is a region in which individuals, groups and nations do not always act in their self-interest. One can only hope that the market’s assessment is the correct one.
On February 14, European Commissioner Michel Barnier and Federal Reserve Governor Daniel Tarullo both indicated their agreement to quickly give the Basel III accord binding force over, respectively, European and American banks. This is welcome. But even more important than the speed of adoption is that implementation should stay true to what the accord stipulates. At this point, and contrary to many perceptions in Europe, this goal is more likely to be reached by the US than the EU.
Basel III is the work of the Basel Committee on Banking Supervision, which includes 27 countries as its members (plus EU institutions and the International Monetary Fund as observers) and is hosted by the Basel-based Bank for International Settlements with a small permanent secretariat there. It is the crowning achievement of the G-20’s financial regulatory agenda in the wake of the Lehman Brothers collapse in 2008. Other prominent initiatives have had only partial or mixed results, including the centralized clearing of over-the-counter derivatives, accounting standards convergence, the regulation of rating agencies, or restrictions on compensation practices or regulatory havens. By contrast, Basel III has moved ahead quickly and can be labeled a clear success for global financial regulation. It is already making a difference, and a positive one, in the way the global banking system operates. Credit for this goes to the Basel Committee’s members and to its successive chairmen and secretaries-general since 2007.
Without going into all the details of a rather long text, Basel III makes the definition of regulatory capital much more rigorous; increases minimum capital requirements dramatically, from 2 percent to 7 percent for the key ratio of common equity to risk-weighted assets; tightens the methodology to weigh the risk of assets; introduces a minimum leverage ratio (capital to non-risk-weighted total assets) to mitigate the risk of manipulation of risk weights; introduces additional requirements depending on the financial cycle and the systemic importance of some banks; and introduces regulatory standards and ratios for banks’ liquidity profile.
The accord has been criticized from all sides of the financial regulatory debate. Much of the banking community, including the Institute of International Finance, has argued that the increase in capital requirements would greatly impede growth and that the liquidity ratios would harm market functioning. J.P. Morgan Chase’s head, Jamie Dimon, has lambasted the additional capital requirements for systemically important financial institutions, including his own, as “anti-American.” But third-party studies suggest that bankers have been exaggerating the negative impact, and that the standards’ adverse effects will be more than compensated by the benefits of additional financial stability for the system.
Conversely, a number of academics and advocates argue that Basel III is insufficient, or even toothless. The critics call for the need for even higher capital requirements (see also here). They also criticize the widespread gaming of risk-weighting calculations; the excessively long phasing-in period for the standards to take full effect; and the recent announcement that liquidity standards would be less stringent than initially envisaged. But the authors of these critiques fail to present an obvious better alternative or address how to avoid banks circumventing the rules. Pushing minimum capital levels even higher would lead to widespread migration of financial intermediation towards the less-regulated shadow banking system. Risk-weighting is flawed, but the alternative of focusing on a ratio of capital to non-risk-weighted assets is even easier to game. Furthermore, Basel III’s leverage ratio creates a backstop against risk-weight manipulation that did not exist in Basel II. The phasing in now looks rather steep to many banks, particularly in Europe, and in any case was arguably the most acceptable price to pay in the compromise to get the accord through in spite of the opposition of some Basel Committee members. The watering down of liquidity ratios appears justified by the uncertainties about the impact of this new and untested regulatory instrument, and the lessons from the euro zone crisis regarding the possible credit risk and illiquidity of sovereign debt markets. In fairness, Basel III goes remarkably far for a consensus-driven Committee that had been much less bold in the past, especially with the previous comprehensive accord (Basel II), which now appears to have been embarrassingly complacent.
Beyond the accord itself, the Basel Committee, in an unprecedented (though arguably long overdue) move, has designed a three-level process to nudge its members to adopt and implement its standards rapidly and consistently. Level One checks that each member jurisdiction has adopted rules that legally mandate the application of Basel III by those for which it was intended, namely large internationally active banks. Level Two checks in detail the consistency of the legislation or regulation with all points covered in the text of Basel III. Level Three assesses how the accord is implemented in practice. The Basel Committee has published regular short reports to the G-20 since 2011, scoring countries’ progress on Basel III and the earlier accords’ adoption (Level One). The Committee also started in October 2012 to publish detailed reports on the consistency of adopted or proposed legislation/regulation with Basel III, with the first three reports devoted to Japan, the US and the EU (Level Two); and in January 2013 the Committee published its first study on actual implementation, devoted to the consistency of risk-weighting across a sample of banks (Level Three).
The picture that emerges is not uniform, but is encouraging from a global perspective. Eleven of the Committee’s 27 members (Australia, Canada, China, Hong Kong, India, Japan, Mexico, Saudi Arabia, Singapore, South Africa and Switzerland) have adopted Basel III and started implementing it in time on January 1, 2013 (India has a delay until April 1). In the EU, which includes 9 other Committee members (Belgium, France, Germany, Italy, Luxembourg, the Netherlands, Spain, Sweden, and the UK), the implementing legislation, known as the Capital Requirements Regulation (CRR) and Fourth Capital Requirements Directive (CRD4), was proposed by the European Commission in July 2011. It is in a final phase of discussion between the European Commission, Parliament and Council. (This phase is known as trilogue in the Brussels jargon.) In the US, the three federal agencies jointly in charge – the Federal Reserve, Federal Deposit Insurance Corporation (FDIC) and Office of the Comptroller of the Currency (OCC) – have published a regulatory proposal in June 2012 and are currently working on a final version. Work is also in progress in the remaining Basel Committee members, namely Argentina, Brazil, Indonesia, South Korea, Russia, and Turkey.
Among the three jurisdictions reviewed in more detail under the Basel Committee’s Level-Two process, Japan gets high marks for essentially complying with the accord. The US (based on the June 2012 proposal) is compliant on all areas tested but one: its rejection of any reference to credit rating agencies’ assessments in bank prudential regulation, enshrined in Section 939A of the Dodd-Frank Act of 2010, creates differences with parts of Basel III which keep some references to credit ratings (even though the Basel Committee has also tried to reduce the extent of such references). The EU is found “materially non-compliant” in two areas: the definition of capital and an exemption that the review found too broad from one of the risk-weighting methods. The definition of capital is the more important of the two, as it goes to the core of capital regulation: it is no good to have high minimum requirements if the definition includes “funny equity” that is not genuinely loss-absorbing in a crisis.
These differences are attributable to differences in financial cycles and local politics. The EU is in a state of banking system fragility that has not been resolved by the recent improvement in market conditions. Forbearance is thus a temptation, even though experience suggests that forbearance is a losing crisis-management strategy. By contrast, Japan, Mexico and much of Asia have learned their lessons the hard way during the crises of the 1990s, and their banks have strong enough balance sheets for the early transition to Basel III to be an easy one. Banks in Canada and Australia have been thriving recently. Switzerland and the US, like the EU, have faced severe banking crises in 2007-08, but unlike the EU, have largely resolved them in 2009-10, which makes their implementation of Basel III requirements less challenging than in several EU member states.
The delay and spotty compliance in the EU stands in stark contrast to Europe’s championing and early adoption of Basel II, in the early 2000s. It is not uncommon for EU financial policy leaders to offer support for the Basel III process and to criticize it at the same time. In particular, the European Commissioner in charge of financial services has reacted angrily to the Basel Committee’s Level-Two report on the EU, arguing that some of its findings “do not appear to be supported by rigorous evidence and a well-defined methodology” while simultaneously affirming his “support [for] the Basel Committee’s intention to assess consistent implementation.”
The Commissioner implies in his reaction that the EU’s CRR/CRD4 legislative proposal was assessed unfairly and negatively in comparison with the reviews of Japan and particularly of the US. However, the Basel Committee’s Level-Two assessment process has involved Europeans prominently: they represent no less than half of the respective assessment teams for both Japan (6-member team led by the Banque de France’s Sylvie Mathérat and also including members from the German and Swedish central banks) and the US (6-member team including members from the French and Italian central banks and from the European Commission). As for the EU, the assessment team was led by Charles Littrell from the Australian Prudential Regulation Authority. It also included five other members from prudential authorities in Japan, New Zealand, Singapore, Switzerland, and the US. (The teams are formed on the principle of no self-assessment, which is why no EU member state is represented in the EU assessment team.)
The Basel Committee has put a lot of effort into ensuring the quality and consistency of its assessment methodology, and there is no convincing evidence of anti-European bias from a detailed reading of the Level-Two reports. The Committee’s policy so far has been not to react publicly to the European Commissioner’s critique. But it is evident from the content of the Level-Two report on the EU that the same arguments put forward in this critique have been carefully considered by the assessment team before completion of the report.
The reaction from many stakeholders in Europe to the US delay in Basel III adoption has been similarly shrill. The joint press release of the Fed, the FDIC and the OCC does nothing more than announce that the deadline of January 1, 2013 will be missed in the finalization of the rulemaking process, given the large number of written comments received on the June 2012 proposals that justify in-depth analysis. This has been widely denounced in continental Europe as a de facto abandonment of the effort, which would justify significant delaying of the EU’s own decision-making process on grounds of competitive fairness: the European Banking Federation sent a letter interpreting the US press release as implying that “our US competitors will not have matching obligations imposed on them in parallel [with the EU’s CRR/CRD4], or in a foreseeable future.” The head of the Italian Banking Associated said that “Basel III must be postponed, full stop.”
In fact, the EU and the US are likely to adopt Basel III around the same time, probably in both cases in the second quarter of 2013. As mentioned above, the procedures are different. In the EU, CRR and CRD4 are produced by a legislative co-decision process that involves the European Parliament and the Council, involving a degree of politicization. (CRD4, being a directive, requires further transposition in all member states’ national legislation, while CRR will be directly applicable in all member states once adopted by the European Parliament and Council.) In the US, the process is more technocratic. It is in the hands of the three federal agencies (Fed, FDIC and OCC) but is also subject to the scrutiny of Congress, which may still impose further delay.
On both sides, there is no indication that the points of “material non-compliance” found in the Basel Committee Level-Two preliminary assessments will be corrected in the final version. In the US, Section 939A of the Dodd-Frank Act prohibits reference to credit ratings in the prudential regulation of banks and is unlikely to be abrogated by Congress any time soon. The EU is ill-placed to criticize the US on this, as it has itself put much blame on credit rating agencies in the crisis context and submitted them to increasingly stringent regulation. In the EU, there is no indication that the revision of the non-compliant parts of CRR are among the points that the co-legislators in the European Parliament and Council intend to revise in the current final phase of legislative “trilogue.”
There would be sound justifications, however, for a second look in the EU that would enable the adoption of a Capital Requirements Regulation that would be fully compliant with the Basel III accord.
This policy note was published last Friday by the European Parliament in anticipation of their "Monetary Dialogue" hearing of ECB President Mario Draghi yesterday (other papers prepared for the same occasion are here). It was republished today by Bruegel and the Peterson Institute in their respective policy series. The content of the three versions (European Parliament, Bruegel, and PIIE) is identical.
In the note, Guntram Wolff and I provide an in-depth analysis of the sequence defined by the European Council in mid-December to complete Europe’s banking union, starting from the first step of creating a Single Supervisory Mechanism (SSM) hosted by the European Central Bank. We make specific recommendations on the successive steps, including the finalization of the SSM Regulation, other pieces of EU legislation (Capital Requirements Regulation, Bank Recovery and Resolution Directive, Deposit Guarantee Schemes Directive), the operational framework that will enable the European Stability Mechanism to recapitalize banks directly, the future “Single Resolution Mechanism” that is intended for discussion later this year and in 2014, and further steps at an even later stage.
We also make the point that policymakers should take decisive action to restore trust in the European banking sector before the Single Resolution mechanism is finalized, because the economic cost of waiting at least 18-24 more months would be simply too high. Article 27(4) of the SSM Regulation in particular provides a unique opportunity for a proactive, system-wide initiative for the assessment and restructuring of Europe’s banks in late 2013 / early 2014.
The note was presented to the press this morning. Click here to listen to the conversation as recorded on the Peterson Institute's website.