Nicolas Véron

An Assessment of Financial Reform - So Far

I contributed this article to a forthcoming book co-edited by Barry Eichengreen (UC Berkeley) and Bokyeong Park (KIEP). The piece attempts to assess the financial reform induced by the crisis so far, and to see the forest for the trees - a challenging task given the multiplicity of reform initiatives and the unfinished nature of most of them. 

Click here for the version published in the PIIE Working Paper series. 

Click here for the version published in the Bruegel Working Paper series. 

Europe's Fiscal Union Still Lacks a Blueprint

This column was published by Bruegel and the Peterson Institute, and separately by Vox, the Globe and Mail (Canada), Caixin (China), Les Echos (France), Kathimerini (Greece), Il Sole 24 Ore (Italy),NRC Handelsblad (Netherlands), El Economista (Spain), Radikal (Turkey), and the Bloomberg Economics Europe newsletter.  

The improvement of eurozone market conditions in January can be attributed to several factors, including the progress made by Prime Minister Mario Monti in Italy, and some constructive if Delphic signals coming from Berlin. It also suggests that a lot of bad news was already priced in in December, including a “credit event” on Greek debt that would trigger payment of credit-default swaps, as now looks very likely. But the eurozone’s fundamental design problems remain unresolved. Even the main positive driver of investor sentiment, the European Central Bank’s long-term refinancing operations offering cheap 3-year liquidity to banks, creates risks of its own. The ECB must have decided to open that window with a heavy heart. A few hard realities have not changed, and if anything have become more inescapable.

First, the core of the crisis is the gradual loss of reference status of the bonds issued by eurozone member states. Sovereign “risk-free” assets are the foundation on which complex financial systems are built. But as Eurozone sovereign bonds are perceived as carrying a risk of non-payment (or credit risk), the foundation becomes ever shakier and the rising tide of distrust engulfs ever more market segments and countries. As things currently stand, even Germany is unlikely to escape a credit downgrade for very long. Thus, the monetary union will become increasingly unsustainable unless a credible reference asset is created at the level of the eurozone, backed either by a joint and several guarantee of the member states (the various eurobond concepts) or a central tax-raising capacity as in most existing fiscal unions. The creation of the European Stability Mechanism (ESM) is but a baby step in this direction.

Second, the credit risk of sovereign debt creates problems in domestic banking systems that cannot be addressed by the toolkit for stand-alone banking crises. This is why the bank recapitalization plan of late October 2011, which assessed each bank’s capital needs on the basis of volatile sovereign yields, is bound to be a policy failure. The sad consequence is that Europe’s longstanding banking fragility cannot be resolved as long as the eurozone’s fiscal framework is not itself fixed. Absent such a resolution, the ECB is justified in providing indiscriminating liquidity support, even if that means prolonging the existence of “zombie banks” and the corresponding misallocation of credit. The same concern underpins the ECB president’s suggestion that there should be no new “stress tests” in 2012. Leaders should buttress the banking system by extending a eurozone guarantee to national deposit insurance schemes, to prevent any risk of retail bank runs, but they cannot hope to restore it to soundness before giving it a new foundation of eurozone-level bonds.

Third, crisis resolution primarily depends not on clever financial engineering, but on political and institutional breakthroughs at the European level. The eurozone’s nation-based political framework is cracking at the seams: the ECB has set the timetable of Italy’s change of government; Greece may formally lose its sovereignty on segments of its economic policy; Germany’s chancellor is becoming a principal player in France’s presidential election. But while national political systems lose their autonomy, existing European institutions remain too weak and not democratic enough to provide an adequate framework for political decision. They lack both executive decision-making capacity, and the ability to make Europe’s citizens feel properly represented. These two dimensions are mutually reinforcing, and major advances are needed on both. Equal representation of the Union’s citizens in the European Parliament (where larger countries are currently underrepresented) would be a good place to start, as the German Constitutional Court suggested in 2009. None of this can be achieved without significant treaty changes, and the considerable risks that come with them, but there is no alternative approach that would make the euro sustainable.

These challenges are reflected in the current central battlefield, namely Greece. The German government seems to have accepted that a Greek exit from the euro would trigger disastrous contagion, but the Greek political system is not delivering the necessary adjustment. If it comes to such a stark choice, most Greeks (though not all) are likely to prefer staying in the euro to a maximalist defense of their country’s economic sovereignty. But this sovereignty has to be transferred to a democratic entity in which Greeks have a stake, not Germany or “Merkozy,” for the trade-off to be viable. In other terms, a meaningful upgrade of EU institutions is a necessary condition for the eventual resolution of the Greek problem.

There is no easy or quick way to solve the eurozone’s complex equation, but one thing is sure: the status quo, even with ESM and fiscal compact, is unstable and unsustainable. The market lull must be used by leaders to prepare the next steps. Otherwise it will be another missed opportunity – with an ever higher price, financial and otherwise, to pay for the lost time.

The French Election and the Stakes for Europe

In this new interview by Steve Weisman, I look at France's presidential election campaign from the perspective of the Eurozone crisis, which has made the relationship with Germany a salient dimension of the domestic political debate. 

The High-Stakes Greek Debt Negotiation

In this just-published interview by Steve Weisman at the Peterson Institute for International Economics, I comment on the current stage of discussion of "private-sector involvement" (PSI) in the issue of Greek sovereign debt, and the prospect for the next phases.  

Europe Must Change Course on Banks

This column was published on Monday by Bruegel and the Peterson Institute, and separately by Vox, the Globe and Mail (Canada), Caixin (China), Lidove Noviny (Czech Republic), El Economista (Spain), La Tribune (France), Kathimerini (Greece), Dziennik Gazeta Prawna (Poland), Publico (Portugal), and Radikal (Turkey), as well as GFS News and the Bloomberg Financial Regulation newsletter.

The Eurozone crisis keeps evolving along multiple dimensions. On the sovereign debt front, no deal is yet in sight on Greece’s debt restructuring, and Italy and Spain face major refinancing needs in early 2012. On the institutional reform front, the summit on December 9 fell short of delivering a true fiscal union, and tensions between the Eurozone and the UK have been brought to boiling point. On the growth front, a possible deep and prolonged recession looms.

As during previous episodes, however, the banking system is a crucial piece of the puzzle and epitomizes many of the contradictions of Europe’s experiment in monetary union. Almost continuously since 2007 that system has exhibited worrying gaps in risk management, compounded by massive supervisory failures in some countries. In the past two years, deteriorating sovereign creditworthiness has increased the system’s fragility. The combination of member states’ guarantees on domestic banks, and those banks’ outsized holdings of home-country sovereign debt in periphery countries, has accelerated the feedback loop between sovereign credit and bank funding conditions. The result is fragmentation: whether a euro held in a Greek bank is equivalent to a euro in a German bank is ever more in doubt. This could produce a slow-moving death spiral for a currency union.

Instead of fighting this trend, the recapitalization plan agreed on October 27 has reinforced it. More guarantees on banks are introduced at the national level, none at the European one. Moreover, when raising the minimum capital ratio to 9 percent, leaders decided that its assessment would rest on fair value (or mark-to-market) measurement of each bank’s portfolio of sovereign debt. The fair-value principle is sound for financial disclosure purposes. But it is dangerously pro-cyclical when applied to regulatory capital calculations, especially when extended to debt that is held to maturity – a radical move towards “full fair value” that accounting standard-setters have never dared to embrace. This is a recipe for massive credit rationing and misallocation, for which there is more and more anecdotal evidence.

The situation should be corrected before it runs out of control. The European Central Bank has introduced unprecedented liquidity support, but this step cannot correct the core problem of the sovereign-banking nexus. Both sides of the equation should be tackled. On the one hand, Eurozone-wide financial mechanisms should at least partly replace national backstops, arguably focusing on retail deposits for which the public guarantee is most harmonized and least discretionary or controversial. Such a move would go a long way towards preventing disastrous retail bank runs. On the other hand, leaders should work toward a partial substitution of national debt held by banks with common Eurozone debt, depending on the advancement of discussions on the fiscal front. Doing so would help reduce the current unreasonable home bias in the balance sheets of banks in periphery countries, especially Spain and Italy. These interventions could be overseen by an ad hoc entity dedicated to Eurozone bank restructuring, by delegation of individual member states.

Of course, such actions would require a political commitment that is currently nowhere to be seen. But there can be no sustainable monetary union without an integrated banking system, which would require an integrated policy framework in compliance with the subsidiarity principle. Two conditions add formidable hurdles on the path to a solution. First, as in fiscal matters, the difficult decisions to be made require proper accountability to Eurozone citizens, at least in the medium term. Establishing such accountability may entail reform and empowerment of the European Parliament, or the creation of an ad hoc chamber that would aggregate delegations from national parliaments, or both. Second, action in the Eurozone must be articulated with the existing instruments of the 27-member European Union, including the recently created European Banking Authority (EBA), which is located in London. This is made more difficult by the growing political distance between the UK and the Eurozone, widened after Prime Minister David Cameron’s veto at the December 9 summit. The pragmatic option is a coexistence of Eurozone and EU instruments, at least for some time, but it will add complexity and friction.

The political affirmation of the integrity of the Eurozone banking system does not require new treaties. But beyond the inherent aspect of financial solidarity, it would run against major political resistance, not least from individual banks that fear the loss of national privileges or protections. However, the creation of a “banking union,” parallel to the fiscal union now advocated by German Chancellor Angela Merkel, would not mean the end of all national and local specificities. In the United States, more than a century has separated the creation of a national banking charter (1863) from the achievement of a true national banking market. Interdependences between banking and political structures at the national and local level will remain. But a Eurozone-level banking policy framework that would transcend them is a necessary condition for the survival of the monetary union. 

Market Reactions to the December 9 Euro Summit

In this new podcast interview by Steve Weisman, I expand on the outcome of last Friday's summit in Brussels and why the market reaction has not been overwhelmingly positive.   

Rating Agencies and Sovereign Credit Risk Assessment

Bruegel just published this Policy Contribution co-authored with Guntram Wolff, at the request of the European Parliament. Building on my earlier piece on credit rating agencies, we examine a series of policy questions specifically related to sovereign credit ratings and their role in financial policy. 

Click here to download the piece in case the above link does not work. The European Parliament has also published it on its own website, with the same text in a different format

The European Summit on December 9

In this podcast interview published by the Peterson Institute for International Economics, Steve Weisman interviews me on the outcome of the EU summit of December 9 in Brussels, and the prospects for next steps.

Europe Needs Institutional Creativity

This column was published by Bruegel and PIIE, and also by Vox, the Globe and Mail, Caixin, FT Deutschland, El Economista, La Tribune, Kathimerini, Il Sole 24 Ore, Dziennik Gazeta Prawna, and Radikal, as well as by Bloomberg's Financial Regulation newsletter.

“I guess you guys have to be creative here,” US President Barack Obama was reported as exhorting German Chancellor Angela Merkel at the Cannes Summit on November 4. This is an apt tagline for the current moment in the eurozone crisis. The European Union needs to radically change its ways, or it may not survive.  

Beyond the headlines about Greece and Italy, the central problem is a crisis of decision-making at the European level. At no point since early 2010 has the contagion ever been seriously contained. This is an astounding policy failure, almost universally seen as such from outside Europe. Blaming the individuals would be unfair. Europe’s leaders may not be heroes but, from a historic or international perspective, most are reasonably competent, dedicated and honest. The problem lies not in them, but in the institutions.

At the core of Europe’s predicament is an obvious mismatch: the key decision-makers at the European level are leaders whose accountability derives exclusively from national electorates. Most have no mandate to work for the common European good. The European Commission is mostly powerless, except in specific areas of autonomy such as trade and competition policy. The European Central Bank (ECB) is a truly federal institution but its scope of action is limited, and rightly so. In the areas of fiscal and banking policy that have been made crucial by monetary union, there is no European executive branch.

Awareness of the mismatch leads to partial fixes such as leadership of the “French-German couple” or the more recent “Frankfurt Group” (José Manuel Barroso and Olli Rehn of the European Commission, Mario Draghi of the ECB, Jean-Claude Juncker of the Euro Group, Christine Lagarde of the International Monetary Fund, Angela Merkel of Germany, Nicolas Sarkozy of France, and Herman Van Rompuy of the European Council). But these fixes do not work. Most elements of the latest “comprehensive solution” agreed in the October 27 summit are unworkable.

Leaders must break this mold and empower individuals or entities to make decisions on behalf of European citizens and with adequate accountability to them. Some actions will require treaty change, others only a change of mindset. The latter category includes such vital moves as providing supranational guarantees to national deposit insurance schemes, to forestall the risk of catastrophic retail bank runs in troubled countries. A single European body should provide a consistent assessment of all Europe’s big banks’ capital position as the basis for a credible recapitalization plan. Member states should be prevented from using domestic financial firms as crutches to their own credit problems, to the peril of depositors and borrowers alike. In addition, treaty changes are required to provide proper accountability, starting with a different composition of the European Parliament to ensure that Europe’s citizens are equally represented, irrespective of their country. One recent piece of good news is Ms. Merkel’s explicit endorsement on November 9 of significant treaty change as part of the solution.

If the euro is to survive, a more federal framework for banking and fiscal policy is needed – what Jean-Claude Trichet, then ECB President, in June called a European Finance Ministry. But federations come in many shapes and sizes. The US is an obvious reference point but others may be more relevant. India, for example, shows that a continent-sized federation can be linguistically and religiously diverse, and politically fragmented into myriads of local parties, but still democratic and resilient. Some European countries are more at ease with the federal principle than others – Germany more than France, to name only those two. An additional major difficulty is to provide decision-making for the eurozone in a framework of EU institutions including countries that keep their national currency.

Such a transformation of the nature of European integration can neither be imagined nor delivered by national leaders seeking national reelection, or by exhausted civil servants. An open public debate is part of the answer; for all its parochialism, Germany has gone further in this respect than most other Eurozone countries. But ultimately a mechanism will be needed to propose institutional changes. A traditional intergovernmental conference is unsuited to the task, as diplomats are bound by old solutions and ossified national positions. A more diverse group of national delegates could perhaps do better, even though the convention chaired by former French president Valéry Giscard d’Estaing in 2002-03 failed to escape the traditional diplomatic game and to propose compelling solutions. Given the urgency, maybe a smaller group should be formed, on the model of the one chaired by former central banker Jacques de Larosière in 2008-09, which ushered in Europe’s most promising institutional innovation in this crisis so far, the creation of the European Supervisory Authorities.

A more federal Europe is not a straightforward proposition, but neither is it an impossible one. New ideas on how to shape it are urgently needed.

A Week of Market Turmoil

In this interview by Steve Weisman, I comment on the latest developments in the Eurozone following the chnages of governments in Greece and Italy, and on the monumental challenges leaders need to address.