Politics, philosophy and economists
In a recent (virtual) event at the Florence School of Banking and Finance, Pascal Donohoe, Irelands’ Minister of Finance and the head of the euro group gave a lecture at the Florence School of Banking and Finance, discussing the current agenda of the Eurogroup. First, completion of the banking union, including the European Deposit Insurance Scheme and the regulatory treatment of sovereign exposures, two topics that many of us economists have focused on for the past decade or so. Second, the introduction of a digital euro, importantly, however, as complement not as substitute for cash; not surprisingly, this as much a question of payment efficiency, as is this a defensive move against private crypto-currencies (I would assume, this refers to Libra/Diem). Third, a strong fiscal response, including the Recovery and Resilience Facility to support the post-pandemic recovery. Quite an agenda and we appreciated the intention of Mr. Donohoe to interact with academics on these important issues.
I was asked to give some closing remarks after the discussion and focused on three issues, using two aphorisms:
First, the Spanish philosopher George Santayana is claimed to have coined the oft-repeated phrase: “Those who do not learn history are doomed to repeat it.” Fiscal policy choices made after the Global Financial Crisis ten years ago set the scene for the Eurozone Debt Crisis. Withdrawing fiscal stimulus, not only in overindebted euro area periphery countries, but also in core countries, most prominently Germany, exacerbated the crisis substantially. Austerity policies in the UK between 2010 and 2016, criticised by economists both in the UK and the IMF, ultimately resulted in the Brexit referendum vote. It is thus critical for democracy and socio-economic sustainability that this mistake not be repeated and that fiscal stimulus and support not be withdrawn too quickly. The example set by the new US administration should certainly be an important signal. Mr. Donohoe was quite defensive when it comes to comparing the European and US fiscal responses to the pandemic and crisis; here I am, however, with Martin Sandbu who pointed to the risks for Europe of an insufficient stimulus.
Second, the Greek philosopher Heraclitus is claimed to have said: “No man ever steps in the same river twice, for it's not the same river and he's not the same man”. As much as we have to learn from history, it is important to realise that the current crisis is different from the previous one and the situation of the European economy is different. While in the Global Financial Crisis the financial sector was at the core of the crisis, this time the financial sector was hit as much as any other part of the economy; however, the financial sector has been critical both as a transmission channel for government support for households and firms during the pandemic and in its post-pandemic role of reallocating capital. As important, the banking sector might also be faced with a wave of corporate insolvencies as fiscal support is being withdrawn and the question arises whether the bank resolution framework as put in place over the past decade in Europe will be sufficient to address with the consequent possible bank fragility.
Finally, an appeal to my fellow social scientists to get more involved in the policy process and beyond the broad debate. My experience with the policy-making process last year at the ESRB was that there are three phases to designing policies (especially if done from a clean slate); the policy phase, when arguments in favour and against are discussed and weighed, the political phase, when the feasibility of actions has to be explored, and the technical/editorial phase, when policy is put on paper and the discussion focuses on detailed wording. Academics are mostly focused on the first phase, but I think we have to get involved in the second if not even in the third phase, where possible. Not getting involved in the second phase risks leaving the public discourse to fringe economists and charlatans; getting involved in the third phase can be an eye-opening but also humbling experience of the sausage-making process.
30. April 2021
Brexit – the first quarter
The first three months after the end of the transition period have passed and we have moved from speculations about the effects of Brexit to the reality of Brexit. What were supposed to be teething problems turned out to be new structural barriers; every week brings a new sector in the UK that finds itself shut out of the Single Market due to non-tariff barriers. British ‘ex-pats’ who had not bothered to get their residence status sorted in time in Spain are complaining that they have to leave the country and the Brexit press is predicting the permanent economic decline of Spain because of their exodus (as, before Brexit, they predicted the permanent decline of the UK because of the inflow of Europeans).
All of this has made it again clear that Brexit will never end and that the Brexit movement has gone fully Trumpian, nourishing a permanent victimhood culture. Or as Chris Grey nicely summarised it in his blog a few weeks ago: “The country, as represented by Frost, seems increasingly like a stroppy, entitled teenager who has stormed out of the family home in a tantrum and now endlessly complains that his awful parents are disrespecting him. ‘Not only are they no longer housing me,’ he whines, ‘but they are insisting I clear my stuff out just because I promised to when I left. And I’m stuck with paying the rent on my new place because they won’t help me out any more. Don’t they realise I’m an adult now?” Until the end of 2020, it was all about escaping the EU, now it is all about blaming the EU for the (predicted) consequences of Brexit.
Only a few months ago, the UK government insisted on getting a trade deal with the EU like Canada and Japan have it, insisting that it wants to be treated like any other third country. Now, that the consequences have become clear (in the form of non-trade barriers), they insist that the EU should treat the UK differently, given the geographic proximity and close economic integration. But of course, the government and the Brexit press is not about to take responsibility for what a few months ago they claimed to be the greatest trade deal and Brexit win ever. Rather, what was once billed Project Fear is now declared Project Revenge by the EU.
The issue that promises to provide most fuel for conflict is the Northern Ireland Protocol, which effectively introduces an economic sea border in the Irish channel in order to avoid a land border between the Republic and Northern Ireland. The UK government agreed to this in the Withdrawal Agreement (even though it tries to disown it now) and it is the direct consequence of the Brexit Trilemma; leaving the EU Customs Union and Single Market requires establishing border controls somewhere! But it has raised the temperature in Northern Irish politics, with unionists feeling abandoned by the British government and the Tory party. It is certainly a sensitive situation and only cooperative behaviour from all sides (UK, EU and Irish government) will avoid these tensions to become worse. It does not look promising, though given the low trust in the UK government by other parties and its confrontational approach.
The relationship with the EU will stay central in UK politics for decades to come (though not necessarily the other way around!). The current government has taken a confrontational approach, under the leadership of an unelected bureaucrat (how ironic!)– David Frost. This will obviously inflict further economic damage on the UK and further undermine its international standing. An alternative approach would be to behave like grown-up adults, take responsibility for the results of the Brexit this government has chosen and try to smooth relationships with the EU. However, this is a hope that I do not have as long as this Prime Minister and this party is in power. But even with Labour in power, the UK-EU relationship will be a difficult one; the main challenge for the UK political class will be to move beyond the culture of victimhood, acknowledge that the Brexit campaign promises were false and there are no benefits to be had, and approach the future relationship with the EU with a realistic and constructive mindset. If one looks at the infighting within the Republican party in the US about a post-Trump future, one cannot be that hopeful that this will happen anytime soon.
7. April 2021
Some thoughts on the pandemic
One year of pandemic and lockdowns has given us economists quite some material to talk about. In the following a collection of initial thoughts, on lessons learnt, the role of externalities, and post-pandemic challenges.
One first lesson is that few countries (in Europe) have been continuously successful in fighting the pandemic – initial success stories have struggled heavily in recent weeks, such as Germany when it comes to rolling out vaccinations. Initial basket cases have been successful in recent months, such as the UK in both mitigating a third wave and in rolling out mass vaccination. A second important lesson: there is no trade-off between public health and the economy. Not locking down society or locking down too late, will damage the economy as either the lockdown will have to last longer or aggregate demand will fall dramatically as people are held back by fear of contagion. Third, even if relying on ‘common’ sense is not enough to reduce contagion risks, neither are lockdowns, a combination of both is critical.
What explains the different success of countries and why has it differed over the past year? I will leave a rigorous answer to future research, but beyond specific country characteristics – smaller countries seem to have an easier time as do countries with no land borders – government reactions have been critical. On the one extreme are countries whose leaders simply ignored the pandemic or talked it down – the US until recently and Brazil come to mind. Similarly, leaders who have been always late in decisions such as lock-downs – Boris Johnson in the UK comes to mind until recently. On the other side, the large majority of political leaders who have muddled through, taking into account expert advice, but never sufficiently aggressive to bend the curve and protect lives. In some countries, it seems governments have learned from past mistakes – Sweden has turned to lock-down like measures after the failure of the initial ‘let’s trust the people’ approach. The UK has learnt from the mistakes of opening up to quickly last summer and allowing mutants to come in through air traffic. I am not as confident that there has been as effective a learning process across countries. In federally organised countries (e.g., Spain and Germany) there have been conflicts between state and federal governments, which has hindered the necessary public health responses in the second and third waves. More centralised countries have not necessarily done better, however, as the examples of France or the UK have shown.
One thing has been clear – pre-pandemic rankings of preparedness for a pandemic have proven to be useless, while early rankings of country performance look outdated. It has become clear that it is not only about medical preparedness, but political willingness to act.
Lockdown restrictions have not been accepted by everyone, with significant shares of the population across the globe protesting against restrictions of their freedom. As Article IV of the Déclaration des droits de l'homme et du citoyen de 1789 states: ”Liberty consists of doing anything which does not harm others”. Not respecting social distance, not wearing face masks does harm others. Catching the virus because of one’s own actions increases the risk that one can pass it on. A libertarian approach to the public health ignores the enormous negative externalities stemming from individual actions. As it is hard to deny such externalities, opponents have turned to denying the risk of Covid-19, the sad role of social media and some influencers in this context has been widely documented.
The crisis has also resulted in a clash between free market principles and principles of equity and fairness. Hoarding of toilet paper and price gouging in the early stages of the pandemic have led to calls for government interventions; common sense has prevailed in most cases. The production and distribution of vaccines has pitted countries against each other, with threats of (and actual) export prohibitions; vaccine nationalism ignores the important positive externalities of vaccinations and the public good nature of a world without Covid-19; only if the large majority of the world population has achieved herd immunity can the world return to a stable and sustainable global socio-economic equilibrium.
Talking about vaccinations, a recent conversation with an NHS volunteer focused on another interesting aspect – opt-in vs. opt-out – is the baseline assumption that everyone will be vaccinated unless they opt-out for a good reason or do people have to opt consciously into vaccination. For most adults, this seems less than relevant, but it is an issue for people that might not be able to take their own decisions and for people that have religious concerns about vaccinations. The UK has decided for an opt-out regime, which might be one – of many – reasons why the mass vaccinations has been so successful.
Which brings me to the recent episodes of stopping (and then restarting) the use of the Astra Zeneca vaccine in several European countries. Public health authorities have (correctly) high standards when it comes to the risk-benefit trade-offs of medications and given the limited data available, there is a high degree of uncertainty and possibly risk involved with this vaccine. It seems to me, however, that the broader benefits of rapidly vaccinating large parts of the population might not have been taken into account in these decisions – similar to missing the macro-prudential picture when judging the stability of individual financial institutions.
Which brings me to a final lesson - the roles of experts and governments. Early on, governments (re-)discovered the importance of experts, in guiding the public health response to the pandemic. It has also been clear, however, that experts have not all had the same opinion and advice (the Swedish non-lock down response seems to have been driven as much by experts as lockdown decisions in other countries). Further, experts cannot take political decisions such as to lock-down a society – these are decisions only for political leaders to take that are accountable to the electorate. Important is the cooperation between experts and political leaders, especially for latter not to hide behind the former, but rather to own the analysis and ultimately the decisions. Communication is critical, but as important is the personal example and being humble when wrong – again, something where many government leaders have failed, but some have succeeded (and here I would point to Angela Merkel).
Will we ever get out of this pandemic? Call me a naïve optimist, but I still believe that as in 1918-20, we will come out of this pandemic and – towards the end – it will be quicker than we fear now. While this might reduce the immediate demand for epidemiologists’ advice, this might be the hour of economists – there will be lots of decisions to be taken – on the right macroeconomic mix of fiscal and monetary policy, on debt restructuring in the corporate sector, on possible bank fragility – but more broadly about challenges that we might be able to address as societies and economies might show some willingness for more radical changes than in normal times – moving towards a green economy and addressing inequality of income, wealth and opportunities, but also between different generations; and ultimately, all of these decisions have strong implications for the role of government.
30. March 2021
Interesting papers in JBF – March 2021
One of the great pleasures as editor is to hit the Accept button. There are quite many, but here is a small selection of recently published papers in the Journal of Banking and Finance that I found interesting, as they also closely relate to my own research.
In Financial structures, banking regulations, and export dynamics, Raoul Minetti and co-authors provide fresh evidence on the role of financial systems in countries’ export structures and contribute to the debate on bank- vs. market-based financial systems. Combining data on the structure of financial systems with data on the number and export sales of exporting firms and on exporters’ entry, exit and turnover rates on the 2-digit ISIC industry level for a large number of countries, the authors find that banks can promote the number of exporters more than decentralized financial markets. However, bank- oriented financial systems tend to reduce the dynamism of the export sector by slowing down the entry and exit of exporters. There is also evidence that it is especially domestic banks that slow down exporters’ turnover, while no such evidence emerges for foreign banks. Combining their data with another database, the Bank Regulation and Supervision database, they also show that in countries with lax bank regulation domestic banks tend to protect incumbent exporters, resulting in a higher concentration in the export sector.
In Local banks as difficult-to-replace SME lenders: Evidence from bank corrective programs, Iftekhar Hasan and co-authors provide evidence from Poland on the importance of local banks for SME funding. Following the Global Financial Crisis, a number of local cooperative banks got into financial trouble and had to go through restructuring programmes. The authors show that such troubled banks exhibit large declines in their loan and asset growth rates compared to other local banks. The effect of such restructuring on local SMEs, however, depends on the presence of other, healthy local banks in local banking markets. While the presence of healthy local cooperative banks off-sets the negative funding shocks for local SMEs, large commercial banks are unable to replace the lost lending from troubled local competitors. Overall, clear evidence that small local banks can be helpful for SME funding and thus – indirectly – evidence for relationship lending.
In Do loan subsidies boost the real activity of small firms?, Akos Horvath and Peter Lang investigate the effects of subsidized loans on the real activity of small firms, using credit and corporate registry data from Hungary and the setting of a large-scale subsidized loan program implemented in Hungary in 2013, which provided loans at 2.5% interest rate through commercial banks. Identification is tricky in such a setting, so the authors use credit registry queries as indicator of loan demand. The authors find that loan recipients invested about 58% more capital and employed about 8% more workers than if they had not received subsidized loans. Moreover, the positive effect becomes stronger over time, as firms have more time to utilize the additional funding. However, the authors also find significant heterogeneity both in the benefits from and access to subsidized loans: while firms with better bank relationships were more likely to receive subsidized loans, firms with lower net working capital and more severe credit constraints responded more strongly to them.
19. March 2021
Exit strategies
A few months ago I wrote a first blog entry on how to exit from the support that governments have provided enterprises and households with (and from which banks have also directly and indirectly benefitted). Over the past weeks, I have worked with Brunella Bruno and Elena Carletti on a policy note for the ECON Committee of the European Parliament on Unwinding COVID-support measures for banks. The note is also summarised in this VoxEU piece.
What have regulators in the EU done over the past year to support the banking system and complements monetary easing and fiscal support programmes? Loan loss classifications for loans with interest payment moratoria were relaxed as well as the application of IFRS9 accounting rules, which demands forward looking provisioning; risk weights were adjusted for government loan guarantees; banks were allowed to operate below the level of capital defined by the Pillar 2 Guidance (P2G), the capital conservation buffer (CCB) and hold liquidity below the liquidity coverage ratio (LCR), while at the same time banks were asked to refrain from profit distribution; finally, stress tests were delayed to 2021.
How should regulators sequence the exit from these support measures? First, none of the regulatory exit steps can be considered in isolation from non-regulatory exit steps. For example, as governments phase out credit guarantees, a need for wide-spread debt restructuring for overindebted firms might arise, with banks being saddled with non-performing assets and a possible need to address bank fragility.
Second, there is a clear advantage in sequencing. One, restoring banks’ balance sheet transparency is a first-order objective to be undertaken early on, after moratoria are phased out (or limited to sectors still affected by lockdown measures). This is critical to avoid zombie lending, as banks have otherwise incentives to evergreen loans, i.e., rolling over non-performing loans rather than recognising losses Re-establishing the preconditions for banks’ balance sheet transparency is also importantto enhance banks’ ability to raise private funds when ECB funding and liquidity support will be phased out. Two, as support measures are being phased out and hidden losses on banks’ balance sheets come to light, supervisors and resolution authorities have to stand ready to act accordingly. Authorities have to consider the possibility that the current framework will not be sufficient to address bank fragility, especially if bank failures are geographically concentrated. Close cooperation in scenario and contingency planning between supervisory and resolution authorities as well as with the European Commission (given possible implications for state aid rules) is therefore called for. Three, capital relief should be phased out last and only in combination (or after) dividend restrictions are lifted to thus ease banks’ access to equity funding.
In summary, designing proper exit strategy requires judgment as well as coordination among different, national and international, institutions. Whichever the exit strategy, this needs to be communicated in a clear and timely manner. This would provide banks sufficient time and space of manoeuvre, and enable market participants (investors, market analysts, and rating agencies) to take actions accordingly.
17. March 2021
The Grensill Failure – looking beyond the headlines
This Monday, Greensill Capital filed for administration in London, while Greensill Bank in Germany was intervened by regulators last week. A lot has been written, but here I’d like to touch upon some less mentioned dimensions – supply chain finance as product, non-bank financial intermediaries/shadow banks and the role of short sellers.
The failure of Greensill has many different aspects and dimensions to it. At the core there seems to be the overexpansion of a financing company providing what has been traditionally known as (reverse) factoring, i.e., the discounting of invoices: Firm A sends invoice to Firm B with payment target of 30 days, and receives (discounted) funding from the factoring company immediately, with the factoring company collecting money from Firm B after 30 days. The additional twist in the case of Greensill seems to have been that it attracted funding from investment funds linked to Credit Suisse (but with credit insurance as condition), benefiting from investors being desperate for any yield in the time of low interest rates. Together with the rapid (over-) expansion there was a concentration risk and some rather non- or less transparent (to stay with diplomatic language) deals with Sanjeev Gupta. The trigger for Greensill’s failure was that its main insurer – Tokio Marine- refused to renew an important credit insurance contract and that, as consequence, Credit Suisse froze its funding to the firm.
At the core of it, supply-chain financing or factoring is a sound financing technique. It is especially attractive for smaller companies in many developing countries that do not have easy access to bank credit. Being suppliers for large firms, they can use invoices to these large firms to gain access to short-term funding, effectively using the reputation and credit rating of their large firm clients to gain access to credit. My former World Bank colleague Leora Klapper has an interesting case study on the introduction of an electronic platform in Mexico in the late 2000s to connect small and unbanked suppliers with factoring companies. So, effectively, a useful technique/innovation that can expand the universe of companies with access to external funding; in the ideal case allowing these firms to get a step on the external financing ladder, allowing them to eventually gain access to bank credit.
However, it is not only in developing markets where this is an interesting financing tool, but also in advanced economies where small companies face financing constraints and/or long payment targets from their clients and delays in payment. This is where Greensill seemed to have come in in the UK. And it went beyond financing for small firms to what amounts effectively to salary loans for NHS staff (again, something that was initially hailed as a positive financial innovation in some African countries, but has the potential to push many households into overindebtedness). And supply chain financing can also be used by risky corporates to hide debt from its balance sheet.
While factoring can be offered by banks, it is often offered by non-bank financial intermediaries. In some developing countries with small financial systems, one can look at this with sympathetic eyes, as expanding financial service provision beyond a concentrated banking system can help increase competition and the range of available products. At the same time and especially in more developed financial systems (including in emerging markets), this can have regulatory implications if these non-bank financial intermediaries (or shadow banks as we used to call them) are linked to the regulated banking system. The case of Greensill is a certainly a posterchild case for this, with its connection to Greensill Bank in Germany, insurance companies and Credit Suisse. While of no systemic importance, it clearly poses regulatory challenges.
Another dimension of the case is the involvement with politics. The research programme on the value of political connections in finance is still growing – their role in boom and bust episodes can use Greensill as interesting case study; maybe it is even time to include political connections as warning signal in the supervisory dash board.
Finally, Greensill is the second time in a short period that short-sellers have gained in reputation, with an Australian short-selling hedge fund pointing Australian regulators to a potentially dangerously high exposure of an Australian insurance group to Greensill capital back in November 2020. This comes after the Wirecard scandal, where short-sellers were first vilified by German bank regulators (Bafin, not Bundesbank) when taking positions against Wirecard, before being proven right. It is telling that it was the (originally left-wing) Green party that invited a New York based short-seller against Wirecard to testify in front of a Bundestag Committee about her experience with Wirecard (report only in German). As the short-seller in question acknowledged herself, there are black sheep in the profession, but short-sellers can constitute an important market intelligence, monitoring and disciplining tool. As the case of Wirecard has shown, exclusive reliance on supervisory discipline is not sufficient, other players are important and short-sellers can be an important player in this context. Greensill is another case to show this.
In summary, supply chain finance is a useful financial product, be it offered by banks or non-banks. As most financial products it can be abused. Greensill has clearly shown this, as well as that market discipline can be very useful!
9. March 2021
Finance in the Time of Covid-19: One year on
Today a year ago I published my first blog entry on Finance in the Time of COVID-19, chapter of a VoxEU eBook. Time to look back and to look forward. A year ago, not much attention was paid to the impact of COVID-19 on the financial sector and rightly so – the immediate focus was on public health. Next came the fiscal policy reaction, supporting households and enterprises during the Great Lockdown(s). However, here the banking system already took an important role as transmission channel for fiscal support measures (loan moratoria and guarantees but also direct support payments). At the same time, there was the justified fear that ‘banks and financial markets might be catching COVID’, resulting in a swift monetary and regulatory policy reaction. It was clear already last year that any fragility in the form of non-performing loans would not show up immediately on banks’ balance sheets, but with a delay – though my original estimate of this possibly happening in the second half of 2020 was clearly – in hindsight – naïve (then again, I was also counting to being back on the road by late May)! Where I was clearly wrong was to call for continued standard loan classification and provisioning standards to be applied – given the high degree of uncertainty, the only wise response was to ease these requirements until more clarity emerged on viability of borrowers. A second source of fragility has not emerged so far: the shift to working from home has worked well for banks and the disruption in public life has not resulted in operational problems for banks. In the long-term, however, the shift to further digitalisation will result in new risks. A third source of risks I pointed to were market disruptions – they happened indeed, with investors chasing liquidity and safety. The central banks as market makers of last resort played a critical role in calming the markets. Regulatory authorities also acted quickly, with capital relief but also imposing profit distribution restrictions, delaying stress tests and an overall accommodative approach.
A journalist recently asked me: “Are banks really suffering – or are they actually doing ok or maybe even making profits?” The answer to this is ambiguous. Banks have been affected by loan moratoria and an increase in general (rather than specific) provisions. Loan losses have been limited (because of the easing of classification standards discussed above) and investment banks have been able to profit from a higher volume of market transactions (including larger firms raising funding on public capital markets). However, it is also clear that the pain is still to come; there is hidden fragility, to surface after the end of support programmes.
One additional source of risk that was on many people’s mind a year ago was the re-emergence of sovereign fragility, as countries with limited fiscal space saw a drop in tax revenues and increase in expenditures due to COVID support measures. Early on, many European economists called for a EU-level fiscal response, e.g., in the form of Coronabonds – well, these might be gone, but we got the European Recovery Fund, and thus an entry into common fiscal policy.
Where do we go from here? Attention has shifted from support measures for households and enterprises (and thus indirectly for banks) to exit strategies. As vaccines hold the promise of a return to some kind of new normal, the attention will shift from helping households and enterprises to survive through the pandemic to helping them to adjust to the new reality. There is clearly a need for reallocation at I outlined earlier. I will come back to this in a later blog entry. It is also clear, however, that while this moment of normalisation might not be here yet, it is important to prepare for it – for widespread overindebtedness in the corporate sector as for banking sector fragility. It is also clear that this does not only require careful coordination and cooperation between governments, central banks and bank regulators, but that many of these steps and possible interventions have to be coordinated if not undertaken on the European level (or at a minimum at the euro area level).
Never let a crisis go to waste. There is a lot of talk that the economic recovery should be a green one. There are also opportunities from crisis and recovery in the banking sector. One, the crisis has been a test of the post-GFC regulatory framework and will certainly lead to a debate on lessons learned and possible future reforms. Two, even more after than before the pandemic, the European banking system needs restructuring and consolidation; the crisis can give an impetus for that. Three, the banking union needs completion, this crisis can provide the necessary impetus.
Today, my worst-case scenario for the next five years is still the Great Lockdown recession being followed by a financial (and possibly sovereign debt) crisis if the economic exit from the pandemic is mis-handled. But there are lots of positive scenarios – yes, there will be losses, there will be a need for restructuring, but ultimately, the European banking sector (and broader financial system) might emerge stronger. May the experience of the last decade allow policymakers to make the right choices!
6. March 2021
Brexit – new season, old themes
We are now over a month into the UK being outside the EU, Single Market and Customs Union and project fear has turned into project reality. While some of this might be transitional teething problems, others are not and will certainly lead to sectoral shifts in the UK. There is the fishery industry, which discovered that being able to fish more does not imply selling more. There are many smaller export-oriented businesses in the UK, focused on the EU market so far, finding out that the costs on either side (UK exporter and EU importer) are simply too large for business being profitable. Social media are full now of former Brexit-fans that feel conned. One of the main frictions on the retail level has been the exit of the UK from the EU VAT system – it is important to note that this was one of the earliest decisions of the UK Parliament to force Theresa May towards as hard a Brexit as possible. While annoying for individuals (like my family and me), it has turned into a major headache for small businesses. And this is just on the goods-side. The service sector has been all but ignored; the performing arts profession has been outspoken about the failure of the UK government to agree to visa-free travel for performing artists. Similarly, the fashion industry has started to complain. It is important to note, however, that this does NOT imply that there will not be winners from Brexit – yes, there will be: most obviously, customs agent has become an attractive career perspective for young people. In the medium- to long-term, firms offering substitutes for imports from the EU will emerge. On balance, however, it has become clear that Brexit will cost the UK economy and society dearly, something that even Michael Gove – though unintentionally – acknowledged when he – correctly – claimed that Scottish independence and a trade border between England and Scotland would be even more costly than Brexit.
Then there is the issue of the Northern Ireland protocol, which introduces border controls between Great Britain and Northern Ireland in order to prevent such controls to happen between Northern Ireland and the Republic of Ireland. The European Commission committed a grave mistake a week ago invoking the emergency provisions in Article 16 of this protocol to prevent COVID vaccines from crossing the invisible border between Ireland (EU) and Northern Ireland (UK). This decision was taken on a Friday late afternoon (someone in Brussels might have started with these weekend drinks just a bit too early), without any coordination with Ireland. The immediate outcry led to a quick turn-around. This mistake was not only grave but surprising, given the critical role that solidarity with Ireland and the Irish peace process has played over the past four years of Brexit negotiations. But it was certainly interesting to see that DUP’s Arlene Foster suddenly discovered the benefits of Northern Ireland staying in the Single Market, something that she and her party had so much fought against.
The main problem is that this mistake gives the UK government yet another excuse in undermining the Northern Ireland protocol – to remind everyone, it was the UK government that first tried to undermine this protocol last year with the Internal Market Bill, which included powers for the UK government contrary to its obligations under the protocol. Back then, it declared that its intention was to put pressure on the EU to get a zero-tariff, zero-quota trade deal. Well, they got this one, though a rather thin agreement. Ultimately the border controls in the Irish Sea are the result of the Brexit Trilemma and the Brexit choices of the UK government – exit from Customs Union and Single Market and you have to put a border either on the Irish Island or in the Irish Sea.
It is interesting to see the reaction of Brexiters to the new reality, ranging from the ridiculous to the bizarre. On the one hand, there is the one academic economist speaking out in favour of Brexit who pronounced that the new trade frictions are illegal under WTO rules (well, they are not). Then there is the call for Britons to go back and plant their own food. At the same time, the government has been busy handing out money to sectors that are most affected and scream loudest and keeps referring to transitional issues. And while the government refused for a long time to acknowledge that there are customs control between Great Britain and Northern Ireland, it has now changed course and is again threatening the EU with defaulting on the Northern Ireland protocol. One minor point that they have been ignoring, however, is that the current trade deal is being applied provisionally as it still has to be approved by the European Parliament (EP), which – unlike the very sovereign mother of all parliaments – has been studying the deal for more than the 24 hours that has been given to the British parliament. A final vote won’t happen until the end of this month. And I am not convinced that the EP will look kindly at the constant threats by the UK to walk away from its obligations under the Northern Ireland protocol.
As I wrote before, the Brexit soap opera is far from over, we are simply in a new season! Old themes are brought up again and again; expect this to continue for many years to come!
5. February 2021
Bank resolution – time for another reform in Europe?
The FDIC, which institutionally combines deposit insurance, supervision and resolution in the US, was established in 1933, but has undergone multiple reforms and changes over the past 88 years. So, it is not surprising that the EU reforms in bank resolution over the past decade, including BRRD and SRM are not the final word. On Friday, I participated in an important and timely workshop, organised by the Banca d’Italia, focusing specifically on how to deal with failing small and medium-sized banks. I was asked to discuss three papers focusing on the gaps in the current framework and possible solutions (two of them are here and here).
One major gap is that currently resolution options are only available for banks where such resolution is in the public interest (focusing mostly on financial stability concerns). All other banks have to be sent into national insolvency proceedings, which vary quite a lot across member countries, some of them court-based and others of administrative nature. This, however, is not only inefficient but also leaves gaps, such as when the regulator declares a bank failing or likely to fail, but the court finds the bank still solvent and it can thus not enter insolvency proceedings (one example was the Latvian ABLV bank where the ECB’s declaration that it was failing was followed by the assessment of the Single Resolution Board that a resolution procedure was not in the public interest. While the Latvian parent shareholders decided to liquidate the bank voluntarily, the Luxembourg subsidiary was initially not declared insolvent). Further, such loopholes give space for political inference into the process, pressure for taxpayer support on the national level, thus leading us back to the bank-sovereign linkage that the banking union was supposed to eliminate.
Second, and as Andrea Enria also pointed out in his keynote speech, “significant differences in national legal regimes for the liquidation of banks imply divergences from the European supervisory framework; they generate level playing field concerns that might impair banking market integration and they may stand in the way of a smooth exit from the market for the weakest players.”
A third issue is that there are restrictions on the extent to which deposit insurance schemes can contribute to such a liquidation. Experiences in Germany and Italy have shown that a strong involvement of deposit insurance schemes in resolution frameworks (either formally or informally) can be helpful for quick and efficient intervention and resolution of failing banks. On a broader level, Luc Laeven and I documented in a cross-country study, published in 2008, higher bank stability in countries where deposit insurers are in charge of bank resolution and lower bank stability in countries with court-led bank insolvency frameworks. A stronger role for deposit insurers in the resolution process can thus be useful.
Different solutions have been suggested. One, would be to get completely rid of the public interest assessment and allow resolution tools for any bank. While dropping the public interest assessment might be a step too far, it could be used for a different purpose, such as determining whether or not state aid is allowed. In any case, extending the possibility to use resolution tools such as purchase and assumption (P&A) to most if not all banks, is certainly an important proposal. The experience of the US in the use of such tools has been promising, especially for smaller banks.
One controversial issue is whether the resolution framework should be further centralised to the Euro area level. On the one hand, this would allow reducing political interference in banking further and it would allow for more effective resolution as there are more good bank candidates for a P&A operation in the Euro area than in any given country. On the other hand, there are still significant cross-country differences in legal frameworks and market structure across countries that might make a completely supra-national approach inefficient and slow. Industry-based deposit insurance schemes and institutional protection schemes (as, for example, in Germany) complicate things further in terms of funding and resolution. A SSM-like solution, where resolution (i.e., tools beyond insolvency) for most banks is on the national level, but under the umbrella of the SSM, and with the largest and cross-border banks directly subject to SRB resolution, might thus be preferable to a completely centralised solution, at least in the medium-term. Further legal convergence on bank insolvency is needed, however, for such a step.
A final institutional question concerns the structure of a future European Deposit Insurance Scheme (EDIS), which by now almost all observers see as necessity for the completion of the banking union. One idea would be to go all the way towards the US/Canadian model of a European Deposit Insurance Corporation (EDIC), which combines resolution and deposit insurance and maybe even a role in bank supervision. Such a centralised approach, however, might shock with the cross-country differences mentioned above. It might also require treaty changes (to my understanding and I am happy to be contradicted, the decision to house the SSM at the ECB was to avoid such treaty changes), which is politically always tricky.
In summary, short-term reforms must focus on making the system, especially for mid-sized banks, more efficient. As laid out in one of the three papers, this involves further harmonisation of bank resolution/insolvency frameworks across the EU and facilitating adequate liquidation funding, including through deposit insurance schemes This is critically important on the background of Covid-related bank fragility, to be expected later this year and in 2022, but also on the background of the need for restructuring and consolidation of the European banking system. While industry observers and insiders often dismiss the calls by regulators and academics alike for more cross-border mergers, only these will ultimately result in a true European banking market. A truly European financial safety net is a necessary though not sufficient condition for this.
17. January 2021