AnAnother war
Another war
As if there weren’t enough conflicts yet, the decade-old stand-off between Iran and Israel has turned into open war. Beyond the politics, my first thought is for the civilians on both sides, including two former PhD students who now work in Tehran.
While Iran’s nuclear weapons’ ambition seems the most obvious trigger for Israel’s attacks, domestic arguments seem critical in Netanyahu choosing this moment. His coalition is fragile, under threat over the question whether or not orthodox Jews have to serve in the army. His legacy is still tarnished by the October 2023 Hamas attack. But this seems also a good moment for him given the weakness of the US. Yes, if one looks beyond social media announcements, Trump has shown an incredible weakness over the past months on the global stage. His attempt to bring peace to Ukraine has failed. And while he was advocating for talks between the US and Iran, Netanyahu has simply ignored this and taken military initiative. One can be forgiven for seeing Netanyahu driving the US agenda in the Middle East.
One important issue to keep in mind: there was a moment a decade ago, when a peaceful solution to Iran’s nuclear weapon ambition seemed possible, with the 2015 agreement between Iran, the US and several European countries. It was Trump who pulled out (even though sceptical Republicans warned against it), for the simple reason that it had been Obama who had come to the agreement. As always, he has been much better in destroying things than building them. His attempt at damage control by negotiating a new agreement came too late and from a weak position (vis-à-vis Israel).
One rather naïve idea is that of regime change in the Iran. One better be careful what one wishes for. The last time the US started a war in the region with the explicit ambition of regime change, was in Iraq in 2003. In spite of ‘mission accomplished’the result was a decade-long civil war and a still fragile situation. It seems far from clear that the fall of the Ayatollah regime (and, no, I would not mourn the demise of such a theocratic regime) will lead to a peaceful, democratic Iran without regional ambitions. It is also unlikely that external pressures will lead to a successful transition, as outside attacks typically lead to a circling the wagons movement in the attacked country.
Netanyahu has taken a huge gamble. It might lead to a further weakening of Iran and reduce its influence in the region. I doubt whether it will result in a more stable region!
16. June 20025
International competitiveness of European banks
In a recent contributionwith Brunella Bruno and Elena Carletti for the ECON Committee of the European Parliament, we explore the competitiveness of European banks compared to their US counterparts. We highlight structural differences between the two systems, particularly Europe’s reliance on traditional bank intermediation versus US’s market-based model. European banks play a significantly larger role in financial intermediation, operating within a predominantly bank-based financial system. In contrast, the US system is more market-oriented, characterized by deep and liquid capital markets and a high level of securitisation activity. This has enabled US banks to expand beyond traditional banking and gain a competitive edge in investment banking, trading, and capital markets—areas in which European banks have lost ground, partly due to the structural fragmentation and bank-centric nature of European financial markets.
European banks generally lag in profitability and market valuations, but remain central to credit provision and financial inclusion across the EU. US banks have benefitted from more favourable macroeconomic scenarios. At the same time, recent improvements in European bank’s profitability and efficiency are driven by temporary macro factors, raising concerns about sustainability. This persistent underperformance reflects structural inefficiencies, including overcapacity, as well as a more difficult macroeconomic environment in Europe, marked by two successive crises and an extended period of ultra-low interest rates.
Despite these challenges, European banks remain central to the real economy, particularly through the provision of credit to firms and households. While they continue to lose ground in investment banking and capital markets, recent improvements in operational efficiency are reflected in declining cost-to-income ratios—although these gains have been driven more by increased income than by sustainable cost reductions. At the same time, European banks have prioritised investments in IT, which, while potentially increasing short-term costs, can enhance productivity and competitiveness in the medium to long term.
Evaluating the performance of individual banks or banking systems provides only a partial perspective. To provide a more comprehensive view, we therefore also presents country-level indicators of financial development, inclusion, financial literacy, well-being, and resilience. In several of these areas, EU economies perform at levels comparable to—or even exceeding—those of the United States, although there is substantial variation across Member States. It is this variation, which seems more interesting to explore than comparisons of EU average with the US or other advanced countries.
To enhance the international competitiveness of European banking, we discuss several policy recommendations, including the harmonisation of regulatory frameworks, advancing the Capital Markets Union (CMU), and supporting the emergence of a few pan-European institutions capable of competing on a global scale—so long as this does not come at the expense of preserving diversity among banks, including in terms of size. Addressing market fragmentation, improving operational efficiency, and promoting financial innovation are essential not only for enhancing relative performance, but also for strengthening the resilience and long-term contribution of the European banking sector to the broader economy and public welfare. This is important to bear in mind given the prominent role banks play within the European economy: sustainable performance should go beyond profitability to include responsible risk-taking, sound prudential regulation, and broader qualitative goals such as financial inclusion and social well-being.
In a related paper, our colleagues at the Leibniz Institute SAFE in Frankfurt point to an interesting empirical phenomenon that supports some of the arguments made above. They show a negative empirical relationship between the cost-to-income ratio (CIR) and the price-to-book (P/B) ratio for both European and US banks, indicating that operational efficiency significantly influences bank valuations. Importantly, however, US banks operate on a systematically higher valuation level, even when controlling for the cost-income ratio, suggesting that their stronger market valuations reflect investor expectations of superior future growth perspectives. As we do, the authors link this back to the lack of cross-border banking and a truly Single Market in banking in the EU.
21.May 2025
Financial sector cooperation between the EU and the UK – looking beyond Brexit
Joint with Christy Petit, originally posted on the DCU blog
While closer cooperation in financial services would make sense for both the UK and the EU in the current geopolitical and geo-economic circumstances, we point to significant legal, institutional and political barriers to such cooperation. However, we also outline some options that respect the red lines on both sides.
The recent and continuing changes in geopolitical and geo-economic circumstances have led to increasing calls to deepen the cooperation between the EU and the UK, most prominently in the area of defence. There are also discussions about closer cooperation in the area of energy, law enforcement, professional qualifications and a possible UK-EU youth mobility scheme. All those developments follow the EU-UK resolve to ‘strengthen ambitiously their structured strategic cooperation’, as evident in the Joint Statement by President von der Leyen and UK Prime Minister Starmer, that announced the upcoming first EU-UK summit on 19 May in London.
However, the UK government has also drawn clear red lines for the relationship between the UK and the EU, namely staying outside the customs union and the Single Market. These red lines impose limitations on how close any cooperation can be, no matter which sector. Although the UK lost its EU passport to provide financial services, it still has a comparative advantage in financial services and may have some leverage to preserve a certain degree of regulatory autonomy.
In the following, we will discuss different options for closer cooperation in the financial sector - beneficial for both sides - to foster a more stable, predictable, and to some extent integrated cross-border environment. This is even more critical given increasing doubts about the role of the US dollar as international reserve currency and the risk that financial sector policies can become part of the trade war that the US has been waging on the rest of the globe.
Any such cooperation, however, is subject to several constraints: in addition to the UK government’s red lines, the indivisibility of the EU Single Market ‘four freedoms’, as well as the respect of the Withdrawal Agreement, the EU-UK Trade and Cooperation Agreement (TCA) – which was very thin for financial services – and the Joint Declaration on Financial Services Regulatory Cooperation. In the following, we will discuss the options for closer cooperation in three steps, from loose to closer cooperation, while acknowledging quite strong constraints.
1. From regulatory divergence to dynamic alignment
One consequence of Brexit was possible active and passive divergence of the UK regulatory framework from that of the EU. Active divergence would occur when the UK “deliberately legislates to move away from retained EU Law” (Reland et al. 2021), as seen, for example, in the UK lifting limits on variable compensation. Passive divergence would reflect the UK not keeping up with EU legislative changes, for example in newly adopted legislation, such as in the area of crypto.
One low-hanging fruit of closer cooperation would be to limit even further such regulatory divergence. The easiest option would be to build on existing structures that were opened by ‘a new Chapter’ in financial sector cooperation already in 2023. Following the Windsor Agreement (which resolved the EU-UK stand-off on the Irish border), the UK and the EU signed a Memorandum of Understanding (MoU) establishing a framework for financial services regulatory cooperation on 27 June 2023 and in particular, the joint EU-UK financial regulatory forum. This forum serves to discuss legislative initiatives, regulatory changes and issues of common interest – including market developments, financial stability issues, and fostering enhanced EU-UK cooperation ahead of global forums. Important outcomes of the structured engagement in this Forum could be:
This would complement ongoing cooperation on the technical level between EU regulatory and supervisory authorities and their counterparts in the UK. All in all, this reflects the options available under the current situation with the operationalisation of the MoU after the Windsor framework, with soft mechanisms and where flexibility prevails. However, this does not equal the level of cooperation encompassed by a comprehensive financial services agreement (as a Chapter of the TCA) and the forum is a sort of satellite to the TCA institutional structures (e.g. the Committee on Regulatory Cooperation under the TCA).
2. The use of clubs and equivalence regimes
One can envision a stronger form of cooperation moving beyond the Forum towards a multilateral club, similar to the Nordic-Baltic Financial Stability Group or the Network for the Greening of the Financial System. This would allow for closer cooperation including across areas currently not captured in discussions at the Forum. However, similarly to the current EU-UK joint forum, such a club would not be able to adopt binding measures, but it might help create more mutual trust between UK and EU and raise the ambition.
Cooperation would certainly benefit from the granting of additional equivalence to the UK, not only in terms of (selective) market access of UK players to EU financial markets, but also, inter alia, in terms of reinforced supervisory cooperation frameworks, data sharing and recognition of equivalent regulatory approaches and outcomes (even without direct access to the respective markets).
However, some of the features of the EU’s equivalence regime, particularly in financial services regulation, are in tension with the objective to build mutual trust and stable EU-UK cooperation. Indeed, equivalence is mostly a unilateral and discretionary policy tool. Unlike a treaty assuring mutual recognition, EU equivalence decisions are adopted by the European Commission (based on consultation with the European Financial Supervisory Authorities), they can be withdrawn at any time or even be temporary from the start (e.g. for UK CCPs), limited in scope and require reciprocity. Its political nature is also evident when equivalence has not been granted even in areas where UK rules are still mirroring EU rules – reflecting the concerns for future divergence.
Yet, in a new political context where overall EU-UK relationship improved with structured and constructive dialogue, the use of equivalence could become more predictable and less sensitive at the political level. In this sense, equivalence could be granted more gradually (limited to specific sectors and activities, e.g. AIFMD and investments services for professional clients, with reciprocity), perhaps on a more flexible outcome-based approach, so as to become a mutually reinforcing instrument of cooperation.
3. A bigger deal?
In principle, any new agreements would become a supplementing agreement to the TCA and be subject to the same governance principles of the EU-UK cooperation framework (as per Article (1) TCA). The reportedly EU preference for supplementing agreement limits the alternative option of negotiating sectoral agreements outside the TCA. However, any financial services closer cooperation than described so far, including market access or on a sectoral basis, is rather limited for political and legal reasons.
First, it is limited given constraints in the UK political landscape (and the government’s red lines) and the constraint that all 27 EU member states would have to back any such new agreement.
Second, regarding the constraints stemming from the TCA – extended with a non-binding MoU on financial services cooperation, we see the reopening of the financial services sector provisions unlikely in the current political environment, at least in the short-run, considering the other priorities expressed for fishing waters, youth mobility, energy, law enforcement and security. Indeed, a review of the TCA is due in 2026 and will allow the parties to review the implementation of the entire agreement (see Article 776 TCA), along the end of transitional periods for fisheries and energy. All in all, it seems clear that the EU won’t let the UK ‘cherry-pick’ to access a part of the single market.
Precisely for this reason, coalitions of the willing (i.e., a subset of EU member states and the UK) cannot agree on deeper cooperation within the financial sector through a binding act, as this would touch the indivisibility of the internal market, whose functioning is the internal competence of the EU, and considering the extensive corpus of EU financial services regulation.
EU secondary legislation, i.e. legal instruments adopted by the EU co-legislators including regulations and directives, may enable the EU to act to adapt the equivalence regime or actually grant it on the basis of existing 13 EU legal acts, or provide for the conclusion of an international agreement (see Article 3(2) TFEU). This could make it easier for the UK to be granted equivalence, thus easing the conditions.
Conclusions
There is a clear appetite on both sides of the Channel to deepen cooperation. The financial sector is an obvious candidate for such closer cooperation. However, the red lines imposed by the UK government and legal constraints on the EU side, most notably the extensive harmonisation of EU Law in the field and the jurisdiction of the CJEU for its interpretation, limit the extent to which cooperation can be deepened and (selective) market access be eased for UK players. Even so, we lay out some options to deepen the cooperation within these constraints, including through more trust-building discussion fora, more extensive use of equivalence within the existing framework and broadening this framework to allow for easier market access by UK players. We believe such deeper cooperation can be beneficial for both sides, but will never replace full integration into the Single Market.
16. May 2025
8 May 2025 – history as warning
80 years ago, World War II ended on 8thMay in Europe (and a few months later in Asia). What few people could dream of back then was that this was the start of an unprecedented period of peace, democracy and prosperity in Western Europe. The European Union has been critical in this process, while also being a symbol of this peace, democracy and prosperity. After 1990, this extended to Central Europe. In 2022, for the first time since 1945, a major war broke out in Europe and is still ongoing. As in 1939, a dictator with imperial ambitions has unleashed a brutal aggression against a neighbouring independent country. As in the late 1930s, there is limited appetite in the rest of Europe to forcefully stop the aggression and push back the aggressor. History does not repeat itself, but it certainly rhymes. And those who have not learnt the lessons from history are doomed to repeat it.
One can argue that this long period of peace after 1945 in Europe was also motivated by the horrible toll that the war and the holocaust had taken across the continent. It seems that this important memory is now in danger of being lost. While there is certainly not really any appetite for war anywhere in Europe, nationalist movements raise their ugly head, under the banner of ‘Europe of sovereign nations’. Rather than less integration as these movements are demanding, however, the current geopolitical developments call for more integration and coordination. The idea that the larger EU economies can stand by themselves has been proven wrong with Brexit, with the UK having lost in global standing after going it alone. Not to mention smaller EU countries!
Rather than limiting European integration to economic integration, there is an urgent need to build up a defence union to thus fend for ourselves in the light of US ambiguity on their NATO treaty obligations. A stronger geopolitical role of the EU can ultimately also strengthen the euro as international reserve currency and possible alternative to the US dollar. As pointed out in this excellent column by Helene Rey, this would, however, also require stronger and more liquid European capital markets – as well as a truly European safe asset. Again, this would require more rather than less integration.
Trump’s politics has helped centre-left parties in both Canada and Australia win recent elections, which can be interpreted as a rejection of the toxic, populist policy agenda. Interestingly, Central European countries do not seem to follow this example, as the recent elections in Romania have shown. There is a risk that more and more countries in Central Europe get populist, right-wing governments opposing any further integration and geopolitical strengthening of the EU. Obviously, there is also lots of resistance in the rest of the EU against further integration. Populist parties often have a valid point in pointing to mistakes made by traditional parties as well as corruption, unnecessary bureaucracy and other flaws. However, populist governments offer few if any solutions. Where they offer ‘solutions’ these tend to impoverish countries- Nigel Farage and his Brexit campaign is the best example and Trump is following the same playbook.
Over the past 80 years, democracy and European integration have been at the core of peace and prosperity in Europe! It is easy to point to institutional flaws and policy mistakes. It is important, however, to take back the narrative and point to the success over the past 80 years and the risks of forgetting history’s lessons. This, as much as the horror of World War II and the holocaust, is an important lesson of today.
8. May 2025
Exorbitant privilege or exorbitant burden?
The former French president Valerie Giscard d’Estaing coined the expression ‘exorbitant privilege’ in reference to the benefits that the US derives from the US dollar being the international reserve currency. Among these benefits are the US not having to fear a balance of payment crisis due to current account or fiscal deficits as the threat of sudden stop does not really apply to the issuer of the global reserve currency. The US government can also borrow at lower interest rates given the high demand for dollar-denominated assets (Barry Eichengreen and co-authors quantify this advantage inthis paper). The position of the US dollar also makes US monetary policy a decisive driver of global financial cycles.
Other economists (e.g., Michael Pettis already in 2011)have re-interpreted the role of the US dollar as exorbitant burden rather than privilege. Most importantly, the position of the US dollar as global reserve currency results in its overvaluation, hurting US exports. These commentators explain the persistent current account deficit and the decline of the US manufacturing industry with the role of the US dollar as global reserve currency. Martin Sandburecently dismissed many of these arguments, popular with US politicians on both sides of the aisle, especially the argument that a strong US dollar explains the decline in GDP’s manufacturing share in the US.
I would rather like to focus on the link between the reserve currency status and current account deficit. It is hard to come up with a counterfactual, as this would require either comparing the US to the UK pre-World War I (two very different periods) or to an alternative universe with a different global reserve currency today. But, some lessons can be learnt from looking at Switzerland (considered as safe haven country) and Germany (the anchor country of the euro).
Take first Germany; it has benefitted from its status as anchor country and its government bonds being the safest and most liquid in the euro area (as documented in this prize-winning paperby Tsvetelina Nenova), resulting in record low interest rates in the 2010s. Did Germany run an internal or external deficit, as the US did? Well, it did run a current account deficit during the 1990s, right after the unification. Since 2000, however, it has run increasing surpluses, related to the debt brake but more generally due to a cultural aversion against debt finance and its obsession with the Swabian housewife concept who always has to balance her books. Ultimately, this obsession with self-imposed austerity hurt not just itself but also the rest of the euro area. And unlike the US, Germany’s safe haven status did not come with an overvalued euro. But this example clearly shows that internal imbalances are not only driven by external factors but by political decisions and broader societal trends.
Take next Switzerland; given its political neutrality, strong institutions but also bank secrecy (partly lifted), the Swiss France is considered a safe haven currency. This has put continuous upward pressure on its exchange rate and in turn on its exporters. Nevertheless, Switzerland continues to run a current account surplus and its manufacturing sector contributes almost 20% to its GDP, comparable to Germany.
Obviously, these comparisons are not completely valid, but they provide some arguments that the causality does not really goes from reserve or safe haven currency to current account deficit. Put differently, arguing that the USD as reserve currency has resulted in internal and external imbalances is like arguing that US polity and society are not capable of passing the marshmallow test. Low interest rates have enabled consistently high fiscal deficits and a thriving credit culture cum low household savings rate. But blaming the rest of the world for this is taking away agency from political players in the US who have fostered these imbalances.
And as I have argued before, the even higher fiscal deficits projected with Trump’s second round tax cuts will do nothing to reduce this internal imbalance.Driving the US into a (deep) recession might help reduce the savings gap by reducing consumption and investment. Similarly, making the US a less attractive place for foreign capital and undermining its safe haven status can reduce external imbalances. However, I somehow doubt that this is in the long-term economic and political interest of the US.
27. April 2025
A new threat for financial stability
Vasso Ioannidou and I just published an Op-Ed in Politico, on the U.S. president’s renewed promises of financial “liberation.” Behind this rhetoric, however, lies a deeper threat — and it’s not just to the U.S. financial system and economy. The new administration is actively undermining the independence of financial regulatory and supervisory authorities in the US. This will not only affect financial stability in the U.S., but might have negative spill-over effects for Europe, given higher interconnectedness. It is more, the financial system might become a political weapon, adding financial instability to an already volatile global landscape. We argue that the EU must not only hold the line, but European governments and regulators need to maintain strong, independent oversight over European financial systems.
8. April 2025
Let the turmoil rule
2025 might turn out to be an important year in the history of the 21stcentury. After the beginning of a geopolitical realignment similar to 1945 (end of World War II) and 1990/91 (end of the East bloc and the Soviet Union) , there seems now also a geoeconomic realignment, similar to 1929 (Great Depression) and 1971-73 (end of Bretton Woods). If the steep tariffs announced this past week stick and are not reversed, the modern international trade structure as we have known it for the past decades is coming to a painful end. Before some people start popping the champagne bottles, let’s just remember that globalisation has helped hundreds of millions get out of poverty, most notably in China but also many other developing countries in the world. Is global trade always fair and just – no; is it better than autarky – absolutely; is it better than a mercantilist regime where military and economic power trumps economic efficiency and benefits as Trump seems to envision it – absolutely yes!
The geopolitical realignment goes hand-in-hand with a decline in democratic and institutional standards in the US and a shift towards tech-oligarchy. The president and his entourage have shown a complete contempt for the judiciary and the rule of law, trampling over the idea of checks and balances that the founding fathers so emphasised (ironically it is the conservative originalist legal scholars who always insist on literal interpretation of the founding fathers’ ideas). Competence and dedication to public service have been replaced with blind allegiance to one man and his family and the idea of abusing public service for immediate and future private gains. Daron Acemoglu elegantly describedwhat will be the long-term consequences of these actions even if there are ‘only’ 45 months left in Trump’s presidency.
As observer of these events and with rather strong views on their disastrous effects, I always have to resist the temptation of thinking: let them do it so they can learn how bad political decisions look like. This was the case for Brexit where most economists predicted the negative consequences that ultimately materialised. Most economists pointed to the complete lack of logic in Brexiters’ arguments and warned against the economic damage Brexit (especially the hard Brexit that ultimately was engineered) would impose on the UK. We were proven right. Rather than feeling vindicated, we should ask ourselves why we were not listened to and where we failed in bringing our message across. Similarly the current situation – with Trump breaking down the global trade structure and steering the US and the world towards a global recession – can also be seen as failure of economists of not bringing their arguments across in the public discourse.
There are still different scenarios going forward, with a more optimistic one seeing these high tariffs as negotiation tools. Even under this optimistic scenario, the damage has been done – the credibility of the US government in policy management has been seriously damaged; the consequent high policy uncertainty ultimately undermines incentives for long-term investment. A more pessimistic scenario sees the conflict shifting from goods trade to service trade and capital flows, which could further exacerbate the negative economic impact worldwide. In either case, we are at the beginning of a long period of high turmoil, with no short-term winners.
7. April 2025
Banks and beyond
I recently attended a very interesting conference at the Hoover Institute at Stanford, with the added bonus that I did not only get to see my PhD supervisor but also Robert King, my third PhD supervisor whom I had not seen for 26 years. The focus of the conference was on Banks and Beyondand there were some exciting papers on non-bank financial intermediaries, specifically on Private Credit, loans to firms by non-bank lenders.
Private credit has grown to 1.7 trillion USD in 2023, still only one percent of the overall financial system, but rapidly growing. Sergey Chernenko, Robert Ialenti and David Scharfsteintry to explain this growth of private credit since 2008, focusing on one important provider of private credit, SEC-supervised closed-end fund Business Development Companies (BDCs). The authors finds these companies to be very well capitalised - 36% risk-weighted capital-asset ratio if one applied the standardised approach to capital requirements. Applying stress test methodologies they show that BDCs are unlikely to fail. This suggests that increased lending by BDCs is not a consequence of tighter capital requirements on banks. However, higher capital requirements on banks post-2008 can explain why it is more attractive for them to lend to BDCs rather than directly to the borrowers served by the BDCs, as loans to BDCs carry a 20% risk weight while direct loans would carry a 100% risk weight. So, ultimately, tighter capital requirements did shift some activity outside the regulated banking system
Sharjil Haque, Simon Mayer and Irina Stefanescufind that a significant portion of private credit borrowers in the US also rely on bank loans (about half in their possibly incomplete sample). Compared to bank borrowers without private credit, these ‘dual borrowers’ tend to be larger and riskier firms, with higher leverage and less tangible assets that can be used as collateral. Their private credit loans are term loans, while they take credit lines from banks. This seems to suggest that while long-term lending has shifted from banks to private credit lenders, liquidity provision through credit lines has stayed with them, consistent with evidence that banks have a comparative advantage in offering such liquidity insurance given their deposit-based funding structure. However, this combination of private credit term loans and bank credit lines also exposes the banks to higher drawdown risks during stress situations; in spring 2020, dual borrowers were more likely to draw down their credit lines than other bank borrowers.
Nicoletta Cetorelli and Saketh Prazad explore the ‘Nonbank footprint of banks’and show that since the 1980s, bank holding companies (BHC) in the US have added thousands of NBFI subsidiaries, including investment funds, securities dealers, insurers, and specialty lenders. These subsidiaries constitute at least 20% of aggregate BHC assets and 11% of the aggregate NBFI industry in the United States. Their main explanation for this trend is diversification - as long as affiliated banks and nonbanks experience relatively uncorrelated liquidity outflows, diversified BHCs can redistribute liquid assets among subsidiaries and thus reduce overall liquid asset holdings. This is what they show for the pre-2008 period, a result, however, that becomes weaker after 2008 when tighter regulation forced BHCs to scale back their nonbank footprint. They show that these results are driven by explicit and implicit intracompany funding arrangements between affiliated banks and nonbanks. In sum, the expansion of banks into the nonbank sector can be explained by the search for liquidity diversification and synergy effects.
5. April 2025
Moving on from Brexit
In the previous blog entry I had already mentioned the panel debate in London I participated in. While the focus was on financial integration within the EU, the role of London as European financial centre naturally came up. With Brexit, there has been understandable reluctance by EU policy makers to rely too much on a financial centre outside its jurisdiction, especially among strong early signals of active divergence by UK authorities. However, attempts to create an alternative to the financial centre London within the EU have not really been very successful, while active divergence has not been that aggressive on the UK side. At the same time, circumstances have dramatically changed. First, after a decade or so, the UK finally has again a government that seems more interested in serious policymaking than populist slogans; this is an excellent basis on which to rebuild trust between the UK and the EU, something clearly missing before. Second, the geopolitical circumstances are dramatically different than even a few months ago: the UK and the EU are certainly closer to each other than either of them to the US in terms of geopolitical interests.
During the Brexit negotiations (which even most UK observers would call a success more for the EU than for the UK) the primary interest of the EU was to protect its single market – mission clearly accomplished. However, there are now challenges far beyond economics (though even here more is needed to deepen the single market), including defence and strategic autonomy, where EU and UK interests are certainly aligned with each other. And while the interest of EU policy makers is clearly on strengthening the capital markets within the EU, this does not necessarily exclude relying partly on and cooperating with financial markets and their regulators in London.
What is needed? I would argue, primarily, flexibility on both sides. As outlined in mypaper with Christy Petit, the EU is somewhat tied to certain forms of regulatory cooperation (including equivalence decisions); is there space to push the boundaries of that? Back in 2018, then UK Prime Minister Theresa May asked for a ‘collaborative, objective framework that is reciprocal, mutually agreed, and permanent’ , but was rebuffed by the EU, which insisted on discretionary and unilateral equivalence decisions, contingent, limited in scope (sometimes in time) and requiring reciprocity. Would the EU be willing to move towards a more flexible regime?
On the UK side, moving away from the obsession with sovereignty (almost impossible for a mid-sized economy like the UK) and accepting some role for European courts can be helpful and might allow the EU more flexibility in turn. Most importantly, any closer cooperation and easing of access for the UK to the EU financial market would have to be part of a broader package. In our report, Christy and I pointed to the stand-off on Northern Ireland, which had prevented the MoU on financial service cooperation to be signed. With the Windsor Framework this hurdle was overcome. This clearly shows that one cannot consider individual sectors and policy areas independently.
A reset in the EU-UK relationship is overdue and clearly a win-win proposition, let’s hope the chance for it will be used.
25. March 2025
Is financial integration in Europe good for growth and stability?
Earlier this week, I participated in a panel discussion on Does Financial Integration hold the key to European Stability and Growth?in London. The discussion was organised by the Chatham House, so the well-known rule applies, but I can certainly report my own thoughts. The question is stated somewhat provocative. There is certainly not one specific policy or reform that holds the key to European stability and growth, but financial integration can certainty contribute. How?
First, there is an expansive literature that shows that more efficient financial systems can support economic growth. While most of this evidence shows the biggest economic effect for emerging markets and non-linearities (i.e., smaller, if not insignificant effects at higher levels of financial and economic development), there are also important effects stemming from financial structure, as shown by several papers, but most prominently and directly applied to Europe by Langfield and Pagano (2016):the bank-bias in Europe’s financial system explains the lower growth and the higher fragility in Europe’s economies compared to other advanced economies. Building up non-bank segments in Europe’s financial system is thus critical to achieve higher growth and higher stability. In a recent paper, I show with several co-authors that banks’ liquidity creation helps foster economic growth only through tangible but not intangible investment; as economies shift their sectoral and asset composition towards intangible capital (both within and across sectors), the growth effect of banking sector development turns insignificant. Finally, Ralph De Haas and Alex Popov (2023)show that more market-based financial systems are better positioned to support economies’ transition to net zero. So, strengthening the non-bank, market-based segment of the financial system would allow Europe to better exploit benefits of the new economy and progress faster towards net zero.
Second, public financial markets are more than other segments of the financial markets reliant on scale and network effects, i.e., the more participants on both sides (investors and listed securities), the higher the liquidity and thus benefit for economic growth. We show this effect in a recent paper on nascent stock exchanges. However, this scale effect is not limited to public financial markets; venture capitalists and equity funds depend on exit options through public markets; institutional investors, including insurance companies, pension funds and other investment funds, rely on deep and liquid markets. Looking at Europe, financial markets are fragmented, which holds back their development but also that of other critical non-bank segments of the financial system.
Third, strengthening market-based finance in Europe through integration does not imply that one should ignore the bank-side of Europe’s financial system. Rather, there are important feedback effects between banking sector and financial market integration. Larger and cross-border European banks allow a stronger role for them in investment banking and thus market development. Developing European safe assets helps both banking sector integration (including by cutting the bank-sovereign vicious cycle) and deepen financial markets. Deeper financial markets allow banks more effective securitisation and, more generally, raising funds beyond deposits. So, it is not banks versus market, but banks and markets that we care about for financial integration.
20. March 2025
The bright side of regulatory arbitrage
Banks might shift assets and risk across countries due to differences in regulatory regimes. In a recently published paper, Consuelo Silva-Buston, Wolf Wagner and I show that cross-border supervisory cooperation agreements can also result in such regulatory arbitrage with risks being shifted into a third country. In a new working paper, we consider the real effects of such regulatory arbitrage. On the one hand, countries with weaker regulatory standards may receive capital inflows that allow firms to borrow more, potentially alleviating financial constraints This may be particularly beneficial if countries with less developed financial systems (and hence more constrained firms) are also countries with relatively lower regulatory standards. On the other hand, such benefits are conditional on whether the additional lending is targeted towards well-managed, efficient, and profitable firms, as a purely risk-motivated reallocation might result in negative NPV projects being funded. Regulatory arbitrage can thus also lead to excessive risk-taking and misallocation of resources.
We use the syndicated loan market as a laboratory to explore the effect of regulatory arbitrage on lending terms, as well as firm behaviour and performance. We first show that a subsidiary of a bank group extends larger loans to firms when the extent to which cooperation covers the group’s global operations (excluding the subsidiary country itself) increases (for example, as a result of the parent country of the group forming a cooperation agreement with another country in which the group has subsidiaries). We also consider the effect on loan pricing and find that when cooperation elsewhere increases, the subsidiary also offers lower lending rates to firms. Thus, lending conditions improve on both the quantity and price margin.
We next investigate which types of firms benefit from the improvement in lending conditions. Our results suggest that the firms that benefit most from improved lending conditions are high-quality firms that are less likely to fail and firms with which the bank is less at an informational disadvantage (in our case: because it has an existing relationship with the firm). This is consistent with the literature on foreign bank entry, which has shown that foreign banks often face a disadvantage in making new loans compared to incumbent local banks, because of inferior access to local information.
Finally, we consider whether there are real benefits arising from the shift in lending conditions. Exploiting the same third-country variation in relative supervisory stringency, we show that firms that borrow from banks that receive positive shocks in third-country supervisory cooperation expand their activities. They increase their asset base, have higher capital expenditures, and do more R&D. These firms also see their profits increase. This is consistent with financing constraints being eased at such firms.
Overall, this points towards positive real effects arising from regulatory arbitrage. In particular, the fact that the additional lending seems targeted towards high-quality and safe firms, coupled with the fact that financial constraints are likely to be tighter in countries with weaker supervisory standards (and hence the ones receiving the inflows), allows for the possibility that a reallocation of lending between countries on net alleviates financial constraints, resulting in more desirable projects being funded. This is by no means to claim that regulatory arbitrage overall is desirable. Rather, our results suggest that there are likely to be trade-offs between additional lending and financial stability. It also points to the possibility that the distribution of benefits and costs of regulatory arbitrage are not necessarily equally distributed across countries. In particular, countries may benefit from relatively weaker regulatory standards as that stimulates the domestic economy through higher lending. This may explain the persistence of significant differences in regulatory standards across countries and the fairly low degree to which countries cooperate in the supervision of their banks.
17. March 2025
Reasons to be optimistic for Europe
The breath-taking realignment of the current US Administration away from democratic Europe towards autocratic Russia, the lack of European leadership, including a gap in German leadership, and a stagnant European economy give lots of reasons to be gloomy about Europe’s future. However, there are also reasons to be optimistic.
One, not only have the German elections provided the clear option of a two-party government (though I would have preferred the Green party to be the second party), but the new partners have moved forward quickly, acknowledging that unprecedented times call for quick reactions by a functioning government. The previous black-red coalitions (they used to be called Grand Coalitions at a time when they combined more than two thirds of seat in the Bundestag, a time which looks far away in the past) under Angela Merkel are for me synonymous with expansion of the social welfare state and reform stagnation, neglect of infrastructure and geopolitical realities; Germany benefitted from cheap Russian oil, a booming Chinese market for German exports, the US security umbrella and its anchor role in the euro area. Except for the last, all of these are gone, so this black-red coalition has to make a break with the past; at least for the chancellor—to-be, Friedrich Merz, not as much a problem given that he was a critic of Merkel. And it seems that both parties are willing to make a break, starting with the economically damaging constitutional debt brake. Obviously, it is not just about spending lots of more money, but investing wisely, in infrastructure and in defence. But the change in the fiscal stance can also have shorter-term positive effects on both German and European economies, something we need urgently.
Two, the UK Prime Minister Keir Starmer has grown in his role and moved towards partly filling the European leadership gap in defence. Not being burdened by the bad relationships between Tories and European partners due to Brexit, the UK has the chance to take again its natural role in Europe, at least when it comes to defending European values and interests. The first time since 2010 that a British Prime Minister looks truly prime ministerial.
Three, European leaders have accepted the challenge and are coordinating a response. It remains to be seen how far the initial willingness will take us and it is clear that unanimous decision-taking in the European Union is being impeded by certain Central European governments. New forms of cooperation (e.g., involving the UK) have to be found. At the same time as Europe has to ascertain its geopolitical clout, the relationship with US has to be managed carefully, given the current dependence of European armies on US weapons and military equipment. The build-up of a European defence industry, however, is critical. At the same time, a more hard-nosed approach, without losing the moral compass, is needed for European foreign policy.
Finally, the Trumpian America First approach has put its populist and right-wing allies across Europe on the back foot, at least for the moment. The example of Canada, where Trump’s erratic and offensive attitude helped revive the chances of the Liberal Party is telling! The Trumpian threat against democratic Europe, economically, politically and socially, has energised the democratic centre! Let’s hope it is not just a short-term sugar boost.
11. March 2025
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