This year, the European Union marked the eighth anniversary of the ongoing fiscal and financial crises that exposed deep structural vulnerabilities within the EU architecture. From the fiscal policies, including dysfunctional taxation mechanisms, to its labor markets; from the banking sector reforms to the weaknesses in regulatory frameworks covering goods and services markets, the EU’s rhetoric about the need for stronger institutions has failed to match the reality. By all realistic assessments, including by Brussels’s own admissions, core institutional superstructures of the euro area remain widely exposed to a range of systemic risks.
Consider the recent research note by Moody’s Investor Services, published in May1. According to Moody’s, the EU is exposed to a toxic mix of potential shocks that can completely reverse previously achieved integration. The list of “significant vulnerabilities” is both broader and deeper than at any point in the EU’s history. These range from the risks of countries’ exits from the EU and the euro area, to the risks of political crises driven by populism and voter disenchantment, on to a wide range of macroeconomic, fiscal and policy shocks.
Multiple crises, from economic stagnation, deflation and high unemployment to the massive influx of refugees, the largest in modern history of the continent, all have created the “impression that the question is when the system breaks, rather than if.”
The key to this assertion is the fragility of the overall institutional infrastructure. Per Moody’s, even a small crisis can pose a structural challenge to the Union, especially if such a crisis amplifies the already negative public sentiment toward the EU institutions. The reason for this bleak assessment is that any further deterioration in public confidence in European leadership will threaten the ability of Brussels to drive forward deeper integration of the EU institutions.
But the malaise reaches deeper than that. As I noted in my assessment of the prospects for the euro area survival prepared for the EU Parliament 4, over the last eight years, the European Union has shown clearly that its systems of policy formation and governance are no longer able to anticipate the evolution of risks and opportunities, and have become purely reactive to crises. In other words, today’s EU is able to evolve only as a response against the risky “alternative of a break-up of the existing system that further [integration] measures come back into consideration,” as put by Moody’s.
Even when existential crises do arise, the EU’s ability to achieve meaningful reforms is weak. Rhetoric on policy changes can be strong. But delivery inevitably runs into the wall of reform fatigue and national intransigencies.
One example of this dynamic is the ongoing refugee crisis, that the European Commissions is attempting to address via introduction of member states’ quotas and by signing a deal with Turkey designed to stem inflows of asylum seekers. Moody’s described the EU migration reforms as “fragmented and disorderly” – an apt definition, given the state of unraveling of the Schengen Agreement on passports travel.
EU’s shambolic financial sector reforms
Another example is the attempted reform of the financial sector. Post-global financial crisis, the EU embarked on developing a much-hyped European Banking Union (EBU) framework. According to Moody’s, the reform is “ambitious,” albeit in a wrong sense of this word.
EU has been promoting several core pillars of the new banking regulation architecture:
- Pillar 1: Harmonized regulatory supervision and oversight over banking institutions (micro-prudential oversight);
- Pillar 2: Stronger capital buffers (in quantity and quality) with a new hierarchical ordering of bailable capital (from Tier 1, to intermediate, to rules on deposits bail-ins), buffered by harmonized depositor insurance schemes (also covered under micro-prudential oversight); and
- Pillar 3: Harmonized risk monitoring and management (macro-prudential oversight).
All of this forms the core idea behind the European System of Financial Supervision (EFSF) that aims to develop “a common supervisory culture and facilitating a single European financial market.”2
Cultural theory aside, the above pillars are little more than a kitchen sink list, which is precisely what the Moody’s politely described as being “ambitious.”
The entire EBU represents a deep confidence bias trap, whereby policymakers, supervisors, banks and their clients are coopting themselves into believing that the very system that actively supported a multi-annual buildup of massive banking sector imbalances in the run up to the global financial crisis will now be able to transform itself into a more competent and more vigilant structure capable of seeing all risks, everywhere, well in advance.
Deposits insurance: More controversial than unifying
Moody’s take on just one pillar, the deposits insurance scheme, is revealing. The key here is that, unlike all other pillars, the harmonized deposits insurance scheme is seen by the majority of analysts as being unquestionably desired. And the EU, never shy of promises, waxes lyrical about the potential of the scheme, claiming that the Deposits Guarantee Schemes (DGSs) “are closely linked to the recovery and resolution procedure of credit institutions and provide an important safeguard for financial stability.”5
In contrast to the Brussels-led enthusiasm, a universal deposit insurance scheme across the eurozone is now being met with fierce resistance from the Northern and Central European creditor nations. Per Moody’s, many member states “do not want to pick up the tab when those holes in bank balance sheets emerge and need to be filled.”
In other words, even the least controversial of the EU’s convergence policies acts as a centrifugal factor within the Union once implementation of it looms large.
Moody’s point is hardly controversial outside the EU. Take, for example, one study published this May by the NBER3 shows that deposit insurance schemes in general act as mechanisms for transfers of political patronage to select private banks, borrowers and depositors, at the expense of the entire banking system sustainability. While in economic theories, a deposit insurance scheme represents an important driver for risk mitigation, under the political theory a DGS becomes a source of risk and can result in a systemic risk amplification. According to the NBER research: “Empirical evidence – both historical and contemporary – supports the private-interest approach as liability insurance generally has been associated with increases, rather than decreases, in systemic risk. […] Exceptions to this rule are rare. […] Prudential regulation of insured banks has generally not been a very effective tool in limiting the systemic risk increases associated with liability insurance. This likely reflects purposeful failures in regulation; if liability insurance is motivated by private interests, then there would be little point to removing the subsidies it creates through strict regulation.”
As unrealistic as the EU planned reforms of the DGSs may sound, the European Banking Union cannot deliver on even the basic infrastructure of risk pricing when it comes to the core banking capital metrics.
Deeper confidence bias traps
In reforming banks’ capital rules, the EU is currently caught between two options:
- Creating a new tier of capital that can be bailed in in the case of a systemic bank becoming insolvent (the so-called bailable capital tier 1, most commonly instrumented in Europe via contingent convertible debt securities or cocos,); and
- Applying risk weighting to sovereign bonds, thereby forcing banks to dramatically raise ordinary capital provisions.
Both approaches risk creating a confidence bias trap. As Moody’s note: “Any form of insulation from sovereign distress, such as direct bank recapitalizations or funds from the EU budget, may prove to be a thin cushion. As long as sovereigns’ vital functions and transfer mechanisms remain fragmented, so, too, will credit risks and market pricing within individual countries.”
Overall, “institutional reform and the euro area’s integration are unfinished and have left the EU exposed to shocks and downside credit risks. …Europe’s Banking Union is incomplete, the ‘Juncker Plan’ to promote investment in Europe has run into difficulties and imbalances in public and private demand are not being addressed through fiscal policy because significant fiscal union is still off the table.” As a result, even “if the EU survives its current challenges largely unscathed, even a ‘small’ future crisis could threaten the sustainability of current institutional frameworks, if it coincided with negative public sentiment and populist political developments.”
This analysis was echoed, previously, by a number of other analysts, including the former Governor of the Bank of England, Melvyn King. In February this year, King argued that the euro area is facing a simple but painful choice: run a long-term economic depression across the European South while accepting much higher inflation in the core euro area states or embark on changing “the composition of the euro area.” King’s analysis fully coincides with my own view expressed in my report for the UE/NGL Group within the European Parliament published last October.4
The key point of both my analysis and that presented by King is that the current architecture and the composition of the euro area creates a series of complex, multidimensional and closely co-integrated conflicts between the central and national elites, and market forces and democracy.
The conflict between the impetus for reforms arising from the recent and current crises and the will of political elites to implement these reforms is emblematic of the EU’s predicament. In the table below, I summarize the state of key reforms across six policy and markets dimensions for 11 euro area states. In part, the table reflects findings reported in the Moody’s analysis, and in part they integrate research published by the EU Commission and Germany’s Ifo Institute.
Overall, seven out of eleven countries scored show on average either lack of reforms or weak reforms coinciding with high risks present in the system. The rest of the countries can be characterized as having embarked onto the path of some reforms, with most of the reforms yet to be completed.
Referencing Moody’s analysis: “Given that significant fiscal union is off the table, that begs the question of how Europe should evolve; unfortunately, the direction of travel does not imply stability.”
Eight years into the crises, Europe is nowhere near finding an exit from its current predicament: the Union torn apart from the inside by the irreconcilable differences and reforms fatigue, shocked to its core by exogenous and internal shocks, floundering on the rocks of poorly designed institutions.
- Calomiris, Charles W. and Jaremski, Matthew, “Deposit Insurance: Theories and Facts” (May 2016, NBER Working Paper No. w22223: http://ssrn.com/abstract=2777311)
- Gurdgiev, Constantin, Euro after the Crisis: Key Challenges and Resolution Options (May 30, 2016). Prepared for: GUE/NGL Group, European Parliament, October 2015. Available at SSRN http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2786660