International Monetary Fund, Deputy Director, European Department
European Commission, Deputy Director-General, Directorate General Economic and Financial Affairs
European Securities and Markets Authority, Chair
European Central Bank, Deputy Director General Research
José Manuel González-Páramo
Banco Bilbao Vizcaya Argentaria, Executive Board Member
Moody's Investors Service, Vice Chairman
1. The Euro Area lacks sufficient cross border private risk sharing
1.1. What private risk sharing is
A public authority representative underlined that risk sharing means the ability to smooth adverse income shocks in a particular country, through channels that operate across borders. In a currency union it operates either by public or private risk sharing. The public channel involves some form of cross border fiscal redistribution, which can take the form of taxes, subsidiaries or social transfer. The private channel works through the operation of banking or capital markets. The cross border element of risk sharing is particularly important in a monetary union, since monetary policy cannot be required to do everything and national fiscal measures may not be enough to address a large country specific shock.
The current degree of cross border risk sharing in the euro area is difficult to assess. A recent study by the European Commission found that, in the euro area, the capital market channel smooths around 5% of income shocks whilst cross borrowing accounts for another 20%. Public risk sharing is almost non existent.
The economic and financial crisis in the euro area has clearly demonstrated that the Economic and Monetary Union (EMU) lacks an adequate degree of cross border risk sharing, hindering the shock absorption capacity of individual countries, consequently resulting in a surge of economic divergence and underwhelming growth performance. By its initial design the EMU did not envisage a substantial role for cross border public risk sharing through fiscal transfers, thereby putting the onus on the private sector, through the operations of credit and capital markets, to provide for the bulk of cross border risk sharing. The incomplete and fragmented financial systems in the EU have proved to be a major handicap.
An industry representative went on to say that risk sharing goes both ways. It does not eliminate risk, but spreads it over a wider group and lessens the impact. It also provides benefits, in terms of the reduction of some of the drivers of credit risk. So theoretically, it is a positive thing.
A public body spokesperson explained that the ESM is usually not incorporated into the various surveys though it does involve de facto substantial risk sharing. Other public authority speakers often present how important the ESM’s support to Greece is in terms of annual savings for the Greek authorities. It is indeed an important form of public sharing, but it is only intended as a last resort. There is no fiscal stabilisation instrument in the euro area that can be used in circumstances that are less extreme.
1.2. At present, private risk sharing in the euro area is much lower than In the US
A public body representative emphasized that the crisis in the euro area has made things worse for cross border risk sharing. Recently, the first signs of progress have been seen, but it is too soon to rejoice. In comparison, risk sharing in the United States helps to absorb around 44% of shocks. About one quarter is smoothed through credit markets, whilst the federal budget smooths only around 10% of income shocks. Public risk sharing is much more modest in the US, with the bulk of the smoothing effect of risk sharing coming from the private sector.
Consequently, the impact of an output shock in the euro area would be three to four times bigger than in the US. In terms of the future, the current institutional architecture does not provide for a supra national fiscal stabilisation in the EMU. In the current context, and this particularly difficult year, little progress can be expected in the short run. The US experience shows that, even when it is there, the capacity to smooth shocks via this fiscal level is relatively modest. The priority of the euro area should be on improving private risk sharing and this is to be done via progress in the CMU and a fully fledged Banking Union.
Other public authority speakers agreed that there is currently not enough risk sharing in Europe. However, that has not always been the case for the euro. The increase in private financial risk sharing at the beginning of the euro in the capital markets and credit market channels broke down with the crisis. There are forms of risk sharing that can contribute to financial instability. Whilst promoting risk sharing, there is a need to be mindful of those aspects and forms of risk sharing that may be detrimental from a financial stability perspective. As the industry moves forward to think about fostering risk sharing across countries, they need to create, or allow for, the right form of risk sharing to emerge. An industry leader also stated that much private sector risk sharing is missing. Studies indicate that current levels of private risk sharing are far from pre crisis levels.
1.3. The most resilient forms of risk sharing
A public body representative explained that their institution believes that more risk sharing would contribute to enhancing the resilience of the monetary union. The discussion ultimately concerns macroeconomic stabilisation from a conjunctural perspective. ‘Growth’ has been mentioned, but the thinking needs to transcend that kind of framework and broaden.
Looking at the most resilient forms of risk sharing, equity based risk sharing tends to be more resilient than debt based, and retail credit risk sharing tends to be more resilient than interbank risk sharing. Long term debt tends to be more resilient than short term debt. Improvements have been seen in all three dimensions since the crisis. They have all become more resilient, but require to be even more so.
1.4. Structural features of EU financial systems, operating conditions and products shape private risk sharing
An industry spokesperson outlined the factors considered as having the most impact in terms of the level of activity and degree of risk sharing seen across the EU: first are the structural features of European financial systems; second are the operating conditions that influence the area of investors and financial market developments; and third are issues related to product specific features. Each category has played a different role in the level of activity currently seen, in the retrenchment of those activities discussed before and finally the fact that some imply a higher level of risk sharing than others.
First, there are the structural features of the European financial system that influence risk sharing. The euro area has a dominant banking market for savings and the financing of the economy, with an absence of liquidity in many secondary markets, especially in stress situations. It is also important to recognise that in Europe there is less cultural, political and societal support for capital market activities. Second is the information asymmetry: there are fragmented infrastructures in terms of supervision, national legal and tax frameworks, and differences in regular treatments. Finally, there are also factors related to specific products and the fact that the risk profiles of some securities are not necessarily well adapted to the risk appetites found in different markets. There are different degrees of standardisation, depth and size of the qualified investor base, each of which is a factor in play.
1.5. Comparisons between the banking channel and the capital market one
A regulatory body representative regarded the topic as a fundamental issue. The representative’s contribution focused on how the system of private risk sharing compares for the banking and capital market systems. Changing the financial systems in an economy is very difficult, but that is no reason not to change them.
In the EU, capital markets play a smaller role. It would be better to have a better balance between a capital market system and financial markets, vis à vis the banking system. Arguably, Europe has paid a high price for being so banking orientated and ultimately the whole financial system will be more stable when capital markets play a bigger role.
It is important to note that capital markets and asset managers have been through the same financial crisis as the banks, having been confronted with large reductions in the values of their assets. But looking at the past decade, they can be considered as a relatively stable part of the financial system.
The fundamental question is why capital markets are apparently better able to cope with some kinds of risks. First, the return characteristics of capital markets differ very much. Returns depend on the performance of the assets or investment, which changes the risk distribution and gives a better capability of response to shocks in the system. Moving from a fixed to a variable return on investment ensures a different way of risk sharing.
Another fundamental thing to realise about securities markets is that the connection between liabilities and assets can vary a great deal. A bank typically maintains a very close connection between the liability and asset sides. In capital markets, if an individual invests in a greatly diversified fund they would suddenly have an investment in all kinds of assets across the world.
However, there are differences. In some cases, there is a tendency for capital markets to have a preference for investing in their own national companies, but in general this connection is less in the capital markets and the return distribution received is different. That helps to make the capital market system more resilient to risks, having a different return distribution, and being better able to withstand shocks. Those two characteristics make the difference between the banking and capital market systems.
Regarding European capital markets specifically, if one goes to the larger listed companies then they basically benefit from an EU capital market. However, as one moves down the list, the smaller listed or non listed companies start to be very national again. One objective of the CMU is to improve cross border investments for the smaller SMEs and such like.
When moving more in the capital market direction, new risks are introduced and the end investor or household becomes more uncertain about their returns. A deposit gives a much more certain return than an investment in a fund where returns depend on investor performance. That is also why there is so much more emphasis on investor protection in securities markets. If the EU were to transition to an increasing role for capital markets, they would need to accompany that with a solid investor protection regime. Progress has been made, but ultimately it is also about supervision and enforcement, and there is a long way to go.
1.6. EU uncertainties also shape private risk sharing
An industry representative stressed that when considering the Banking Union and the CMU in the context of risk sharing across the EU, Europe needs to decide what it wants. The goal is to achieve a marketplace where a European bank can operate in any country of the EU in the same way it operates in its home base, and it is clear that there is still some way to go to achieve this goal. A great deal progress has been made on the Banking Union, and it is much further along than the CMU, but there is more work to be done.
In terms of what could help facilitate the level of risk sharing through the banking channel, there are features linked to an element of confidence that will drive participation and engagement: first is the reduction and elimination of national differences in the interpretation of rules and supervision; second would be a fully functional, transparent, funded and simplified mechanism for resolution, with fiscal support in case of need; and third is the free flow of funding and lending in a harmonised and credible European Deposit Insurance Scheme (EDIS). Those three pieces would make significant headway for the Banking Union.
With the CMU, the industry is at a different stage. The issue is how to achieve a higher level of integration within the markets and what can be done to create favourable conditions for their development. In both cases many things can be effected, but nothing can be done instantly. The reality is that some of the factors that impact the level of risk sharing are entrenched. They are deeply cultural, and will take time to evolve.
The first suggestion is to focus on market infrastructure, as this is an area of little controversy which can deliver greater market efficiency. The second is that the CMU ambition needs to be reset; Europe needs to decide whether to do more of what it is currently doing or to do less, but more effectively. The final point concerns the manual on securitisation. It is disappointing that the issue is still being discussed, and that the industry is unable to deliver anything functional that can provide an asset class that is a good representation of what is possible within the constraints and the proper level of supervision and market discipline, with a good opportunity for market risk sharing.
The Banking Union and the CMU are important policy agendas. A public authority representative stressed that a key question is how the Monetary Union can become more resilient. There are two developments which could really make a difference to promoting the banking and capital markets channels: promoting the CMU on the one hand and developing cross border bank consolidation in Europe on the other. Fostering resilient retail banking integration would also be appropriate. However, without a more complete Banking Market in that regard, they would most likely not see much more retail integration that would foster the credit channel.
2. Further integrating banking and capital markets in Europe are two priorities for improving sustainable private risk sharing In the EU
2.1. Further integrating the banking markets and completing the Banking Union are key urgent priorities
2.1.1 Further integrating banking markets
One public body speaker agreed with the need to further integrate the banking markets. Europe needs to make the single rulebook into a single rulebook: there is too much discretion on the banking side, which makes it hard to implement. Europe needs to end ring fencing behaviour and the SSM should also make structural progress.
There is also a need for structural reforms. There is some work to be done at national levels. Some markets are underdeveloped for national reasons, which is the case for the NPL and distressed assets markets. There need to be changes in insolvency legislation and more harmonisation if Europe wants its distressed asset market to pick up.
Another public authority representative stated that, regarding cross border matters, it would be a favourable moment to treat the SSM area as a single jurisdiction for the purpose of capital surcharges if we wanted to have a single integrated banking market. If an entity becomes larger and more complex, it would currently have higher surcharges because of the greater systemic risk. If we had to do this at the national level for each country, there would be an even higher penalty, so it must be a favourable moment to improve the situation and to treat the euro area as a single jurisdiction for the purposes of calculating systemic surcharges.
Additionally, regarding cross border mergers and consolidations, such developments are usually favoured by growth and low uncertainty. As the recovery now takes hold, the representative hoped that the environment would be friendlier towards the strategic decisions of banks in this direction. As the regulatory reform reaches a new steady state, uncertainties on some capital planning issues are also being reduced. This should be helpful, even without additional policy initiatives.
2.1.2 Making the SSM and the SRM more efficient
An industry representative largely agreed with what other speakers had said. To move forward, it is important to take into account that Europe is a bank based area. It needs consolidation, but since 2012, when the Banking Union project was launched, Europe has not seen a significant movement in that direction. Moreover, alternative ways of sharing risks have not fully emerged, notably because the collapse of certain markets following the crisis has been an obstacle to the development of the capital market channel.
There are various ways of improving the situation. Cross border banking consolidation is certainly required. Europe does not have this because it is not close to completing the Banking Union project. Progress has been made, but it remains to be seen whether there will be a Single Supervisory Mechanism or two layers of supervision (EU and national); this is a very important question. The EU and national regulations are indeed not fully aligned; indeed, many prudential requirements for EU cross border banks are defined on a solo basis and not on the consolidated one (pillar 2 requirements, NSFR…), which makes consolidation in the banking sector more difficult. The ECB is working hard, but the fruits of supervisory convergence remain to be seen.
Much progress has also been made regarding resolution and the speaker supported the work of the Single Resolution Board (SRB) in Brussels, and the Single Resolution Fund (SRF) will be filled over a long period. Nonetheless, the capacity to cushion shocks at a private level remains essentially national for the time being.
Positive work can be done in investor and consumer protection, particularly in connection with new forms of finance. There are fintech movements and b2b initiatives that exploit imperfections in the market with opportunities for new digital business models. In that domain, regulation still has some way to go in order to understand that banking consolidation could move faster if regulation could understand what ‘digital’ means for banks. One could have cross border banking without physically being there, but a number of issues stand in the way: first is a common understanding of what ‘digital’ means; and second is that anti money laundering (AML) and Know Your Client regulations are very serious, but are interpreted by Member States in different ways.
2.1.3. Achieving an agreement on EDIS
An industry representative stressed that the EDIS is still under discussion. The first step is to complete the Banking Union project, which will provide more clarity and incentives for banks to engage in cross border consolidation. The EDIS proposal is facing some strong opposition. According to the representative, this is based on the misbelief that EDIS implies a risk transfer from weak to sound financial systems, increasing moral hazard problems. Critics argue that a mutualised scheme should not be put in place as long as bank risks have not been reduced and become more homogeneous across geographies.
It is vital that the following concerns should be taken seriously: the reduction of bank risk is important and an incomplete Banking Union could have destabilising effects, increasing financial fragmentation among Member States. This would lead to the discrimination of banks based on their location, perpetuating the sovereign bank vicious circle. Furthermore, the European Commission launched last November a new comprehensive package of banking reforms. This package amends both the prudential and resolution banking frameworks and includes the implementation of several international standards into EU law and also a package of technical improvements. In parallel, a legislative proposal to harmonise the creditor hierarchy of senior debt across the EU was also released. There is a clear objective in this new legislative package, which is to further increase the resilience of EU institutions. This should contribute to achieving an agreement on the EDIS proposal.
A public authority representative commented that the Council is clearly ‘misbehaving’ in relation to EDIS. It is a natural complement to what is on the table with the SSM and SRB, but is being blocked and pushed back. There is also a need to make progress on adding a fiscal backstop to the SRF. There is little money in the Fund today and, without a backstop, no mutualisation is possible in the short term. Europe has been ‘running in circles’ for three years, annually reopening the same option and pretending that it is a new idea. In the end, the ESM will be the option chosen, but there is a continued pretence that there are other options on the table as a backstop to the SRF.
2.2. Accelerating the implementation of the CMU is also essential for fostering private risk sharing in Europe
2.2.1 Developing pensions systems would promote equity market development
A public authority representative moved on to explain that the structure and function of pension systems could promote equity market development in Europe and more resilient risk sharing across countries. Pensions hold a large amount of savings which could be channelled into productive investment and the real economy. In economies with developed pension systems those savings could be 180% to 200% of GDP, whilst in other countries pension savings are only 6% to 9% of GDP. The difference illustrates some funding gaps, and the money to fill these could be available in capital markets. If equity investments in the existing pension systems were elevated to the US level, all the countries below that level in the euro area would enhance their risk sharing, and there would be an increase in total demand for equity products of 5% to 6%, relative to the current equity market capitalisation. This is a material number, but not a ‘revolution’.
The second consideration would concern where the biggest effect would line. The speaker estimates that if the funding gaps were to be filled and the population, and their retirement needs, were to be compared relative to their current savings, they would need the ‘pie’ to increase, and for a share of it to be equity. This exercise demonstrates an increased demand for equity markets of roughly the same amount as the current equity market capitalisation. Investors are both increasing ‘the size of the case’ and having a more material equity share in it, which would make a difference.
There are many caveats to this argument, but pensions are undeniably important funds that could go into productive and innovative investment. Consideration has to be given to whether regulation is a constraint. There are still large Pillar 1 pension aspects in certain countries, but the constraints on equity investments within the European Union and the euro area overall are no longer that restrictive. There is still an issue of the risk attitude of people and parts of pension systems if one wants risk/return behaviour of normal human beings and investors. The transition to a more complete funding is on its way, but much more investment could be achieved.
Regarding capital markets, the regulatory constraints are not major, but there are pockets where there are constraints, one of which is unlisted equity. A number of countries still have rules more restrictive than EU ones, which allow pension funds to invest some share in unlisted equity. It might be worthwhile to look at those national cases.
2.2.2. The importance of the Simple, Transparent and Standardized (STS) securitisation initiative
An industry speaker explained that the CMU has to complete the Banking Union. The STS initiative is very important and Europe is close to seeing its outcome. Securitisation has fallen sharply in Europe, and this is an essential component of pooling risks together and being able to sell them in a European market. A public authority representative stressed that there is a need to bear in mind that much has been done.
In terms of what could be done, those things already in progress need to be finalised. There are very important texts that are sometimes blocked for reasons that are difficult to understand, as has been the case with the STS text. Everyone understands the importance of securitisation, but in the European Parliament it falls victim to the bad image of securitisation on the other side of the Atlantic because of mistakes that were made. During the crisis of securitisation in Europe, the default rate remained below 1%. It was safe in Europe, but we are still a victim of it and face major problems.
2.2.3. Consistent supervision, developing pension systems and ensuring better information for retail investors are of the essence.
A public body representative stated that the question of what a reasonable objective to achieve would be is difficult to respond to because capital markets are so diverse. It is clear that the stability of the financial system is hurt by not being big enough. Over the past year, Europe has made good progress on the CMU, and has performed well in terms of the single rulebook, with steps forward in the area of post trading, moving it from a national issue to a European, consistently regulated and supervised, system. Convergence issues are now a much higher priority. There is more work to be done, but supervisory convergence and issues with getting data on securities markets across the EU are very important.
The representative reemphasised the importance of the pension systems issue: the countries that have been successful in developing capital markets are typically also the ones where there is a developed pension system. Moreover, the countries where individual pensioners have the ability to directly decide their investments are typically the ones that are more willing to be very broad in their investments. Institutional pension funds typically look for liquid markets, whilst if one considers to more individual pensioners who select their own investments, this typically benefits smaller listed entities.
A further issue is the risk for more cross border investment. Looking at the current mechanisms for securities markets, there are already many opportunities to locate oneself anywhere in the EU 28. On that basis, they have seen specialisations in financial centres. Post trading and trading venues are located in the UK, and asset management plays a great role in Dublin and Luxembourg. Cross border investments and activities are already an important part of the current CMU.
At this stage, the industry is also seeing that it does not have the right mechanisms at the EU level to make sure that this is done on a proper basis. A specific example, where there has been much consumer detriment, relates to the very aggressive CFDs and binary options. These products are mainly sold from one financial centre in the UK, and create problems for the rest of the EU. Work has been underway with the regulator for one and a half years to get this issue under control and some progress has been made, but success has been limited. This is an issue that needs to be addressed: it is a weakness of the capital market system that there is freedom for an entity to locate itself in one of the 28 EU Member States, or in the future, one of the 27. This also relates to the Brexit debate, as UK market participants will look for a new location in one of the EU 27, but it appears difficult to make sure that this is done on an appropriate basis without undermining regulatory and supervisory standards.
The representative is in favour of reducing barriers. At the same time, in the EU and capital markets, there are not currently enough instruments to ensure that a national regulator sufficiently takes into account the risks that may be created in other parts of the EU, and that can undermine the CMU. In addition to reducing barriers and ensuring a single rulebook, it is also needful to ensure that there are sufficient mechanisms to certify that the EU level perspective is taken into account.
The representative commended the European Commission. They have issued their evaluation of the authorities and asked stakeholders for feedback on issues, such as whether there should be more direct supervision and supervisory convergence powers at the EU level. That is are the right type of question to ask at this stage.
Finally, Europe also needs to help member states build their capital markets where these do not exist. Capital markets are underdeveloped, particularly in Eastern Europe. The Commission has created a new service called the Structural Reform Support Service (SRSS), which now sends missions to Member States that are no longer new to help them boost their capital markets and move closer to the situation in the West. A review of the CMU is ongoing, and those who have not participated are encouraged to send their comments to the CMU.
Risk sharing mechanisms, whether private or public, can help smooth private consumption and investment against income shocks, enhancing social welfare. The Chair expressed interest in the numbers referred to by speakers notably regarding the potential benefits of pension reform for the Europe wide equity market. In the discussion of promoting private risk sharing, it is clear that the issue is not just CMU. There are many issues relative to the Banking Union that are incomplete and yet able to foster private risk sharing. Moving to more ambitious CMU issues and addressing Banking Union issues would strengthen the EU’s single market and contribute to financial stability and growth in the EU.