breaking the common fate of banks and governments by daniel gros and cinzia alcidi

Breaking the common fate of banksand governments

* Dr. Daniel Gros is the Director of the Centre for European Policy Studies (CEPS) since

2000. Among other current activities, he serves as adviser to the European Parliament

and is a member of the Advisory Scientific Committee of the European Systemic Risk

Board (ESRB), the Bank Stakeholder Group (BSG) of the European Banking Authority

(EBA) and the Euro 50 Group of eminent economists. He also acts as editor of Economie

Internationale and International Finance. In the past, Daniel Gros worked at the IMF

(1984-86), at the European Commission (1989-91), has been a member of high-level

advisory bodies and provided strategic advice to numerous governments and central

banks. Gros holds a PhD. in economics from the University of Chicago, has taught at

prestigious universities throughout Europe and is the author of several books and nume-

rous contributions to scientific journals and newspapers. Since 2005, he has been Vice-

President of Eurizon Capital Asset Management.

** Dr. Cinzia Alcidi holds a Ph.D. degree in International Economics from the Graduate

Institute of International and Development Studies, Geneva (Switzerland). She is

/DANIEL GROS*/ CINZIA ALCIDI**/

197

1. Introducción; 2. Recent eurozone history: From bad to worse; 2.1. Recallingthe building blocks of the EMU construction; 3. A false solution to the crisis: thefiscal compact; 4. Fiscal indiscipline versus financial regulation inconsistency;5. A proposal for a new regulatory treatment of sovereign debt securities in theeuro area; 6. Conclusions; Bibliography

Breaking the common fate of banks and governments

1. Introduction

Since 2010 the news about Europe has gone from bad to worse.

In early 2012, it still cannot be claimed that the eurozone crisis is

solved, thought markets within the euro area seems to return

(maybe only temporarily) to more normal conditions.

Interestingly enough, the average of the fundamentals of the

euro area looks actually relatively good: compared to the US, the

eurozone as whole has a much lower fiscal deficit (4% of GDP in

2011 against almost 10% for the US) and unlike the US, it has no

external deficit. Its current account is close to balance, which

means that enough savings exist within the monetary union to

finance the public deficits of all its member states. This implies, in

turn, that potentially enough, domestic, euro zone’s resources exist

to solve the debt problem, without recurring to external lenders.

Whether these resources will be invested to finance eurozone

governments is a different question.

198

currently LUISS Research Fellow at Centre for European Policy Studies (CEPS) in

Brussels where she is part of the Economic Policy Unit dealing mainly with issues rela-

ted to monetary and fiscal policy in the European Union. Before joining CEPS in early

2009, she taught undergraduate courses at University of Perugia (Italy) and worked at

International Labour Office in Geneva. Her research interest focuses on international

economics and economic policy. Since her arrival at CEPS, she has worked extensively

with Daniel Gros on the macroeconomic and financial aspects of crisis in Europe and

at global level, as well on the policy response to it. She has published several articles on

the topic and participates regularly in international conferences.

The Future of the Euro

In spite of this relative strength, eurozone policy-makers seem

incapable to solve the debt crisis. Meeting after meeting, heads of

state and Government or finance ministers have failed to convince

markets of the validity of their strategy, which has focused almost

exclusively on fiscal discipline and has repeatedly advocated the

need of financial help from outside investors, e.g. IMF and Asian

investors, regardless of whether resources exist within the eurozo-

ne. This approach has been both misguided and unconvincing.

Against this background, the paper emphasizes that while the

political agenda is almost obsessively focused on fiscal issues, the

euro zone crisis does not have a mere fiscal nature neither a simple

fiscal solution. It involves different dimensions running from

current account and external debt problems to the weak state of the

banking sector, which is still largely undercapitalized. This paper

will focus on the last element, the state of the banking system and

attempts at highlighting how features of the existing financial mar-

ket regulation framework which are inconsistent with main buil-

ding blocks of the monetary union have affected the course of the

crisis. We will argue that this inconsistency has crucially contribu-

ted to eurozone crisis and still remains unaddressed. The paper also

expresses concern about the misleading, prevailing view that the

just signed fiscal compact will work as crucial ingredient in the reci-

pe to overcome the eurozone crisis, while the banking sector

remains highly leveraged and exposed to the fortune and misfortu-

ne of sovereign governments. On this ground, the paper puts for-

ward some ideas about how to break the tight linkage between

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governments and banks. This is at the root of their common fate

and represents a decisive obstacle to overcome the eurozone crisis.

2. Recent eurozone history: From bad to worse

To understand why the euro crisis has gone from bad to worse,

one needs to develop a better understanding of the inconsistencies

in the setup of European Monetary Union (EMU) that caused the

problem in the first place. The official reading is that this is not a

crisis of the euro, but of the public debt of some profligate euro

area member countries. Therefore, tackling the causes of this crisis

and averting future ones requires only a new, tighter framework for

fiscal policy – which will be delivered by the new ‘fiscal compact’.

Yet, financial markets do not seem much impressed by a further

strengthening of fiscal rules: Portugal and other countries still have

to pay high risk premia while Greece has defaulted on its debt and

still teeters on the brink of a total collapse. This suggests that the

official approach captures only part of the problem and still misses

the full picture.

It is not only fiscal indiscipline in the periphery which turned

the public debt problems of a small country like Greece into a cri-

sis of the entire euro area banking system. The euro zone crisis is

the result of a constellation of vulnerabilities within the eurozone.

They include balance of payments problems, foreign debt, sudden-

200


stops of crosser-border financing running from North to South

combined with a generalized undercapitalization of the banking

system.

This financial fragility has been the result of inconsistencies in

the setup of the EMU as well as a fundamental inconsistency in

financial market regulation that has yet to be addressed.

2.1. Recalling the building blocks of the EMU construction

The original design of EMU, as established by the Maastricht

Treaty in 1992, contained three key elements:

i) An independent central bank, the ECB, devoted only to price

stability.

ii) Limits on fiscal deficits enforced via the excessive deficit pro-

cedure (Treaty based) and the Stability and Growth Pact (SGP,

essentially an intergovernmental agreement, although still

within the EU’s legal framework).

iii) The ‘no bail-out’, or rather ‘no co-responsibility’ clause (art.

125 of the TFEU).

The treaty also contained other elements of economic gover-

nance,1 but this remained mostly declamatory as in reality

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1 For instance, Article 121 of the TFEU contains the provision that member states

should regard economic policies as a matter of common concern and shall coordinate

them within the Council.


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Member States did not see any need to coordinate economic poli-

cies; at least, not before the crisis.

The first key element of the Maastricht Treaty, i.e. the very

strong independence of the ECB, was based on a large consensus

among both economists and policy makers that the task of a cen-

tral bank should mainly be to maintain price stability. The con-

sensus was based on a common reading of the experience of the

previous decades that higher inflation did not buy more growth

and independent central banks (with the Bundesbank as the most

prominent example) are best placed to achieve and maintain price

stability.2

Some academic economists and some observers at international

financial institutions worried already in the 1990s about financial

instability and advocate a clear role of the EBC in safeguarding

financial stability.3 Some also emphasized that a common currency

area also requires a common system of supervision of financial

markets.4 But the issue of financial stability did not attract the

attention of policy makers mainly for two main reasons. The first

one is theoretical: most prominent economic models before 2007

suggested that price stability delivers financial stability as by-pro-

2 A prominent paper of the period when plans for EMU were taking shape encapsula-

ted this insight in the title ‘The advantage of tying one’s hands’ (see Giavazzi and

Pagano (1988).

3 See for instance Garber (1992).

4 Among others Tommaso Padoa Schioppa (1994).


203

duct, with no need to add another tool to achieve it. The second

one is much less sophisticated and relates to the fact that the two

key member states driving EMU, France and Germany, had not

experienced a systemic financial crisis for decades.

The second element of the Maastricht Treaty, namely the limits

on fiscal policy, did not enjoy the same consensus in the academic

profession (nor among policy makers) as central bank indepen-

dence. During the 1990s a wide ranging debate took place about

the sense or non-sense of the Maastricht ‘reference’ values of 3% of

GDP for the deficit and 60% for the debt level. Apparently the

advantage of tying one’s hands was much less recognized in the field

of fiscal policy. However, this debate did not need to be resolved as

long as benign financial market conditions prevailed and even the

core countries conspired to weaken the limits on deficits set by the

SGP in 2003.

The third element was only in the background and remained

untested until recently. Contrary to a widespread misconception,

Article 125 of the TFEU does not prohibit bail outs. It merely

asserts that the EU does not guarantee the debt of its member sta-

tes and that member states do not guarantee each other’s obliga-

tions. Germany had insisted on the no bail-out clause when the

Maastricht Treaty was negotiated about 20 years ago. Today, it is

clear that this clause does not provide the kind of protection that

was sought and widespread financial market turbulences threaten

to engulf Germany to agree to huge bail-out packages which would


204

have been unthinkable only recently. However, instead of working

on averting the repeat of this situation in the future, German

policy makers are focusing exclusively on the need to ensure lower

fiscal deficits. This is the purpose of theTreaty on Stability, Coordination

and Governance in the Economic and Monetary Union also called the

‘fiscal compact’ under which euro area member countries agree to

adopt strict rules, ‘at the constitutional or equivalent level’, limi-

ting the cyclically adjusted deficit of the government to less than

0.5% of GDP. Will this fiscal compact work where the Stability Pact

failed?

The ‘original’ SGP already contained the engagement by mem-

ber states to balance their budget over the cycle. If implemented

since the onset of the monetary union, the rule would have led to

a continuous reduction of the debt-to-GDP ratio towards the 60%

target. But this did not happen. The promise or rather exhortation

contained in the SGP to balance budgets over the cycle was widely

ignored, given that the rule was not binding and financial markets

remained in a ‘permissive’ mood. All of the larger euro area mem-

bers ran budget deficits in excess of 3% of GDP threshold for the

first 4-5 years of the euro’s existence. Even Germany ran deficits

above 3% of GDP from 2001 to 2005. In 2003 a proposal put for-

ward by the Commission to ratchet up the excessive deficit proce-

dure to the point where fines might have been imposed on France

and Germany was defeated in the Council (of finance ministers,

ECOFIN). In the crucial vote the large countries (most of which

had excessive deficits, except Spain) colluded to water down the


205

proposal and won the opposition of the smaller countries. The

’band of three large sinners’ (Germany, France and Italy) even

managed to put together a qualified majority to ‘hold the proce-

dure in abeyance’.5

This narrative is interesting in the light of the new ‘fiscal com-

pact’ which is supposed to radically strengthen the enforcement of

the fiscal rules by the application of the ‘reverse qualified majo-

rity’. Under this principle, an excessive deficit procedure launched

by the Commission is taken to be approved unless it is opposed by

a qualified majority. As past experience shows, despite the new sys-

tem makes the opposition harder, it does not ensure enforcement.

In 2005, following the 2003 episode, the SGP was changed. The

official justification was the need to improve its economic rational

and thus ownership,6 but it clear that it was necessary to avoid the

repeat of the embarrassing situation in which a literal application

of the rules would have led to sanctions for Germany and France

among others. The reaction in academia and among policy makers

was mixed: the SGP was ‘softened’ according to some, but ‘impro-

ved’ according to others. The very fact that professional opinion

on the merits of ’binding rules for fiscal policy’ was divided from

the start certainly facilitated the change in the SGP when it beca-

me politically opportune.

5 See Gros et al. (2004). 3 See for instance Garber (1992).

6 Annex to the 2005 Council conclusions

(http://register.consilium.europa.eu/pdf/en/05/st07/st07619-re01.en05.pdf).


206

As matter of facts, shortly after the SGP was made less stringent,

the upturn of the business cycle allowed most governments to

reduce their deficits to below 3% seemingly vindicating the official

position that the ‘improved’ Stability Pact had led to a more res-

ponsible fiscal policy. But structural deficits (i.e. adjusted for the

cycle) actually improved very little even at time the boom reached

the peak in 2006-7 and, when the crisis hit, any remaining caution

was thrown overboard as deficits were allowed to increase again.

The euro area countries thus never lived up to the rules they gave

themselves. But even so, on average they remained relatively con-

servative in fiscal terms. In 2009, the average deficit peaked at 6.5%

of GDP, its highest level, whereas both the UK and the US went

above 11% during that year. Moreover, while the eurozone deficit

has brought back to 4% of GDP in 2011, it has remained at double

digits levels in both the UK and the US. In this limited sense, one

could argue that the Maastricht provisions against ‘excessive’ defi-

cits did have some influence after all, at least on average.

While the average deficits for the euro area appear today

‘modest’ by the standard of other large developed countries, one

euro area country, Greece, clearly violated all rules for years. But

mounting evidence that the Greek fiscal numbers did not add up

was never acted upon until it was too late. As long as financial mar-

kets provided financing at favorable rates any action was politically

inconvenient and was avoided.


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When the euro debt crisis started in early 2010 following the

discovery that Greece was running a deficit of 15% of GDP (and

that previous deficits had been misreported), some policymakers,

German in particular, started to call for tighter fiscal rules as essen-

tial to the survival of the euro.Despite Greece was an extreme case,

the case of Italy is widely seen as providing another justification

for tighter fiscal rules. However, the country seems to stand for

complacency rather than fiscal profligacy. Over the last ten years

the deficits of Italy have on average been lower than those for

France and even today its deficit is below the euro area average

(and declining rapidly).Yet, the incapacity of the country to redu-

ce its very high debt-to-GDP ratio has made it vulnerable to a loss

of investor’s confidence.

3. A false solution to the crisis: the fiscal compact

The new Treaty that was agreed upon in March 2012 has a long

title, Treaty on Stability, Coordination and Governance in the Economic

and Monetary Union, but upon closer examination it is long on

good intentions and rather short on substance in terms of binding

provisions.

The core of the new ‘fiscal compact’ is an obligation to enshrine in

national constitutions the commitment not to allow cyclically adjus-

ted deficits to exceed about ½ of 1% of GDP, which is roughly equi-

valent to balancing the budget over the cycle as in the original SGP.


208

This should be done ‘preferable at the constitutional level’. The

European Court of Justice (of the EU) can be asked to pass a judg-

ment on these national rules, but the maximum fine that could be

assessed is capped at 0.1% of GDP – hardly a strong deterrent by

itself. This Treaty concerns only the framework for fiscal policy, i.e.

the rules setting up national ‘debt brakes’, not their implementa-

tion. This Treaty thus does not give any new powers to the Court

of Justice (neither to the Commission) to interfere with the actual

conduct of national fiscal policy. None of the provisions on eco-

nomic policy coordination are binding. Essentially they reiterate

the already often repeated statements of good intentions on struc-

tural reforms.

Among the provisions, the specification on governance institu-

tes regular meetings, at least twice a year, of the heads of state and

government of the euro area. However, since these meetings will

remain informal, in truth, there was no need for an international

treaty to establish them.

As far as the non-euro EU member states who signed the Treaty

are concerned, there is no obligation for them to do anything, but

the signature constitutes a political statement which gives them a

partial ‘seat at the table’ of the eurozone meetings, allowing them

to participate in most of the euro area summits.

From a purely legal point of view, this Treaty contains an inhe-

rent contradiction: it implies that its signatory countries agree on


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binding constraints for their constitutional order via an ordinary

international treaty. In most countries the national constitution is

of a higher in legal hierarchy than international treaties. This

means that even the provisions on the ‘fiscal compact’ constitute

essentially a political statement, unless the treaty is ratified with a

constitutional majority, as will be done in Germany.

The main value of this political statement coming from all euro

area member states is of course that it provides political cover for

the German government in its efforts to sell the euro rescue ope-

rations to a sceptical domestic audience. However, it is doubtful

that the ‘fiscal compact’ was really needed for this purpose. Data

on German support of the euro show that public opinion remains

much more constructive on the euro than widely assumed (see

Gros and Roth, 2011). Moreover even before the fiscal compact

existed, all votes in the Bundestag have resulted in very large majo-

rities in favour of the euro area rescue operations, even when they

contained large fiscal risks for Germany.

In judging the value of this Treaty one should also keep in mind

that, of the four large euro area countries, three have already natio-

nal debt brakes at the constitutional level: in Germany it is already

operational, in Spain has been adopted recently and in Italy is in

course of adoption. In the fourth country, France, it is already clear

that the Treaty will be implemented, if at all given the negative

attitude of the current opposition, via a so-called ‘loi organique’ and

that the French constitution will not be changed.


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All in all, the fiscal compact is probably useful in the long run

and may contribute to avert a future crisis. It forces Member States

to adopt stronger national fiscal frameworks at home. Some, per-

haps most, would have done so anyway under the pressure of the

markets, but it is unlikely that the new Treaty will make a signifi-

cant difference. The main danger is that that it has been oversold.

It is likely that the ratification process (e.g. the referendum in

Ireland) and then the implementation process in some difficult

countries (e.g. France) will receive a lot of attention and create a

distorted impression of the importance of the Fiscal Compact.

However, the initial excitement will be over once the national

fiscal rules have been put into place and this Treaty will quietly be

forgotten. Its only remaining impact will consist in the meetings of

the euro area heads of state which are likely to produce the regular

conclusions that ‘Member States commit’ to everything desirable

(structural reforms, etc.). Conclusions which become irrelevant

once the heads of state return to their capitals and their domestic

political realities.

The experience with the SGP suggests that how this new ‘fiscal

compact’ will be applied in future will depend on the degree of con-

sensus on the need to balance the budget over the cycle. If anything,

political will to follow this balanced budget rule will be even more

important for the new ‘fiscal compact’ since it will take the form of

an intergovernmental Treaty outside the legal framework of the EU.


211

Today the consensus that only balancing budgets can solve this

crisis and allow the euro to survive seems strong and the position

of the German government seems particularly tough. This is cer-

tainly desirable to prevent future public debt problems but it

neglects the crucial role financial market fragility has played in this

crisis. The case of Greece is emblematic in this sense: despite

Greece accounts for less than 3% of the euro area’s GDP, the pros-

pect of the Greek government becoming bankrupt caused Europe’s

financial markets to go into a tailspin. The reason behind it was

the fragility of banks due to their undercapitalization and their

large holdings of government debt.

In this perspective, while for a creditor country like Germany it

might be important that other member states are forced to copy its

balanced budget rules, it should be even more important to ensu-

re that financial regulation helps to provide additional incentives

for good fiscal policy and that financial markets become more

robust and able to withstand a sovereign insolvency. This is what

would reduce the need for future bail outs by the German govern-

ment. German savers have over the last decade of current account

surpluses accumulated about one trillion euro worth of claims on

other euro area countries. Safeguarding the value of these claims

(which amount to about 50% of GDP) and ensuring the future

German savings surpluses are invested with minimal risk should

thus be a key policy goal for German policy makers.


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4. Fiscal indiscipline versus financial regulation inconsistency

The key insight that has been overlooked in the official circles

dominating EU policy making today is that today’s crisis is largely

due to an inconsistency in the original design of EMU, not in the

area of fiscal policy, but in the area of financial market regulation.

Even after the start of the EMU, financial regulation in general, and

banking regulation in particular, continued to be based on the

assumption that in the euro area all government debt is riskless.

This was from the start logically incompatible with the no-bail out

clause in the Maastricht Treaty, which implies that a euro area

member country can become insolvent, and the institution of an

independent central bank which cannot monetize government

debt. But it was adopted anyway, maybe because of the perception,

expressed recently in a spectacularly mis-timed paper from the IMF,

which proclaimed: “Default in Today's Advanced Economies:

Unnecessary, Undesirable, and Unlikely”.7

In the much more forgiving environment of the turn of the cen-

tury, it was quite natural for policy makers to ignore the logical

inconsistency between the no bail-out clause and maintaining the

assumption that government was really risk less. Yet this contra-

diction had two important consequences. First, banks did not (and

still do not) have to hold any capital against their sovereign expo-

7 Cottarelli, C., L. Forni, J. Gottschalk, and P. Mauro (2010) Staff Position Note No.

2010/12.


213

sure. Second, it was also deemed unnecessary to impose any con-

centration limit on the claims any bank can hold on any one sove-

reign. This lack of a concentration limit for sovereign debt is in

clear contrast to the general rule that banks must keep their expo-

sure to any single name below 25% of their capital. This exception

would make sense only if government debt is really totally riskless.

The main result of this special treatment reserved to govern-

ment debt securities on banks’ balance sheets has been that about

one third of all public debt of the eurozone is held by eurozone

financial institutions, which also tend to privilege the financing of

their own government. The fate of governments and banks is thus

tightly linked.

To the inconsistency of financial market regulation it must be

added that the ECB failed to apply differentiated haircuts to

government debt it accepted as collateral. Debt securities issued by

euro area governments ware accepted in indiscriminate fashion

provided that the country was rated at investment grade. This was

the case for all euro area member countries, of Greece as Germany.

When the Stability Pact was weakened by Germany and France in

2005, the ECB took member countries to court, but it did not

change its collateral policy. By doing so it would have given a con-

crete signal that it was worried about the long run sustainability of

fiscal policy and its consequences for the future of the single

currency. Alas, it did not do so, not even during the crisis, after it

was clear that it was changing its policy stance. Only now, the ECB


214

applies a sliding scale of graduated haircuts which makes it less

attractive for banks to hold lower rated government debt.

The idea that governments provide the only safe assets even in

a monetary union where a no bail-out clause exists was also the

main reason for another omission: a common euro area (or EU)

deposit insurance scheme was never seriously considered. At EU

level, deposit insurance is regulated by the 1994 Directive on depo-

sit guarantee schemes, but the minimum harmonization approach

adopted at that time has proven largely insufficient and the ulti-

mate back up for all national schemes remains the national govern-

ment. A common European deposit insurance modeled on the US

approach of a fund financed ex-ante by risk based contributions

from banks like the Federal Deposit Insurance Company – FDIC-

would have had obvious advantages in terms of risk diversification.

But the preference for national solutions (based on the fear that a

European equivalent to the FDIC would lead to large transfers

across countries) and the bureaucratic interests of the existing

national deposit guarantee schemes ensured that such ideas do not

get a hearing even today.

The experience with Greece should have served to rest the idea

that government debt in the euro area is riskless. But so far no cri-

sis summit has drawn the conclusion from this experience for ban-

king regulation. Of course, it is true that once the crisis has hit it is

no longer possible to tighten the rules on government debt becau-

se this is pro-cyclical as the mayhem which followed the only


215

attempt to shore up the banking system in the context of the

recent EBA stress tests on government debt has shown.

However in order to illustrate the importance of thinking about

the larger benefits from a different kind of banking regulation it is

still worthwhile speculating what would have been different if

banking regulation had been ‘Maastricht’ conform, i.e. if it had

recognized that belonging to the European Monetary Union

implies that national government debt is no longer riskless.

One could thus consider how the crisis would have played out

if the following rules had applied since 1999:

i) Forcing banks to have capital against their holdings of euro area

government debt.

ii) Applying the normal concentration limits also to government

exposure.

iii) A different collateral policy of the ECB, for example with a sli-

ding scale of increasing haircuts on government debt in func-

tion of the country’s deficit and debt and its position in the

excessive deficit procedure.

One can only speculate what would have been different if this

kind of regulation had been in place during the boom years. But a

few conclusions seem certain.


216

Greece would certainly have encountered much more difficul-

ties selling its bonds to banks which would have had to hold capi-

tal against it would be less able to use them to access ECB funds.

The same applies to Italy, whose rating went already in 2006 below

the threshold at which under normal banking rules higher capital

requirements kick in. Both these countries would thus have seen

gradually increasing market signals, which would have most pro-

bably led to a more prudent fiscal policy.

Moreover, their problems would today have been much easier

to deal with because banks would have more capital and the con-

centration limit would have prevented Greek banks to accumulate

Greek government debt worth several times their capital. The

resources necessary to prevent the collapse of the Greek banking

system has increased considerably (by about 40 to 50 billion euro)

the size of the financial support Greece needed so far.

The negative feedback loop between the drop in the value of

banks and in the yields on government bonds which destabilized the

entire European banking system so much during the summer and fall

of 2011 would also have been very much mitigated if the concentra-

tion limit had been observed. Italian banks would have accumulated

less Italian debt and would have been able to offset some of the mark

to market losses on the Italian debt with their gains on German debt

holdings which they would have had to hold as well.


217

Common euro area wide deposit insurance would have contri-

buted in several ways to deal with the financial crisis from the

beginning. First of all, in 2008 it would have obviated the percei-

ved need for the competitive rush to provide national guarantees

for bank deposits. The Irish government would thus probably not

have had felt the need to provide the blanket guarantee for all lia-

bilities of its local banks which proved fatal once the extent of the

losses was revealed.

Ireland would still have suffered from a massive real estate bust

with all the consequences in terms of unemployment, but the Irish

government would not have been bankrupted by its own banks.

Paul Krugman has drawn attention to the parallels in terms of eco-

nomic fundamentals between Nevada and Ireland8 arguing that

explicit fiscal transfers and higher labour mobility within the US

constitute the main differences. However, Ireland has actually

experienced a degree of labour mobility which is quite similar to

that among US states like Nevada. During the boom it had immi-

gration running at over 1% of its population, which after the bust

turned into emigration of a similar order of magnitude. The wides-

pread held opinion that the euro could never work because there is

not enough labour mobility in Europe is not entirely correct.

In the case of Ireland the key issue was not one of a lack of labor

mobility, but of the absence of a common safety net for banks. A

8 See http://krugman.blogs.nytimes.com/2010/12/29/ireland-nevada/.


218

European deposit insurance would have provided stability to the

deposit base. It is also likely that the European Deposit insurance

would have been less complacent and less beholden to the inte-

rests of Irish banks and would thus have started to increase its risk

premium when the signs of a local real estate bubble were clear to

almost everybody outside the country.

Greece, where the national deposit guarantee scheme is now

practically worthless because it is backed up only by the Greek

government, which has just defaulted on its debt, provides anot-

her example of the potential importance of stabilizing the banking

system. With a European deposit guarantee scheme there would

have been no deposit flight, which has amounted so far to about

50 billion, or over 25% of GDP. There would have thus been much

less need for the ECB to refinance the Greek banking system, lowe-

ring again the cost of the Greek bail out.

The next crisis will be different from the current crisis, but it is

clear that different rules for the banking system could bring two

advantages: they would provide graduated market based signals

against excessive deficits and debts. Moreover, a better capitalized

banking system with less concentrated risks would be much better

able to absorb a sovereign insolvency, thus reducing the need for

future bail outs. Acting on this front seems a much more promi-

sing route to reduce the likelihood for future crises and minimize

the cost should they occur anyway.


219

Perceptions matter. Europe’s policy makers seem to be driven by

the perception that this crisis was caused by excessively lax fiscal

policy in some countries. In reality, however, the public debt pro-

blems of some countries have become a systemic, area wide, finan-

cial crisis because of the fragility of the European banking system.

The ‘euro’ crisis is likely to fester until this fundamental problem

has been tackled decisively.

5. A proposal for a new regulatory treatment of sovereigndebt securities in the euro area

The purpose of this section is to sketch a simple proposal for a

new regulatory treatment of sovereign debt securities in the euro

area which follows the arguments illustrated in the previous sec-

tions.

1. Any risk weights to be introduced after the crisis might better be

based on ‘objective’ criteria, rather than ratings.

2. Diversification of banks’ exposure; this is even more important

than risk weighting for sovereign exposure.

A simple way to attach a risk weight on government debt secu-

rities of a given country would be to make the weight function of

objective factors like the debt and deficit of the country. For exam-

ple, one could imagine that the risk weight could remain at zero if

both government debt and fiscal deficit relative to GDP remain

below 60% and 3% respectively. If the deficit and/or the debt ratio


220

exceed the ‘reference’ values of the Treaty, the risk weight would

increase by certain percentage points in a proportional or progres-

sive fashion. In addition the risk weights should be linked to the

stages of the excessive deficit procedure (EDP). When the procedu-

re is launched, the risk weight is increased and at each additional

stage of the EDP the risk weighting would be increased further. This

would provide the EDP with real incentives even without the need

to impose fines.

Introducing positive risk weights for government debt will not

be enough to prevent crisis because of the ‘lumpiness’ of sovereign

risk. Experience has shown that sovereign defaults are rare events;

but the losses are typically very large (above 50%) when default

does materialize. Even with a risk weight of 100% banks would

have capital only to cover losses of 8%. Risk weights would thus

have to become extremely high before they could protect banks

against realistic loss given default scenarios. This suggests that the

more important aspect is diversification.

All regulated investors, i.e. banks, insurance companies, invest-

ment funds, pension funds, have rules which limit their exposure

vis-à-vis a given counterpart to a fraction of their total investment

or capital (for banks). However, this limit does not apply to sove-

reign debt, especially within the eurozone for banks. The result of

this lack of exposure limits has been that, in the periphery, banks

have too much debt of their own government on their balance

sheet which has led to the deadly feedback loop between sovereign


221

and banks. In Northern Europe, investors, such as investment

funds and life insurance companies, which typically cannot avoid

government debt have also concentrated their holdings nationally.

This has led to a significant fall and in some cases even to negati-

ve value of government bond yields, not only in Germany but

throughout Northern Europe. From the point of view of core

Europe investors, today this might appear as being a prudent stra-

tegy, but this concentration increases the vulnerability of the sys-

tem to any reversal of fortunes. Moreover, if Northern investors

were required to diversify their holdings there would be a natural

demand for Southern European bonds, which would bring some

oxygen to those governments which have experienced a dramatic

surge in their borrowing cost.

Introducing exposure limits during a crisis period would be

much less pro-cyclical than introducing capital requirements. In

practical terms, the simplest approach would be to grandfather the

existing stocks, but apply exposure limits to new investments.

6. Conclusions

This paper has emphasized that while the political agenda has

been obsessively focusing on fiscal issues since the early onset of

the euro zone crisis; this crisis has neither a mere fiscal nature nor

an exclusively fiscal solution. Despite the Greek episode seemed to

point only to fiscal indiscipline, the reasons why the crisis did not


222

confined itself to Greece but spread out to the entire euro area assu-

ming a systemic nature should be sought in the state of the euro

area banking sector. European banks were, and still are, largely

undercapitalized and too tightly linked to the fortune and the mis-

fortune of governments.

The paper spots three contradictory building blocks of the EMU

construction: the no bail-out rule in the Stability and Growth Pact,

the independence of the European central bank and the provision

in the financial market regulation framework that government

bonds are considered as risk free assets. The combination of the no-

bail clause with the institution of an independent central bank

implies that fiscally undisciplined countries may have to face

default as no other country, nor the EU can take on its debt and the

central bank cannot monetize it. This definitely collides with the

principle that banks are not required to hold any capital against

government debt securities as it assumed that they do not carry

any default risk. In fact, Greece has proved this assumption wrong.

This contradiction was completely overlooked during the good

years in the turn of the new century and the politically more con-

venient approach suggested by financial regulation became the

dominant. The ‘risk free treatment’ of public debt securities has clearly

worked as incentive for banks to finance profitable government

spending and accumulate large amounts of government bonds.


223

This is at the root of the common fate of euro area banks and

governments. Alas, the crisis has made that fate an evil one.

Though these contradictory elements have now emerged clearly,

the issue has not been addressed and the regulator treatment of the

government bonds has not changed yet.

On this ground, the paper puts forward some concrete ideas

about how to break the tight linkage between governments and

banks, which represents a decisive obstacle to overcome of the

euro zone crisis.

We argue that positive risk weights for government debt securi-

ties must be introduced in the banks’ balance sheet, but alone this

measure will not be enough to prevent a new crisis. A clear pres-

cription to reduce concentration of the risk and impose diversifi-

cation is at least equally important and complementary to the risk

weighting.

While developing the arguments for the regulatory changes, the

paper expresses skepticism about the official, widespread view that

the just signed fiscal compact will have a crucial role in overco-

ming the eurozone crisis. As far as the banking sector remains weak

and highly exposed to governments, and the common fate of

government and banks is not broken, the crisis will be hard to die.


224

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breaking the common fate of banks and governments by daniel gros and cinzia alcidi

Education