23 March BruegelThe Future Face of Europes Financial System 1 EU as a Framework for National Governments Intervention Vitor Gaspar (with Joep Konings) Bureau of Economic Policy Advisers, European Commission Workshop on The Future Face of Europes Financial System, Bruegel, 23 – 24 March 2009

23 March BruegelThe Future Face of Europes Financial System 2 Disclaimer The views expressed are my own and do not necessarily reflect those of the European Commission

23 March BruegelThe Future Face of Europes Financial System 3 Introduction and Motivation Global crisis and many policy responses: –Central banks liquidity provision and aggressive lowering of interest rates; –Extension of guarantees on banks liabilities. –Capital injections and (in some cases) state- control –Treatment of impaired assets. –Discretionary fiscal stimulus. –A review of the regulatory and supervisory framework in Europe

23 March BruegelThe Future Face of Europes Financial System 4 In this presentation I concentrate on: Global crisis and many policy responses: –Central banks liquidity provision and aggressive lowering of interest rates; –Extension of guarantees on banks liabilities. –Capital injections and (in some cases) state-control –Treatment of impaired assets. –Discretionary fiscal stimulus. –Regulatory & Supervisory Framework.

23 March BruegelThe Future Face of Europes Financial System 5 Outline A/ Common framework for public intervention: linking gains of co-operation to spillovers B/ Single Market: Functioning of competition and State Aid Rules Example: Using the banking crisis to illustrate the risk of negative spillovers and the need for co-ordinated action in the context of the internal market C/ A new EU framework for crisis prevention and crisis management

23 March BruegelThe Future Face of Europes Financial System 6 A/ Common framework for public intervention: linking gains of co-operation to spillovers (Berrigan, Gaspar, Pearson, 2008) Coase Theorem as a benchmark to identify the gains from co- operation: In an environment with perfect information, well-defined property rights an costly bargaining: -Private provision of public goods is not pareto efficient in case of non-cooperative interactions (Nash). -inefficient as individuals do not take into account the externality to other economic agents - Pareto-improved outcomes can be achieved through collective action (bargaining; co-ordination)

23 March BruegelThe Future Face of Europes Financial System 7 -Let the units of public good that individual i contibutes to the provision of the public good be denoted by - Individuals have preferences for the public good and one private good

23 March BruegelThe Future Face of Europes Financial System 8 Relevance of this framework in the EU context Across the border spillovers as a result of public intervention are much clearer when they materialize in the areas in which the European Union has core competence, such as aspects related to the working of the internal market, including regulation and supervision. In times of crises conditions of the Coase theorem are not met (e.g. costless bargaining, symmetric information,…) and therefore there is increased pressure for decentralised and uncoordinated actions. Legal framework of the internal market is therefore a very powerful tool: Member States have delegated authority to the European Commission to have legally binding procedures governing the working of the internal market. These legal and binding procedures have fostered the working of the internal market to the benefit of market integration, which in turn has forced further political integration.

23 March BruegelThe Future Face of Europes Financial System 9 B/ Single Market: Functioning of competition and State Aid Rules – key features Internalising negative spillovers State aids rules are designed to prevent un-coordinated government interventions to interfere with the functioning of the Single Market and also to improve the effectiveness of public intervention. Proportionality,non-discriminatory and conditionality of the measures The EU framework guarantees that measures taken by Member States comply with the key principles in state aid rules Reconciling short term imperatives with longer term considerations Design of the intervention of the intervention should reconcile short term imperatives (safeguarding financial stability, underpinning bank lending) with longer term considerations (avoiding fragmentation of the Single Market, distortion of competition, emergence of a structurally weak banking sector, unsustainable public finances)

23 March BruegelThe Future Face of Europes Financial System 10 Example: The Banking Sector EC provided (ex-ante) guidelines on the application of State aid rules to measures taken in relation to financial institutions in the context of the current global financial crisis. Guidelines on six classes of measures since the start of the crisis (Com 2008/C 270/02): Guarantees covering the liabilities of financial institutions Recapitalisation of financial institutions Controlled winding-up of financial institutions Provision of other forms of liquidity assistance Rapid treatment of state investigations Treatment of impaired assets

23 March BruegelThe Future Face of Europes Financial System 11 Key features of guidelines common across measures (background) -Non discriminatory coverage (to avoid undue distortive effects on neighbouring markets and the internal market as a whole) -Minimum private sector contribution (fees charged for the provision of the scheme should come as close as possilbe to that could be considered a market price) -Temporal scope -Behavioural commitments to avoid distortions of competition (including compulsory restructuring plans)

23 March BruegelThe Future Face of Europes Financial System 12 Background: Communication ( 2008/C 270/02) : The application of State aid rules to measures taken in relation to financial institutions in the context of the current global financial crisis Article 87(3)(b) of the Treaty the Commission may allow State aid "to remedy a serious disturbance in the economy of a Member State". In the present circumstances: legal basis for aid measures undertaken to address this systemic crisis. general support measures have to be: - well-targeted in order to be able to achieve effectively the objective of remedying a serious disturbance in the economy, - proportionate to the challenge faced, not going beyond what is required to attain this effect, and - designed in such a way as to minimize negative spill-over effects on competitors, other sectors and other Member States.

23 March BruegelThe Future Face of Europes Financial System 13 Background: Communication ( 2008/C 270/02), contd. Guarantees covering the liabilities of financial institutions eligibility: non-discriminatory so as to avoid undue distortive effects on neighbouring markets and the internal market as a whole types of liabilities covered: mainly depositors guarantees to avoid bank runs and contamination Temporal scope of guarantee scheme Aid limited to minimum-private sector contribution: fees charged for the provision of the scheme should come as close as possilbe to that could be considered a market price. Avoidance of distortions of competition: negative effects on non- beneficiary banks must be avoided by: - behavioural constraints - restrictions on commercial conduct (e.g. advertising using guarantee status) - prohibitions of conduct incompatable with the purpose of the guarantee scheme (e.g. new stock options for management)

23 March BruegelThe Future Face of Europes Financial System 14 Background: Communication (2008/C 270/02), contd. Recapitalisation of Financial Institutions Used to support financial institutions that are fundamentally sound but may experience distress because of extreme conditions in financial markets strengthen capital base to avoid negative systemic spillovers. considerations in relation to general guarantee schemes apply, mutatis mutandis, also to recapitalisation schemes. The particular nature of a recapitalisation measure gives rise to the following considerations: - objective criteria, to avoid unjustified discriminatory treatment - minimal capital injection and must include private participation - Member State concerned should, in principle, receive rights, the value of which corresponds to their contribution to the recapitalisation + consider claw back mechanisms or better fortunes clauses

23 March BruegelThe Future Face of Europes Financial System 15 Background: Communication (2008/C 270/02), contd. Controlled winding up of financial institutions considerations in relation to general guarantee schemes apply, mutatis mutandis Other considerations: -Minimise moral hazard, notably by excluding shareholders and possibly certain types of creditors from receiving the benefit of any aid -Liquidation phase should be limited to the period strictly necessary for the orderly winding-up to avoid competitive distortions -Sales process should be open and non-discriminatory -Sale should take place on market terms -Maximise sales price for the assets and liabilities involved

23 March BruegelThe Future Face of Europes Financial System 16 Background: Communication (2008/C 270/02), contd. Provision of other forms of liquidity assistance Provision of central banks funds to finanicial institutions are not considered as aid when: -The financial institutions is solvent at the moment of the liquidity provision -Fully secured by collateral -Central bank charges a penal interest rate to the beneficiary -Measure is taken by the central banks own initiative

23 March BruegelThe Future Face of Europes Financial System 17 Most member states appealed to the revised guidelines on timely and coordinated state aid in the financial sector since last September

23 March BruegelThe Future Face of Europes Financial System 18 The Irish banking crisis triggered the awareness among the member states to have a co-ordinated response across Europe, given the potentially large negative spillovers undermining the working of the internal market

23 March BruegelThe Future Face of Europes Financial System 19 Economic Rational for Co-ordinated Intervention: Internalising negative spillovers 1.Guarantees covering the liabilities of financial institutions: In volatile markets, need to reassure depositors that they will not suffer losses and therefore to avoid bank runs. Potential negative spillovers: - Bank run can cause contamination of healthy banks - If decentralised and uncoordinated national measures are taken, increased risk of a disturbing impact on deposit shifting from non- beneficiary banks to beneficiary banks (e.g. Irish case). Deposit shifting has the effect of contaminating healthy banks in neigbouring countries

23 March BruegelThe Future Face of Europes Financial System 20 2.Recapitalisation of Financial Institutions Financial sound institutions may experience distress because of extreme conditions in financial markets (falling asset prices, deposit runs, etc.) Potential negative spillovers: - When the compensation scheme does not reflect market prices, banks in other member countries not benefiting from the capital injection are put at a disadvantage. - Irreversible nature of capital injections can trigger in a later stage expansion of the beneficiary bank at the expense of non- beneficiary banks in the same or other countries

23 March BruegelThe Future Face of Europes Financial System 21 3.Treatment of impaired assets Reducing uncertainty about exposure of banks to financial losses is key to restoring investor confidence (resolving the information problem!) Impaired asset relief is required to get credit markets functioning again Potential negative spillover: Introducing asset relief measures by a first-mover Member State results in pressure on other member states to follow suit, risking a subsidy race between Member States

23 March BruegelThe Future Face of Europes Financial System 22 C/ Towards a new EU framework for crisis prevention and crisis management To have an efficient internal market in financial markets, there is a need for further procedural agreement between the Member States de Larosière group formulates recommendations towards (i) a new regulatory agenda, (ii) stronger coordinated supervision and (iii) effective crisis management procedures In particular: European System of Financial Supervision (ESFS) create a network of EU financial supervisors, based on the principle of partnership, cooperation and strong coordination at the centre European Systemic Risk Council (ESRC) decide on macro-prudential policy, provide early risk warnings to EU supervisors, compare observations on macro-economic and prudential developments and give direction on these issues.

23 March BruegelThe Future Face of Europes Financial System 23 Important Role for the EU in achieving global solutions Solutions at the European level can only have full effect if they are part of a global effort to improve stability Benefits of openness, non-protectionism and the internal market have been clear in the past Financial system is global, so the EU must work also with third countries to foster global co-ordination and to obtain the best regulatory framework. G20 initiative is essential to enhance regulatory and supervisory standards It is therefore important that the Commission is a permanent member of the G20 & the Financial Stability Forum to properly represent EU interests

23 March BruegelThe Future Face of Europes Financial System 24 Conclusions Coase theorem is a useful framework for analysing public intervention Existing EU State-aid rules & ex-ante guidance of the EC have played a major role in ensuring a minimum degree of consistency between the measures taken by Member States and therefore to minimise non-cooperative outcomes. Key characteristic of intervention: Reconciliation of short-term and longer-term perspectives of public intervention is crucial to reach a sustainable and competitive banking sector and hence financial sector basis for the real economy. But to prevent and manage future crises, further progress in the area of regulation, coordinated supervision and crisis management procedures (as put forward in the ESRC & the ESFS recommendations) is essential, within a global context (G20)

23 March BruegelThe Future Face of Europes Financial System 25 THANK YOU FOR YOUR ATTENTION! You can find more details at: ancial_services/financial_crisis_news_en. htmlhttp://ec.europa.eu/competition/sectors/fin ancial_services/financial_crisis_news_en. html

23 March BruegelThe Future Face of Europes Financial System 26 EU as a Framework for National Governments Intervention Vitor Gaspar (with Joep Konings) Bureau of Economic Policy Advisers, European Commission Workshop on The Future Face of Europes Financial System, Bruegel, 23 – 24 March 2009