The Financial Crisis and the EU Policy Responses Marie Donnay European Commission – DG Ecfin – Unit C4 The views expressed in this presentation do not necessarily represent those of the European Commission.

2 Outline of this presentation The crisis The crisis  Chronology  Origin and root causes of the crisis EU policy responses EU policy responses  Central banks interventions  Coordinating Member States  Regulatory responses  Application of state aid rules  Stimulating the real economy Consistency with international reactions (if time allows) Consistency with international reactions (if time allows)

3 The crisis

4 Outline of this presentation The crisis The crisis  Chronology  Origin and root causes of the crisis EU policy responses EU policy responses  Central banks interventions  Coordinating Member States  Regulatory responses  Application of state aid rules  Stimulating the real economy Consistency with international reactions Consistency with international reactions

5Chronology

6 Outline of this presentation The crisis The crisis  Chronology  Origin and root causes of the crisis EU policy responses EU policy responses  Central banks interventions  Coordinating Member States  Regulatory responses  Application of state aid rules  Stimulating the real economy Consistency with international reactions Consistency with international reactions

7 Origin of the crisis, what went wrong? Very early in the crisis the following observations have been made and lead to policy answers: Fundamental mismatch: medium-term, illiquid and hard-to-value assets such as credit securities were being funded by very short-term money market securities. Fundamental mismatch: medium-term, illiquid and hard-to-value assets such as credit securities were being funded by very short-term money market securities. Absence of accurate and timely information on the exposures to credit risks undermine investors’ confidence (including off balance sheet and indirect through credit lines to SIVs). Absence of accurate and timely information on the exposures to credit risks undermine investors’ confidence (including off balance sheet and indirect through credit lines to SIVs). How to ensure valuation of an illiquid asset? Difficulty to provide a reliable market price. How to ensure valuation of an illiquid asset? Difficulty to provide a reliable market price. Discipline in the transfer of risk off balance sheets of credit institutions, questioning of the “originate and distribute model” (securitization process). Discipline in the transfer of risk off balance sheets of credit institutions, questioning of the “originate and distribute model” (securitization process). Regulatory arbitrage?, liquidity risk management? Regulatory arbitrage?, liquidity risk management? Herding behaviour: losses were magnified as many participants tried to exit similar positions simultaneously. Herding behaviour: losses were magnified as many participants tried to exit similar positions simultaneously. Role played by rating agencies (incentive structure, conflict of interest, rating methods). Role played by rating agencies (incentive structure, conflict of interest, rating methods).

8 Origin of the crisis, what went wrong? Widespread consensus on root causes: 1. Ample liquidity; global imbalances; search for yield; increasing leverage 2. Financial innovation gone astray 3. Excessive pro-cyclicality 4. Flawed incentives structure 5. Poor risk management 6. Supervisory deficiencies 7. International governance deficiencies

EU Policy Responses

10 Outline of this presentation The crisis The crisis  Chronology  Origin and root causes of the crisis EU policy responses EU policy responses  Central banks interventions  Coordinating Member States  Regulatory responses  Application of state aid rules  Stimulating the real economy Consistency with international reactions Consistency with international reactions

11 Outline of this presentation The crisis The crisis  Chronology  Origin and root causes of the crisis EU policy responses EU policy responses  Central banks interventions  Coordinating Member States  Regulatory responses  Application of state aid rules  Stimulating the real economy Consistency with international reactions Consistency with international reactions

Coordinated EU response Summit of European G 8 members (4 Oct.) Summit of European G 8 members (4 Oct.) Ecofin conclusions (7 Oct.) Ecofin conclusions (7 Oct.) « We agree to coordinate closely in our actions and to take into consideration potential cross-border effects of national decisions. We agree that public intervention has to be decided at national level in a coordinated framework. » EA agreement (12 Oct.): coordinated approach aiming at: EA agreement (12 Oct.): coordinated approach aiming at: i. Ensure appropriate liquidity conditions. ii. Facilitate longer maturity funding. iii. Allow the provision of additional capital. iv. Commit to recapitalize distressed banks. v. Apply accounting rules more flexibly. vi. Enhanced cooperation and information exchange.

Coordinated EU response European Council (15/16 Oct.) i. i. Endorses the 12 October principles. ii. ii. Commits to preserve financial stability with measures to protect taxpayers, accountability executives and shareholders protect other legitimate interests iii. iii. Supports speedy and flexible European rules. iv. iv. Establishes a “financial crisis cell”. v. v. Welcomes the setting up of a high-level group by the Commission to strengthen supervision.

14 Outline of this presentation The crisis The crisis  Chronology  Origin and root causes of the crisis  Crisis in figures and financial-economic outlook EU policy responses EU policy responses  Central banks interventions  Coordinating Member States  Regulatory responses  Application of state aid rules  Stimulating the real economy Consistency with international reactions Consistency with international reactions

15 Regulatory response: Ecofin roadmaps ECOFIN agreed roadmaps of actions ECOFIN agreed roadmaps of actions “On actions taken in response to the financial turmoil” (Oct. 2007) “On actions taken in response to the financial turmoil” (Oct. 2007) “Strengthening EU arrangements for financial stability” (Oct “Strengthening EU arrangements for financial stability” (Oct “Review of the Lamfalussy process” (Dec. 2007) “Review of the Lamfalussy process” (Dec. 2007) Update on the three roadmaps: Ecofin May 2008 Update on the three roadmaps: Ecofin May 2008 Roadmap in response to the financial turmoil focuses of 4 key areas Roadmap in response to the financial turmoil focuses of 4 key areas Transparency (adequacy of disclosure of banks' exposures relating to securitisation and Special Purpose Vehicles). Transparency (adequacy of disclosure of banks' exposures relating to securitisation and Special Purpose Vehicles). Valuation standards (valuation of illiquid assets and asset valuation standards used by non-bank investors). Valuation standards (valuation of illiquid assets and asset valuation standards used by non-bank investors). Prudential framework, risk management and supervision. Prudential framework, risk management and supervision. Market functioning (credit rating agencies, securitisation models, non-regulated debt markets and the mis-selling of mortgage credit). Market functioning (credit rating agencies, securitisation models, non-regulated debt markets and the mis-selling of mortgage credit).

16 Regulatory response: Ongoing work Accounting: Reclassification of financial instruments from the trading book to the banking book Accounting: Reclassification of financial instruments from the trading book to the banking book Capital Requirements Directive: Improving the management of large exposures, supervision of cross-border banking groups, quality of banks' capital, liquidity risk management and risk management for securitised products Capital Requirements Directive: Improving the management of large exposures, supervision of cross-border banking groups, quality of banks' capital, liquidity risk management and risk management for securitised products Deposit Guarantee Schemes: Gradual increase of minimum level of coverage from €20000 to € and reduction of payout period Deposit Guarantee Schemes: Gradual increase of minimum level of coverage from €20000 to € and reduction of payout period Solvency II: Modernisation of solvency rules for EU insurance companies and strengthening of supervision of cross-border insurance group. Solvency II: Modernisation of solvency rules for EU insurance companies and strengthening of supervision of cross-border insurance group. Credit Rating Agencies Credit Rating Agencies Ensuring adoption of existing legislative proposals

17 Coming forward with further work soon Derivatives and Credit Default Swaps: OTC derivatives, industry working group will come forward with proposals to mitigate risks on CDS by the end of the year. Derivatives and Credit Default Swaps: OTC derivatives, industry working group will come forward with proposals to mitigate risks on CDS by the end of the year. Hedge Funds and Private Equity Hedge Funds and Private Equity Executive pay: Work on going, report on actions expected for the end of the year. Executive pay: Work on going, report on actions expected for the end of the year. Reflection on financial services policy and regulatory structures (first half 2009). Reflection on financial services policy and regulatory structures (first half 2009). De Larosière Group on EU supervision (Report to Commission by end February - beginning March): De Larosière Group on EU supervision (Report to Commission by end February - beginning March): Regulatory response: Ongoing work

18 Outline of this presentation The crisis The crisis  Chronology  Origin and root causes of the crisis  Crisis in figures and financial-economic outlook EU policy responses EU policy responses  Central banks interventions  Coordinating Member States  Regulatory responses  Application of state aid rules  Stimulating the real economy Consistency with international reactions Consistency with international reactions

Application of state aid rules Commission communication: The application of State aid rules to measures taken in relation to financial institutions in the context of the current global financial crisis (13 Oct.). ECB guidelines for the pricing of the guarantees (20 Oct.). Commission communication: Recapitalisation of financial institutions in the current financial crisis: limitation of the aid to the minimum necessary and safeguards against undue distortions of competition (5 Dec.). (17 Dec.) Commission communication: Temporary framework for State aid measures to support access to finance in the current financial and economic crisis (17 Dec.)

Application of state aid rules 17 Member States have announced national schemes aiming at restoring confidence in the markets :   State-backed guarantees for bank liabilities.   Increased access to liquidity from central banks (in some case covered by state guarantee).   Capital injections into financial institutions.   Increase in the level of minimum deposit insurance. Others have intervened on individual rescue cases

Application of state aid rules Since the beginning of October to date, 16 plans have been endorsed by the Commission, sometimes by means of several decisions (in chronological order, DK, UK, IE, DE, SE, PT, NL, FR, ES, IT, FI, EL, AT, SL, LV and HU). In parallel, the Commission has approved several individual new rescue plans (Roskilde, Sachsen LB, Bradford and Bingley, Hypo Real Estate, IKB, ING, Dexia, Fortis, Parex, Aegon, SNS Reaal, Carnegie, KBC, Bayern LB, Nord Lb, SdB, Anglo Irish, Kaupthing Bank Finland, Ethias). As of beginning of February, around 10 national schemes (or sub-components) or individual rescue aid are still in the pipeline (for example: PL scheme, BPN, Northern Rock).

22 Outline of this presentation The crisis The crisis  Chronology  Origin and root causes of the crisis  Crisis in figures and financial-economic outlook EU policy responses EU policy responses  Central banks interventions  Coordinating Member States  Regulatory responses  Application of state aid rules  Stimulating the real economy Consistency with international reactions Consistency with international reactions

23 The Commission Action Plan on 29 October presented Europe’s integrated approach along three strands: A new financial market architecture at EU level. Measures to deal with the impact on the real economy. A global response to the economic slowdown. The Commission European Economic Recovery Plan, presented on 26 November and adopted by the December European Council, presents more details making use of existing policy instruments and coordination arrangements. Stimulating the real economy

24 Stimulating the real economy Key elements of the EERP: Comprehensive approach: Macroeconomic response using monetary and fiscal policy instruments. Structural reform measures to complement macroeconomic impulse and enhance resilience (short-term), boost growth potential and pave way for low carbon economy (longer term). Integrated response is essential to enhance effectiveness (coordinated fiscal impulses). Increased Community financing via EIB and EBRD. Coordinated response at the EU level, at both national and the EU level to secure synergies and avoid negative spill- overs.

25 EERP –Structural policy (1) Structural reforms that support demand and enhance resilience in the short run: Support of consumer purchasing power through improved market functioning. Support of consumer purchasing power through improved market functioning. Address immediate competitiveness problems through adequate wage setting. Address immediate competitiveness problems through adequate wage setting. Harness labour markets by facilitating transition and flexible working time. Harness labour markets by facilitating transition and flexible working time. Reduce regulatory and administrative burden (e.g. cut red-tape for business starts). Reduce regulatory and administrative burden (e.g. cut red-tape for business starts). Stimulating the real economy

26 (2) Structural reforms in four priority areas of Lisbon Strategy to boost growth potential and economic sustainability over medium term: Labour market policies: promote employability and rapid re- integration of unemployed through flexicurity and targeted support measures. Labour market policies: promote employability and rapid re- integration of unemployed through flexicurity and targeted support measures. Business: enhance financing for business and cut red tape; promote entrepreneurship. Business: enhance financing for business and cut red tape; promote entrepreneurship. Infrastructure and energy: step up investments to modernise Europe’s infrastructure and energy efficiency. Infrastructure and energy: step up investments to modernise Europe’s infrastructure and energy efficiency. Research and innovation: increase public and private R&D expenditure; support cleaner technologies (construction; ‘green car initiative’; promotion of high-speed internet). Research and innovation: increase public and private R&D expenditure; support cleaner technologies (construction; ‘green car initiative’; promotion of high-speed internet). Stimulating the real economy EERP –Structural policy

International dimension

28 Outline of this presentation The crisis The crisis  Chronology  Origin and root causes of the crisis  Crisis in figures and financial-economic outlook EU policy responses EU policy responses  Central banks interventions  Coordinating Member States  Regulatory responses  Application of state aid rules  Stimulating the real economy Consistency with international reactions Consistency with international reactions

29 Key players (among others): Key players (among others): International level: FSF, G20, Basel Committee, IASB, G8 International level: FSF, G20, Basel Committee, IASB, G8 EU level: Commission, EP, Council, ECB, 3L3 Committees EU level: Commission, EP, Council, ECB, 3L3 Committees Consensus on the need for reform of international financial architecture (but Europe may need to go further) Consensus on the need for reform of international financial architecture (but Europe may need to go further) Strengthening transparency, international consistency and quality of regulatory standards. Strengthening transparency, international consistency and quality of regulatory standards. Enhancing sound regulation. Enhancing sound regulation. Promoting integrity in financial markets. Promoting integrity in financial markets. Reinforcing international cooperation, including cross-border co-operation among financial supervisors. Reinforcing international cooperation, including cross-border co-operation among financial supervisors. Working with our international partners

30 Working with our international partners G20 Washington Summit, 15 Nov: IMF and the FSF to enhance their “efforts to better integrate regulatory and supervisory responses into macro-prudential policy framework and conduct early warning exercises”. IMF and the FSF to enhance their “efforts to better integrate regulatory and supervisory responses into macro-prudential policy framework and conduct early warning exercises”. IMF to “conduct vigorous and even-handed surveillance reviews of all countries, as well as giving greater attention to their financial sectors and better integrating the reviews with the joint IMF/World Bank financial sector assessment programs (FSAPs)”. IMF to “conduct vigorous and even-handed surveillance reviews of all countries, as well as giving greater attention to their financial sectors and better integrating the reviews with the joint IMF/World Bank financial sector assessment programs (FSAPs)”. Role of the IMF in providing macro-financial policy advice would be strengthened. Role of the IMF in providing macro-financial policy advice would be strengthened. Commitment was made by all G20 members “to undertake a FSAP report and support the transparent assessments of countries’ national regulatory systems”. Commitment was made by all G20 members “to undertake a FSAP report and support the transparent assessments of countries’ national regulatory systems”. Next Summit of G20, Berlin, 22 February

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