'Whatever it takes': the Five Presidents' Report on completing Economic and Monetary Union Contents

Chapter 3: Risk reduction and risk-sharing

Risk reduction and risk-sharing methods: complementary or conflicting?

98.There will always be differences between those who believe that there should be more extensive support for Member States facing difficulties and those who insist that Member States should be largely responsible for solving their problems themselves. Several of the reforms enacted since the onset of the 2008 crisis have been aimed at preventing problems arising in the first place, notably through better adherence to fiscal discipline. A division is now evident between those who see such prevention as the key to a more sustainable EMU, and those who believe that greater solidarity is the essential ingredient.

99.If risky policies are pursued, but the consequences fall on others where things go wrong, there is moral hazard. We argue in this chapter that many of the suggestions in the Five Presidents’ Report propose a means of pooling the risks facing certain Member States, but that resistance to them reflects others’ concern that they would face an unreasonable burden of responsibility for those risks. Common deposit insurance, common stabilisation policies and other forms of risk-sharing are more likely to be accepted if there is a balancing insistence on mitigating the risks in the first place.

100.This chapter distinguishes between risk reduction and risk-sharing, including the appropriate sequencing of the different stages of the two, as the lens through which to assess some of the more contested elements of the Report.

101.Vice-President Dombrovskis described the need to reach a balanced approach: “one thing seems to be emerging already: on the one hand, there is a demand for more solidarity, risk-sharing and mutualisation, while on the other there is a demand for more control and more sovereignty-sharing.” He added:

“If we are going to deepen economic and monetary union, those two elements, risk-sharing and sovereignty-sharing, will have to go hand in hand. The more we engage in risk-sharing, the more important it is that all Member States involved in those mechanisms follow the same rules. That is why we will need to find a balanced approach between those two tendencies.”115

102.Sir Jon Cunliffe, Deputy Governor for Financial Stability, Bank of England, shared this view. He said that in order for a further transfer of sovereignty to take place, a balance between collective discipline and collective support had to be struck. Any sharing of risk would require an agreement on collective discipline.116

Financial Union

103.The ‘Financial Union’ pillar of the Five Presidents’ Report proposes a number of risk-sharing and risk reduction measures. Among them, the development of a Banking Union is seen as key to deepening Economic and Monetary Union. The European Commission, in its Communication ‘Towards the Completion of the Banking Union’, notes that “the completion of the Banking Union will reinforce financial stability in EMU by restoring confidence in the banking sector through a combination of measures designed to both share and reduce risks.”117

104.In particular, the proposal to create a European Deposit Insurance Scheme (EDIS), published in November 2015, emphasises the simultaneous development of risk reduction and risk-sharing. It includes measures to reduce financial risks, such as implementing current legislation in full, as well as the possibility of further measures “in addition to and beyond the single rulebook”. Elements of risk-sharing within EDIS include access to the Deposit Insurance Fund once national deposit funds have been exhausted. The proposal therefore attempts to tackle the moral hazard problem through the measures outlined in paragraph 117 below.

105.Fiscal sharing—that is, the pooling of public funds—is also introduced in Banking Union, in the context of a common backstop to the Single Resolution Fund. Action towards this goal is in step with the proposed transition timeline for the creation of the Single Resolution Fund. Private risk-sharing is also envisaged through the Capital Markets Union agenda.118

Fiscal union

106.Within the ‘Fiscal Union’ pillar, the Five Presidents’ Report underscores budgetary responsibility and the creation of the ‘European Fiscal Board’, discussed earlier. Encouraging budgetary responsibility may be seen as a risk reducing measure, but the establishment of the Fiscal Board can also be seen as a step towards shared sovereignty in terms of its capacity to provide advice on the euro area fiscal stance.

107.The Report does not put forward concrete plans for how to develop a fiscal union, but instead refers to a “fiscal stabilisation function for the euro area”, and sets a number of preconditions in the form of economic convergence, financial integration, as well as further coordination and pooling of decision making on national budgets.119 This stabilisation function could be considered as a key risk-sharing measure. The Report states that when national budgets become strained in a crisis:

“national fiscal stabilisers might not be enough to absorb the shock and provide the optimal level of economic stabilisation, which in turn can harm the whole euro area. For this reason, it would be important to create in the longer term a euro area-wide fiscal stabilisation function. Such a step should be the culmination of a process that, whilst avoiding moral hazard, requires preconditions commensurate with the strengthening of democratic accountability.120

108.Taking the Five Presidents’ Report as a whole, some proposals are clearly intended as risk reduction measures. One of the core disagreements among Member States is whether progress on risk reduction is a pre-condition before more risk-sharing can take place. We explore the possible formation of a fiscal stabilisation function later in this chapter, but first we turn to the status of Banking Union and current forms of risk-sharing.

Banking Union: state of play

109.The evidence we received indicated, not surprisingly, that, while a significant amount of institutional change had developed to address some of the key risks in the European banking and finance sector, further action on risk reduction and risk-sharing was needed.

110.The European Commission’s Communication, ‘Towards the completion of the Banking Union’, stated that: “a key objective of Banking Union was to reverse the fragmentation of financial markets caused by the euro crisis, by weakening the link between banks and sovereigns.”121 The aim was to break the negative feedback loop, whereby a failing bank endangers public finances and in turn the vulnerability of a sovereign further destabilises banks. In the past four years, EU legislators agreed to elevate supervision, resolution and resolution funding of significant banks to the Banking Union level.

111.Several witnesses recognised the achievement of EU authorities in setting up key pillars of the Banking Union in a relatively short space of time, while also arguing that important risks persisted. Kay Swinburne MEP, a member of the European Parliament ECON Committee, thought that the single supervisor was key to breaking the link between banks and sovereigns. The supervisor was working reasonably well, but there was room for improvement.122 Thomas Wieser said that the most important element of Banking Union was the creation of the single supervisor, because it removed the “industry policy type of banking supervision that we witnessed.”123

112.Professor Lucia Quaglia, Professor of Political Science, University of York, warned that the decision-making process underpinning the Single Resolution Mechanism seemed “quite convoluted”, because so many bodies were involved in determining whether to resolve or wind up a bank. The big question was whether the resolution mechanism would “be effective enough in taking decisions in the heat of the crisis of, say, a major bank failing.”124 David Marsh was also cautious about the role of the Single Resolution Board.125

113.Sir Jon Cunliffe told us that, while resolution could be quite complex in practice, “it could be made to work, and in a crisis, you find ways of making things work.” He continued: “the Single Resolution Board has only just been born, but they need to work through those issues as to how those different responsibilities and authorities would interact in a crisis.”126

114.Sir Jon said he had always supported Banking Union, “because when you have a single central bank and you have a single currency, then your financial systems are linked together. They transfer risk, and we have just seen that happen in the crisis.” He told us that Banking Union was “a necessary move for a single currency”, and was “glad that it has at least been recognised.” The benefit for the Bank of England was “the possibility of having a strong partner with similar concerns, the ECB, with whom we can build a relationship.”127

Box 7: The Single Resolution Mechanism

The Single Resolution Mechanism replaces the coordination required by a network of national resolution authorities. The SRM has a number of key features:

  • Strong central decision-making aims to ensure that decisions on resolution (dealing with failing banks) across participating Member States are taken effectively and quickly, avoiding uncoordinated action, minimising negative impacts on financial stability, and limiting the need for financial support.
  • A central body with expertise and experience on bank resolution is intended to resolve banks more effectively, and with more limited effects on taxpayers, than individual national authorities with more limited resources and experience.
  • A Single Resolution Fund is able to pool resources from bank contributions with the aim of protecting taxpayers more effectively than national funds, while at the same time providing a level playing field for banks across participating Member States.

Decisions by the SRM involve all relevant Member States. When the Board (consisting of a Chairman, a Vice Chair, four permanent members and relevant national authorities. Representatives from the ECB and the European Commission participate as permanent observers) has been informed that a bank is failing or likely to fail, it will adopt a resolution scheme for the failing bank using relevant tools, including the use of the Single Resolution Fund (SRF). National resolution authorities are closely involved in the process. The scheme should be in place within 32 hours so as to be able to rescue or resolve a bank over a weekend. Depending on the sums required by the SRF over one year, the Board will convene in its Plenary Session or in its Executive Session. The Commission, and to a lesser extent, the Council, has a role in “endorsing or objecting to the resolution scheme proposed by the Board.” The scheme would need to be revised if one member disagrees. The Board actively follows the execution of the scheme, which is carried out by national resolution authorities.

The ECB has the competence to decide whether a bank is failing or likely to fail, providing a warning signal to the Board. If the ECB does not do so, the Board is able to request information from the ECB and ultimately has the responsibility and retains the power to make a decision on whether there are alternative solutions or whether a resolution is necessary in the public interest.

Risk-sharing and risk reduction arrangements in the Banking Union

115.A certain degree of risk-sharing already exists within the Banking Union, for instance the Single Resolution Fund (SRF), currently set up under the Single Resolution Mechanism (SRM), which was established to ensure the orderly resolution of failing banks.

116.Political agreement on the establishment of the SRF was reached in December 2014. The fund will be built up through contributions from participating banks over a period of eight years to reach a target level of at least 1% of the amount of covered deposits of all credit institutions authorised in all the participating Member States (estimated to be around €55 billion).128 Within the wider crisis management framework for the eurozone, Roberto Gualtieri MEP, Chair of the European Parliament ECON Committee, and Guntram Wolff highlighted the existence of institutions set up to lend to countries in a crisis. Guntram Wolff said that the European Stability Mechanism was such a risk-sharing mechanism, which acted to “prevent excessive austerity in countries that lose market access.”129 The ESM can be used to recapitalise banks in certain circumstances through its Direct Recapitalisation Instrument.

Proposed methods to enhance risk-sharing and risk reduction: completing Banking Union

117.The European Commission Communication ‘Towards the completion of the Banking Union’ set out the following measures:

(a)Full and rapid transposition and implementation of the already agreed legal provisions;

(b)Swift agreement on an effective bridge-financing arrangement for the SRF and on a common fiscal backstop, which should be fiscally neutral over the medium term;

(c)A legislative proposal for a European Deposit Insurance Scheme (EDIS)

(d)A parallel effort further to reduce risks in the banking sector and weaken the link between banks and their national sovereign.130

Agreement on bridge financing arrangements

118.Bank contributions to the Single Resolution Fund began in January 2016, but an agreement on bridge financing was seen as key to avoiding a scenario in which the Fund would run out of funds while bank contributions were being built up. The agreement reached by the Council of Ministers in December 2015 introduces some degree of public support through the establishment of national credit lines that would provide a loan to the SRF. As well as providing support if necessary, the existence of the credit line is intended to enhance the credibility of the fund.

A common backstop to the Single Resolution Fund

119.A common backstop has been part of the design of Banking Union since its inception. The Five Presidents’ Report said that “setting up a credible common backstop to the Single Resolution Fund and making progress towards a full level playing field for banks in all Member States should be a priority during the transition period to the creation of the Single Resolution Fund.”131 In ‘Towards the completion of the Banking Union’, the European Commission noted that the “extensive menu of prudential and crisis management measures cannot eliminate entirely the risk that public funding may be required to enhance the financial capacity of resolution funds.”132

120.The Commission foresees a common fiscal backstop to acting as a last resort. This would “imply a temporary mutualisation of possible fiscal risk related to bank resolutions across the Banking Union”. The Commission notes that the use of the backstop would be fiscally neutral in the medium term, as any public funds used would be reimbursed over time by the banks (via ex-post contributions to the SRF).133 We supported the introduction of common fiscal backstop in our 2014 report on ‘Genuine Economic and Monetary Union’ and the implications for the UK.134

121.Evidence from Guntram Wolff, Christian Odendahl, Professor Quaglia, Sebastian Barnes and the BBA agreed that a backstop to the Single Resolution Fund was essential.135 Thomas Wieser told us that the general debate on whether to mutualise risks also applied when constructing the Single Resolution Fund, the Single Resolution Board and bank resolution. Pressure was mounting to develop a backstop for the short term and long term for the SRF, when the European Stability Mechanism could play this role. He implied that the consensus on the long-term backstop to the SRF had not yet been reached.136

122.Professor De Grauwe argued that the resolution fund lacked credibility, because “its capacity to act in times of crisis is limited”. He told us that a “real banking union” presupposed some kind of fiscal union: “at some point, you need an institution with deep pockets that in a time of crisis is capable of resolving it. If you do not have that, a banking union has no credibility”. He therefore maintained that a Banking Union would need to be “embedded in or part of a fiscal union”. In times of crisis someone had to have the capacity to raise taxes and fund rescue operations.137 Dr Schelkle believed a re-insurance mechanism that could “draw on deep pockets of central banks” was an alternative path. She noted that “the re-insurance capacity of the resolution mechanism could be enhanced if it were given a banking licence and could thus get access to the ECB as a lender of last resort.”138

123.Although the UK is not a participant in Banking Union we fully support its aims. Achieving consensus on the long-term backstop for the Single Resolution Fund will require a balance to be struck between risk-sharing and risk reduction, both between taxpayers and the banking sector and among the Member States participating in Banking Union. We stress the importance of working towards a common fiscal backstop to the Single Resolution Fund and welcome the agreement of short-term bridging arrangements as an interim measure.

A European Deposit Insurance Scheme

124.The European Commission published its proposal for a European Deposit Insurance Scheme for the euro area on 24 November 2015.139 This was the third pillar of the original Banking Union proposal, which was postponed. The proposal aims to guarantee bank deposits in the euro area and builds on existing national deposit guarantee schemes. The scheme would work in three stages:

(a)The first stage, ‘reinsurance’, is proposed to last for three years until 2020, and will be available to those Member States that have complied with the Deposit Guarantee Scheme Directive. It will function by allowing a national deposit guarantee scheme to access joint EDIS funds only once it has exhausted its own resources. Funds from EDIS would complement the funds from a national scheme but funds would be limited to a certain level.

(b)The second stage is ‘co-insurance’. The proposal is that in 2020, after three years as a reinsurance scheme, EDIS funds would become progressively mutualised. Appropriate limits and safeguards against abuse would apply. Importantly, when accessing EDIS funds, a national DGS would not need to be exhausted first. EDIS funds could automatically contribute to the share of the deposit owed to depositors. The share contributed by EDIS would start from a low level of 20% and would increase over a four year period.

(c)The third stage is ‘full insurance’, under which, from 2024, EDIS funds would guarantee 100% of the deposits previously guaranteed by participating national deposit guarantee schemes.

The risk reduction agenda accompanying EDIS

125.The European Commission announced in November 2015 that a risk reduction agenda would be pursued at the same time as contributions built up in the EDIS fund. The agenda is seen as essential to avoiding moral hazard among participants using the scheme. The fear is that wealthier Member States would have to pay for unstable banks in weaker euro area Member States. Some Member States, notably Germany, the Netherlands and Finland, have supported more risk reduction measures before any risk-sharing begins.

126.The risk reduction agenda includes reducing national options and discretions in prudential rules, harmonising deposit guarantee schemes, legislating to implement remaining elements of the Basel Accord, pursuing initiatives on the prudential treatment of banks’ exposure to sovereign risk and full transposition of the Bank Recovery and Resolution Directive and the Deposit Guarantee Schemes Directive. An ad hoc Council Working Group has been established to consider both the EDIS proposal and the measures set out in the Communication.140 Mike Vercnocke, head of the City of London office in Brussels, noted that this risk reduction agenda involved all 28 EU Member States.141

Sequencing of risk reduction and risk-sharing

127.Vice-President Dombrovskis told us that “before we engage in additional risk-sharing, we need measures to reduce risks.” He maintained that the “exact sequencing” still needed to be discussed.142 In addition, Thomas Wieser told us that “all the measures that would make all Member States agree to joint deposit insurance are just as important as deposit insurance itself.” He continued: “I refer to anything that produces significant convergence to a level playing field, on the one hand, and what we are also talking about—the code word nowadays is ‘de-risking’—on the other hand.”143 He also observed, with respect to deposit insurance, that there was “a very clear divide between what you could call the ‘mutualisers’ (in favour of instant mutualisation) and the risk reducers.”144 The Minister recognised that for the European deposit insurance to operate effectively, “those participating would need to consider measures to address risks and to develop a more consistent risk profile across Member States in the eurozone”.145

128.Guntram Wolff was optimistic that the proposal could reduce and share risks simultaneously. Deposit insurance would happen over a substantial transition period of 10 years. In this same period, rules on risk weights or large exposures to sovereign debt would be introduced, while the insurance component built up. He believed the logic went in that direction and predicted political support would develop.146

129.Roberto Gualtieri MEP agreed that the risk reduction strategy should be undertaken in parallel with risk sharing, but he disagreed with the specific agenda to recalibrate banks’ exposures to sovereign debt (which is currently treated as having zero risk, regardless of which eurozone Member State issues it). He did not think it would be acceptable to impose preconditions, and said he would “strongly discourage the frontloading of measures at the EMU level”, as that would create imbalances. Work should continue, instead, at the international level through the Basel Committee on Banking Supervision. He maintained that single supervision and single resolution were already “strong elements of risk reduction”, and believed the Commission proposal was “very gradual”.147

130.On the issue of moral hazard, the BBA agreed that there should be a first tranche of losses borne by the national DGS before an EDIS intervention. They explained that “in this way national DGSs will be able to deal with idiosyncratic failures of domestic banks, and recourse to the EDIS would be limited.”148 Roberto Gualtieri MEP argued that current legislation and the new proposal met moral hazard concerns: “current recovery and resolution provisions are a very, very strong ingredient against moral hazard. I do not see that ensuring the same level of protection of deposit across the Banking Union would enhance this moral hazard.”149

131.Vice-President Dombrovskis told us that the EDIS proposal had “received a mixed welcome. Some Member States very much favour this proposal and are willing to move forward; some are more hesitant or reluctant.”150 Several witnesses said that the proposal could be interpreted as transfer of resources taking place. Henning Christophersen, Senior Partner, KREAB, and a former European Commissioner and Danish Finance Minister, told us that the proposal introduced “common financing of banking crises, so the wealthier Member States will have to finance the recapitalisation of less profitable banks in some Member States”.151

132.We note that the German position supports risk reduction measures being established before any risk-sharing can take place. Markus Ferber MEP, a member of the European Parliament ECON Committee, largely agreed with this position. He referred to the Deposit Guarantee Scheme Directive when assessing the EDIS proposal: “when all 28 Member States have proper systems in place, fully equipped, fully financed, then we can discuss an insurance mechanism.” He added that money transferred from one scheme to another would constitute a ‘bail-in’, and this would need to be agreed unanimously by the Council, not by qualified majority, as would be the case under the legal basis of the EDIS proposal.152

133.Sylvie Goulard MEP thought it was a mistake to look at it as a German problem. She reflected, however, that “if we all share the idea that we will finance the economy and allocate the resources in a better way with more circulation of capital, then we should make sure that this pillar exists one day. It is the modalities and the rhythm that we then have to work on”.153

134.Sir Jon Cunliffe argued that the reinsurance stage of the proposal was “a relatively small step”, and predicted that “it may be possible to make progress”. He also noted that “on the bigger issues of real risk-sharing that involve those questions of collective discipline and collective support, the political bargain has to be made first, and it has not been made yet.”154

Is EDIS necessary?

135.Witnesses were divided on whether European deposit insurance was necessary to complete Banking Union. Janet Henry said that deposit insurance was “quite critical”, at least “to show there is something in place to deal with asymmetric shocks … in the eurozone.”155 Christian Odendahl thought that deposit insurance was not necessary because the Cyprus crisis had demonstrated strong political will to protect deposits. He said that the ECB was “a strong defender of depositors, both internally and externally”. He “would much rather have the resolution procedure reopened and for there to be a proper backstop for the resolution fund, which the European Commission also proposes in its action plan”.156

136.Dr Andrew Lilico, Executive Director and Principal, Europe Economics, took a similar view, explaining that the most useful next step would be to achieve a common resolution framework and greater cross-border collaboration. He thought that moving towards increased collective risk-sharing in the form of common deposit insurance was “a mistake”. His preference was to have “two kinds of deposits in every bank licensed to accept retail deposits.” Those who wished merely to store their money could do so safely; those who wished for a greater return could use uninsured deposits at their own risk.157 Kay Swinburne MEP judged that if both existing pillars—the SSM and the SRM—worked, “we will not need a deposit guarantee scheme; we are not going to get the failing institutions because we will have already had the early indicators and then the intervention by the ECB through the SSM.”158

137.Guntram Wolff highlighted the problem of ‘ring-fencing’ in the absence of a cross-border guarantee. This meant that deposits and capital were “kept in the banks of the country concerned and cannot be shifted, in the banking group, across borders.” He explained that it was felt that the deposits needed to stay ring-fenced, because national insurance was liable and could not be transferred.159 The BBA also referred to this and thought it “contrary to the objectives of the efficient allocation of capital which underpins the EMU and acts as a deterrent to further integration of the banking market.”160

138.The Bank of England and the BBA both drew attention to the new regulatory framework supporting national deposit guarantee schemes, and pointed out that deposit insurance would be unlikely to be used in the case of a large bank failing. The BBA explained that the implementation of provisions within the BRRD “reduce the circumstances in which it can be expected that a bank would be liquidated, with the DGS called upon to compensate eligible depositors.”161 Andrew Bailey, Deputy Governor for Prudential Regulation, Bank of England162, drew on his experience of handling bank crises in the UK: “in many ways, if you look at big banks, the deposit insurance is there, but it is not the tool you use when the bank fails. That is why resolution is so important. It does come into play with smaller institutions, when you effectively want to use an insolvency tool, and you are not sure whether there is enough effective protection in the balance sheet.”163

139.Roberto Gualtieri MEP recalled the steps that would need to be taken before a pay-out would take place, and emphasised the scale of risk-sharing required: “when we arrive, at the end of 2024, at mutualisation, we are talking about only a very limited percentage. It is not open-ended; it is 0.8% [of covered deposits].”164

140.Philippe Legrain and Professor Jones drew attention to the structure of deposit insurance currently in place. Professor Jones noted that “the different types of German banks have different deposit insurance. That is the biggest part of the problem. Sparkassen and Landesbanken do not want to get implicated in a European system because they have their own preferential arrangements.”165 Philippe Legrain predicted that one could imagine a ‘carve out’ for the very politically powerful Sparkassen banks, similar to their arrangements under the Banking Union.166 Should EDIS be developed, the BBA supported it being embedded into the Banking Union framework, so that “the scope of banks mirrors closely the scope of single supervisory and resolution mechanism.”167

141.Thomas Wieser thought that deposit insurance was “not one of the major constituent pillars of making banking and monetary union significantly more resilient … it would be good to have but one does not desperately need it.”

142.From a UK perspective, Andrew Bailey and Sir Jon Cunliffe supported efforts to establish a European Deposit Insurance Scheme, because it added some stability and reassurance that the national deposit protection scheme would have the ability to pay out in a crisis. Andrew Bailey said that the solvency of the deposit protection scheme was important for UK depositors. Where a bank branched from a country in the euro area to the UK the deposit protection for the depositors in the UK branch came from the home state.168

143.Efforts to reduce risk in the banking sector are in principle welcome. The European Deposit Insurance Scheme would be a useful addition to the Banking Union architecture. Although we note the significant moral hazard concerns of countries such as Germany, we believe that pursuing risk reduction and risk-sharing in parallel would both reduce any actual moral hazard and ensure political buy-in for the measure. For this reason EDIS should be encouraged, but should not be thought of as a panacea. As with other retail deposit insurance schemes, the value of EDIS may ultimately lie more in the reassurance engendered by its existence rather than its practical benefits.

144.We note that ‘ring-fencing’ of bank deposits continues despite the establishment of a single supervisor. This may have an effect on the efficient allocation of capital across the eurozone—insofar as EDIS may help to alleviate the concerns of the supervisor and allow deposits to move across borders, it is to be welcomed.

145.We welcome the risk reduction agenda for all 28 EU Member States. Our concern is that UK-based banks could be at a competitive disadvantage through not benefiting from the cover of European deposit insurance. We therefore urge the Government to remain vigilant in preserving the integrity of the Single Market.

Proposed methods to enhance risk-sharing and risk reduction: Capital Markets Union

146.The Five Presidents’ Report argues that capital markets can act as an important shock absorber as they do in the United States. The consideration of CMU in the Five Presidents’ Report builds on work already undertaken through the Capital Markets Union Green Paper169 in February 2015, which led to the publication of the Capital Markets Union Action Plan170 in October 2015. We reported on the Green Paper in March 2015171, and our comments below are limited to the evidence we have received in this inquiry, specifically on the role that capital markets can play in absorbing shocks across the EU and particularly within the eurozone.

147.The Commission’s Green Paper and Action Plan aim to ensure that alternative sources of non-bank finance are available in addition to existing bank finance. The Five Presidents’ Report states that “truly integrated capital markets would also provide a buffer against systemic shocks in the financial sector and strengthen private sector risk-sharing across countries”. It adds that this would in turn reduce the level of public risk-sharing that needs to be achieved. The Report acknowledges, however, that well integrated capital markets can create new risks to financial stability and, as a result, changes to the macroprudential toolkit and the supervisory framework may be needed. It notes that “this should lead ultimately to a single European capital markets supervisor.”172

Private risk-sharing through capital markets union

148.A number of witnesses saw the immediate benefit of a CMU in helping to absorb shocks within the euro area. Examples were given from the United States, where capital markets make up a larger proportion of financing for business. Christian Odendahl said “capital markets in monetary unions such as the US play a very important role in spreading regional shocks. So truly integrated capital markets and more private risk-sharing would be a big step forward.”173 Megan Greene agreed.174 Martin Sandbu thought that integrated capital markets could reduce the need for fiscal risk-sharing: “it is a mistake to think that the eurozone needs large fiscal risk-sharing in order to survive. It could do what the US does, which is to have large private risk-sharing.”175 He argued that the Five Presidents’ Report did not place enough emphasis on this element and it was more important than deposit insurance for the euro area.176

149.A number of MEPs emphasised, however, that CMU should be seen as separate from Economic and Monetary Union. For instance, Kay Swinburne MEP said: “I do not see the CMU project as being a eurozone project; I see it as a project of the single market.”177

150.Guntram Wolff was optimistic that CMU could achieve better risk-sharing across borders, and pointed towards research that indicated that it would be better for economic growth and for systemic risk. He also believed that the eurozone needed deeper capital markets “much more urgently than [non-eurozone countries]”. This did not necessarily imply that the non-euro states would suffer from this: “on the contrary, they can actually benefit by being the hub that provides these services.”178

Capital Markets Union: a long term project

151.Capital Markets Union covers a range of work streams, including securitisations, venture capital, tax and insolvency law among others. A large majority of our witnesses agreed that CMU would take time to achieve. Megan Greene highlighted the need first to address property rights and the legal enforceability of cross-border property rights.179 Other witnesses drew attention to cultural and other differences between Member States that would need to be overcome.180

152.Some witnesses highlighted that the agenda depended on Member States driving it forward, particularly for complicated and technical pieces of legislation. Reza Moghadam, for instance, referred to the simplification of bankruptcy rules.181 Thomas Wieser told us, however, that the ‘CMU’ label bundled initiatives together and helped to ‘market’ them among Member States. He described CMU as having a “ribbon around it”: this was important “because it improves the quality of the debate, it makes it politically more visible and it increases the probability of rapid passing of legislative acts”. He added that it created a “big picture into which you can fit the individual measure, such as securitisation, and it shows the wider audience how things hang together”.182

153.Reza Moghadam hoped that progress on CMU could be made faster and infrastructure established that was better able to support it. In the US there was just one regulator to deal with, rather than several in the EU.183 Professor Codogno said that to achieve real reform, there must be “an institution to take care of the project. The Commission cannot do it, because it is not in charge of all the aspects of this process.”184

154.The Capital Markets Union is an EU-28 project and we continue to welcome it, as we did in our 2015 report Capital Markets Union: a welcome start. We noted then that it is likely to benefit the UK in particular. We now note that, properly constructed, it should produce added benefits for the resilience of the eurozone through spreading risk more evenly across countries and acting as a shock absorber, as happens in the United States. However, private risk-sharing is not a panacea and may have limited effect in a crisis.

155.CMU is an aspect of risk-sharing—albeit private risk-sharing. Though included in the Five Presidents’ Report, it is unlikely to be achieved in the short term. We are concerned that CMU will not make progress without agreement on tax and insolvency law, stimulating greater cross-border investment. We acknowledge that harmonising measures are likely and that a consequent need for additional institutional oversight may arise as a result of efforts to deepen financial integration.

156.The Five Presidents’ Report hints at the creation of a European Single Supervisor for capital markets, which would have ramifications for the UK and which we have previously opposed. However, the CMU Action Plan, presented by Commissioner Hill in 2015, did not mention this. Any ambiguity over the creation of a Single Supervisor is unhelpful.

A path towards a fiscal union

157.The Five Presidents’ Report acknowledges that there are many paths to a fiscal union, and argues that all mature monetary unions, while budgetary instruments may differ, have a common macroeconomic stabilisation function to help absorb the shocks felt at the national level. The Report envisages a euro area fiscal stabilisation function as a development under ‘Stage 2’ and in the longer term. It sees it as the “culmination” of work on economic convergence, financial integration and coordinated and pooled decision-making. The Report states that “the objective of automatic stabilisation at the euro area level would not be to actively fine-tune the economic cycle at euro area level. Instead, it should improve the cushioning of large macroeconomic shocks and thereby make EMU overall more resilient.”185 The Report makes it clear that further work needs to be done and refers to the “expert group” to carry this forward. The Report contains several options and guiding principles for a euro area stabilisation fund.

158.Vice-President Dombrovskis told us that sound fiscal macroeconomic governance and progressive joint decision making at the EMU level would go hand in hand with a euro-area fiscal stabilisation function to help deal with large asymmetric shocks: “both elements will need to be in place.”186

Towards a fiscal union: definitions and current practices

159.Witnesses provided various definitions of ‘fiscal union’ which included a mixture of risk reduction and risk-sharing mechanisms. An example of risk reduction would be the imposition of stricter fiscal rules on Member States, while an example of risk-sharing would be the pooling or sharing of fiscal risks, perhaps through some sort of fiscal capacity in the form of a stabilisation fund. Several witnesses interpreted the development of fiscal union through the lens of a stabilisation mechanism, and some acknowledged that elements of a fiscal union were already in place. It was not clear how much more public risk-sharing would be needed to create a fiscal union, but most witnesses believed that the existence of permanent fiscal transfers would not be a feature.

160.Box 8 sets out some of the options for fiscal union. To demonstrate the range of possible interpretations of the term we include some accounts from our witnesses in Appendix 5.

Box 8: Interpretations of ‘fiscal union’

‘Fiscal union’ as a dimension of completing EMU has many possible interpretations, all of which are likely to imply differing balances between risk reduction and risk-sharing.

In nation-states, whether federal or unitary, it is both normal and politically accepted for there to be substantial flows of public money across internal borders. Usually (though by no means always), richer areas are net contributors, while poorer areas are net recipients. In most cases, the central government collects and distributes public money, although there can also be ‘horizontal’ equalisation mechanisms which, as in Austria and Germany, distribute resources from the fiscally better-endowed states or regions to the others.

At least five distinct forms of fiscal union, each reflecting different political compromises and strategic visions of the euro, can be envisaged for the eurozone (possibly for the EU as a whole).

  • A first, comparatively narrow, variant is more intrusive oversight at EU level of governance of national budgetary policies. The reforms embodied in the six-pack, the two-pack and the Fiscal Compact effectively move the European Union (and more so, the euro area) in this direction, and the emergence of Fiscal Councils (linked to the Fiscal Compact and the two-pack) can also be seen in this light. Because their focus is fiscal discipline through adherence to rules, this form of fiscal union is manifestly about reducing risks. It is also largely in place (but not rigorously enforced) and could be characterised as a German/Dutch preference.
  • The second interpretation is the provision of support by either EU institutions or partner countries for governments encountering financing difficulties, with the prospect that they will then be subject to high interest rates. The bailouts for Greece, Ireland, Portugal and Cyprus exemplify this approach, but are best thought of as providing liquidity. Bond purchases by the ECB have also, effectively, provided this kind of support and, by lowering the costs of servicing the national debt, have had a marked effect on the public finances of the more indebted countries. Although these actions are not strictly fiscal, the ECB has been criticised—notably in Germany—for engaging in quasi-fiscal policies. The creation of the ESM as a permanent source of funds is an important outcome of the crisis. However, while it is a means of sharing risk, the fact that ESM loans require stringent conditions to be met also entails risk reduction.
  • Some form of stabilisation policy could be imagined as a third form of fiscal union. Rather than relying only on coordination of national policies to arrive at a common eurozone fiscal stance, either an additional fiscal capacity could be introduced, or there could be ad hoc funds (e.g. an unemployment related fund) that provide a degree of automatic stabilisation to counter asymmetric shocks.
  • Risk-sharing would become more prominent if there were mutualisation, whether of public debt (some variant on Eurobonds) or more narrowly through common deposit insurance. In both cases, a collective fiscal backstop would be a logical complement to the existence of the mutualised risks. This fourth interpretation of fiscal union is, manifestly, strongly resisted by the net creditor countries because of moral hazard.
  • Fifth, it could mean a system of transfers from Member States with relatively abundant public resources to fiscally-strapped parts of the European Union to pay for public services (a genuine transfer union). This would mean a rather different political objective of redistributing resources permanently, rather than pure risk-sharing. However, it is a well-known macroeconomic property of redistributive measures that they also have a demand stabilising effect.

In addition to all the above, which can be thought of as having macroeconomic objectives associated with how best to manage EMU, there could be moves towards harmonisation of taxes (for instance, on single market grounds), or harmonisation of expenditure entitlements.

A euro area stabilisation mechanism

161.The Five Presidents’ Report suggests the establishment of a stabilisation fund, as set out in Box 9.

Box 9: Options and guiding principles for a euro area stabilisation fund

The Five Presidents’ Report sets out the options and guiding principles as follows:

  • It should not lead to permanent transfers between countries or to transfers in one direction only, which is why converging towards Economic Union is a precondition for participation. It should also not be conceived as a way to equalise incomes between Member States.
  • It should neither undermine the incentives for sound fiscal policy-making at the national level, nor the incentives to address national structural weaknesses. Accordingly, and to prevent moral hazard, it should be tightly linked to compliance with the broad EU governance framework and to progress in converging towards the common standards described in Section 2 of the Five Presidents’ Report (and in Chapter 2 of this report).
  • It should be developed within the framework of the European Union. This would guarantee that it is consistent with the existing EU fiscal framework and with procedures for the coordination of economic policies. It should be open and transparent vis-à-vis all EU Member States.
  • It should not be an instrument for crisis management. The European Stability Mechanism (ESM) already performs that function. Instead, its role should be to improve the overall economic resilience of EMU and individual euro area countries. It would thus help to prevent crises and actually make future interventions by the ESM less likely.

Source: Five Presidents’ Report, p 15

162.Thomas Wieser said that “everybody who agrees with the concept of fiscal union would agree on the need for setting up a central budget that has a stabilisation function, with the presumption that asymmetric shocks, over time, will be more or less evenly distributed around the euro area.”187

163.Janet Henry thought that a stabilisation mechanism could play a major role in offering financial support to countries undergoing structural reforms, though she acknowledged there would be opposition to big permanent transfers.”188

164.Professor Quaglia said that the “construction of a stabilisation mechanism in a countercyclical way” would be politically more feasible than a transfer union of permanent transfers. Even that, however, “would be quite difficult to achieve, because there is concern in particular Member States about moral hazards and about being permanent net contributors, if you want, to this sort of euro-area mechanism for stabilisation and distribution.”189

Transfer unions

165.Raoul Ruparel observed that transfer unions within countries like Italy and Germany did not promote economic convergence or development, and putting such transfers in place would require a political union or political acceptance.190 Professor Codogno supported fiscal transfers “seen in the context of risk-sharing and in the context of providing facilities to compensate for asymmetric shocks that might happen in the area.” He said they “should not be perceived as permanent transfers from one area to another”, and argued that the existence of permanent transfers indicated that there was a fundamental problem that needed to be addressed. He acknowledged that some transfers in transfer unions were automatic and implicit, but said that if structural problems were not addressed, transfers became permanent: “permanent transfers should not be the rule; they should be the exception or should compensate for shocks. But if there are permanent transfers, it means you have a problem. You have to address the problem from the point of view of structural policies.”191

166.Dr Lilico agreed that elements of a transfer union were already in place: “There is already a system of fiscal transfers within the European Union: the structural and cohesion funds.” They were very small and at the regional policy level in the EU. He continued: “I agree absolutely that they need to get to something like 3%. I think they will get there in the end; I just think that there is a bit of political difficulty in getting there.”192 Roberto Gualtieri MEP said that it was possible to achieve a certain level of transfer within the existing EU budget of 1% of GDP but suggested that an additional 1% would allow enhanced investment and an automatic stabiliser.193 Thomas Wieser said that a permanent transfer system existed through the operation of EU structural funds: “in the case of Greece, the present co-financing rate is 0% … it is not explicitly or even implicitly linked to monetary union, but Greece is getting 4% or 5% of GDP per annum in what, in balance of payment terminology, is called ‘unrequited transfers’. Opinions may differ, but the reality is already partially there.”194

Mutualised debt

167.Mutualised debt, though featuring in the Four Presidents’ Report, is absent from the Five Presidents’ Report. Several witnesses told us that they expected or believed mutualised debt would be needed to support a common fund in the future. Sir Jon Cunliffe thought that debt mutualisation was not completely off the table:

“I read the reference to the fiscal stabilisation mechanism, which ‘could be financed in various ways’, as a way of leaving open some of those possibilities. The stabilisation mechanism is not defined—it is going to be one of the most difficult things for the euro area and the states to agree—but it could be financed by debt, and there could be mutualisation underneath that. I did not think it closed any doors completely.”195

168.Raoul Ruparel said that mutualised debt in the form of ‘Eurobonds’, whereby all countries jointly issue debt underwritten by each Member State, would reduce fiscal pressures on individual Member States and would benefit from the weight of the eurozone as a whole to issue debts.196 Graham Bishop argued that his proposal for a ‘Eurobill’ fund would provide a good discipline mechanism for the enforcement of public finance and macroeconomic policies.197

169.Megan Greene told us that one key distinction between the US and EU was that the US issued mutualised sovereign debt while Europe did not issue Eurobonds. She said that US treasury bonds were the most liquid asset class in the world, and argued that the absence of mutualised debt would reduce the effectiveness of Capital Markets Union as a shock absorber.198

170.Professor De Grauwe supported the idea of a “budgetary union so as to be able to consolidate at least a significant part of national debt into common debt.” He explained that in a recession, financial markets affected countries in different ways, and supported the idea of a fiscal union to prevent market instability:

“Instead of markets stabilising during a recession, they typically will be destabilising the system, forcing some countries into excessive austerity precisely at the moment that you do not want that and moving other countries into good times, thus intensifying conflicts within the Union.”199

He argued that debts needed to be consolidated so that destabilising capital flows within the union were eliminated and also that financial markets could not be trusted to stabilise the eurozone during recessions.200

171.Dr Lilico did not think that debt mutualisation would need to take place, based on the current level of transfers within the union. He argued that a “relatively modest contribution” transferred to countries to enhance the growth of struggling eurozone Member States would be far less objectionable than exposing oneself to “two trillion-plus of debt mutualisation or debt risk.” Future transfers would be “a natural extension of kinds of programmes that are already in place, you could transform the situation—not provide a final solution, because you need to be getting up to 3%-plus of GDP—merely by providing something of the same order of magnitude again as the structural and cohesion funds that are already in place.”201

Sequencing within a fiscal union

172.Several witnesses questioned the sequencing of a fiscal union. Baroness Bowles of Berkhamsted told us that she saw fiscal union forming in two stages, as suggested by the Five Presidents’ Report: first, ensuring that rules are obeyed and second, “they want to move further together and maybe to fund some things out of some form of joint taxation.”202 Dr Marek Dabrowski, Fellow at the Center for Social and Economic Research (CASE), Warsaw, argued that the history of other fiscal federal arrangements suggested that the development of a macroeconomic stabilisation function “usually follows fiscal centralization.”203

173.Roberto Gualtieri MEP told us that there were “conditions for enhancing the level of fiscal transfer and risk-sharing gradually, in parallel with the strengthening of our convergence and budget rules … The two things could arrive in parallel and gradually evolve: first, by making use of the current set of rules; secondly, by having legislative changes within the current treaty framework; and, thirdly, by arriving at treaty change.”204

174.Professor Codogno believed that “a successful monetary union ultimately requires some form of fiscal risk-sharing. It is moving towards that, but in a gradual way.” He predicted it was likely that we would see “halfway houses”, or that “in the time of crisis you will have risk-sharing.”205

175.Kay Swinburne MEP told us that the incentives to create a fiscal union could disappear as the economy became more normalised: “It will take the next crisis for us to get closer to any more fiscal union.”206 Mike Vercnocke told us that if one solved recovery and resolution of financial institutions in the financial sector, and the link between the sovereign and bank were broken, some of the “fiscal issues probably go away.”207 Sir Jon Cunliffe did not agree that “fiscal union necessarily means becoming a complete federal country, but there has to be a much higher level of fiscal integration that includes risk-sharing and collective support.”208

176.‘Fiscal Union’ is not defined in the Five Presidents’ Report. Perhaps this was deliberate but we are alarmed that such a key component of that report remains such a nebulous concept and was interpreted in so many different ways by our witnesses.

177.Some form of stabilisation function would be necessary and this would entail transfers between Member States. The question is the level of those transfers and the trigger for making them. Because the EU does not have the sort of tax and expenditure powers that are the norm in Member States, it lacks a capacity for automatic stabilisers to function when there are cyclical upswings or downswings. Nor does it have permanent transfer mechanisms that provide equalisation. Neither appears to be politically feasible in the near future. The stabilisation mechanism proposed by the five Presidents, which would be automatic (so not contingent on a decision-making authority such as the Troika) but not permanent, and responding only to asymmetric shocks, seems a pragmatic way forward.

178.We note that there may be higher political support for transfers responding to a cyclical shock rather than structural problems. Such an arrangement would need appropriate agreement at Member State level and some form of institutional oversight. The plans put forward at the moment are vague, although we note the suggestion of an unemployment reinsurance scheme to deal with cyclical, rather than structural, unemployment. A precondition for any such system would be appropriate structural convergence, or at least coordination.

179.Financial integration, through the completion of Banking Union and Capital Markets Union, may appear to be more achievable than a fiscal union in the short term. However, several challenges remain. These include a potentially ambitious risk reduction agenda before risk-sharing through EDIS takes place, and uncertainty surrounding the long term common backstop to the Single Resolution Mechanism. In addition, the opening of politically sensitive legislative agendas such as insolvency and tax, within the Capital Markets Union initiative, may limit private risk-sharing in the short term.

180.We welcome the fact that the initiatives and programmes aimed at financial integration are already underway and can be completed without a major revision of the Treaties, or the creation of significant new institutions. These projects largely aim to reduce risk, though we note that a single backstop for Banking Union and the EDIS proposal entail a degree of risk-sharing. It is the risk-sharing elements that have proved the most controversial, and this suggests that any further ‘fiscal union’ that entails pooling of funds will be unlikely to succeed in the short term, and certainly not before significant risk reduction measures have been put in place.

117 Communication from the Commission to the European Parliament, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions, ‘Towards the completion of the Banking Union’, COM (2015) 587 [accessed 8 April 2016]

118 European Commission, Completing Europe’s Economic and Monetary Union: https://ec.europa.eu/priorities/sites/beta-political/files/5-presidents-report_en.pdf [accessed 6 April 2016]

119 European Commission, Completing Europe’s Economic and Monetary Union: https://ec.europa.eu/priorities/sites/beta-political/files/5-presidents-report_en.pdf [accessed 6 April 2016]

120 European Commission, Completing Europe’s Economic and Monetary Union: https://ec.europa.eu/priorities/sites/beta-political/files/5-presidents-report_en.pdf [accessed 6 April 2016]

121 Communication from the Commission to the European Parliament, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions, ‘Towards the completion of the Banking Union’, COM (2015) 587 [accessed 8 April 2016]

128 Council of the European Union, press release: Single Resolution Fund: Council agrees on bank contributions (9 December 2014): https://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ecofin/146
[accessed 8 April 2016]

130 Communication from the Commission to the European Parliament, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions, “Towards the completion of the Banking Union, COM (2015) 587 [accessed 8 April 2016]

131 European Commission, Completing Europe’s Economic and Monetary Union: https://ec.europa.eu/priorities/sites/beta-political/files/5-presidents-report_en.pdf [accessed 6 April 2016]

132 Communication from the Commission to the European Parliament, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions, “Towards the completion of the Banking Union” COM (2015) 587 [accessed 8 April 2016]

133 Communication from the Commission to the European Parliament, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions, “Towards the completion of the Banking Union” COM (2015) 587 [accessed 8 April 2016]

134 European Union Committee, Genuine Economic and Monetary Union’ and the implications for the UK (8th Report, Session 2013–14, HL Paper 134)

138 Written evidence from Dr Waltraud Schelkle (EMU0008)

139 Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) 806/2014 in order to establish a European Deposit Insurance Scheme, COM(2015) 586 [accessed 8 April 2016]

140 See Outcome of the Council meeting of 8 December 2015: http://www.consilium.europa.eu/en/meetings/ecofin/2015/12/08/ [accessed 8 April 2016]

148 Written evidence from the BBA (EMU0008)

160 Written evidence from BBA (EMU0008)

161 Written evidence from BBA (EMU0008)

162 Appointed CEO of the Financial Conduct Authority on 26 January 2016 though still at the Bank of England when he gave evidence.

167 Written evidence from BBA (EMU0008)

169 European Commission Green Paper, Building a Capital Markets Union, COM(2015) 63: http://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=COM:2015:63:FIN&from=EN

170 Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions, Action Plan on Building a Capital Markets Union, COM(2015) 468: http://eur-lex.europa.eu/legal-content/EN/TXT/HTML

171 European Union Committee, Capital Markets Union: a welcome start (11th Report, Session 2014–15, HL Paper 139)

172 European Commission, Completing Europe’s Economic and Monetary Union: https://ec.europa.eu/priorities/sites/beta-political/files/5-presidents-report_en.pdf [accessed 6 April 2016]

177 Q 90. Similar views were expressed by Roberto Gualtieri (Q 103) and Markus Ferber (Q 90)

180 Written evidence from Anneliese Dodds MEP (EMU0006); Q156 (Mike Vercnocke) and Q90 (Kay Swinburne MEP)

185 European Commission, Completing Europe’s Economic and Monetary Union: https://ec.europa.eu/priorities/sites/beta-political/files/5-presidents-report_en.pdf [accessed 6 April 2016]

203 Written evidence from Dr. Marek Dabrowski, EMU0010

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