Fernando Fernandez Mendez de Andes, Professor at IE Business

Breaking the Sovereign
Banking Feed Back Loop
Public Hearing
Success and Failures in Crisis Countries
Committee on Economic and
Monetary Affairs
European Parliament
Brussels, November 5, 2013
Fernando Fernández
[email protected]
Europe: the solution to a self inflicted problem
What is wrong with Europe?: an alternative narrative
Understanding the euro project
Why is Banking Union so important?
A brief note on Spain
© Fernando Fernández 2013
Macro imbalances around the world
Source: Barclays, European Economics Quarterly, July 2013
© Fernando Fernández 2013
The Euro unsustainability as seen from the outside
Source: Institute of International Finance, Eurobrief, March 2013. IMF EuroArea Consultation, July 2013
© Fernando Fernández 2013
Aggravated by Financial Fragmentation
Source: IMF, WEO, October 2013
© Fernando Fernández 2013
Interest Rates in the Euro Area
Source: IMF, Global Financial Stability Report, October 2013
© Fernando Fernández 2013
And the vicious circle of bank-sovereign-corporate deterioration
Source: IMF, Global Financial Stability Report, October 2013
© Fernando Fernández 2013
The Maastricht Treaty: a strange animal by design
• Independent monetary policy by the ECB
• ECB response is not really that different, but the environment is
• No safe European asset for monetary policy
• No lender of last resort facility until OMT was improvised
• No fiscal policy coordination
• National regulation and supervision of financial systems
• No European approach to banking regulation, supervision and
resolution until late 2013 and still in the works
• National regulators, facing a textbook collective action problem,
acted to aggravate the Euro crisis
• National fiscal policies subject to non-binding rules
• The Stability and Growth Pact unenforceable ex-post
• No bail-out, why can California default but Greece could not?
• No exit works both ways
© Fernando Fernández, 2013
The crisis showed the Euro was naked
• The Greek fiscal problem and what it reveals of EMU
• Open fiscal contingencies
• No stabilization fund
• Ireland and its banking problem
• No national lender of last resort
• Banking problems become sovereign problems
• Reflation is not possible, so default the only alternative
• No growth, loss of competitiveness in Portugal
• The “Argentina syndrome”
• How to ensure/impose structural reform?
• Internal devaluations are painful and take time
• Cyprus:
• Sequencing issues: Bail in before Resolution Authority and
Common Deposit Guarantee
• Capital controls cannot be part of the tool kit
© Fernando Fernández, 2013
The Cost of the Banking Crisis
Source: IMF, Fiscal Monitor, October 2013
© Fernando Fernández 2013
Understanding Europe: Likely scenarios
 Monetary Union as envisaged in Maastricht is dead
 For good reasons. It was never an optimum currency area
 But it is taking a long and painful time to go
 Normative Economics: what should happen
Banking Union
Fiscal Union
Political Union: No taxation without representation
And even so, everything is possible, because growth is of
essence in a democratic Union
 Positive Economics: what is likely to happen
• Muddle through, playing at the edge
• Uncertainty, volatility, sudden events and prolonged subdued
 But an accident may always happen
• Despite today being highly unlikely
© Fernando Fernández, 2013
Banking Union
 A single supervisor. Basically agreed but
• Will markets wait for late 2014? Too much national discretion
• AQR, Balance sheet assessment and Stress testing dangerous
without a common fiscal back stop
 A Common Resolution Authority
• A 3 stage approach: prevention, restructuring and liquidation
• Will the pecking order of losses be applied uniformly?
• It entails, by definition, mutualization of the debt. (quasi-fiscal)
• It cannot be the Commission: No country allows Bank
recapitalization to be decided by the Competition Authority
• An European Deposit Guarantee Fund is missing
To break the vicious cycle of banking ad sovereign crisis
To allow fair competition to the benefit of the consumer
To avoid extensions of “bank holidays”
Three decisions: coverage, funding and institutional
© Fernando Fernández, 2013
A Limited Fiscal Union
– A Fiscal Union does not mean full tax or expenditure harmonization
• but simply avoiding externalities
– Euro Treasure
• Common monetary policy requires an euro risk free asset
• An asset that has to meet strict requirements: (i) depth and liquidity (ii)
ample references at all maturities; (iii) actively traded in liquid markets;
(iv) available in the short run for existing debt and not only for future
debt, the legacy problem; and (v) its emission to be the sole responsibility
of the Euro Treasure
• An Euro Treasure issuing an euro asset leads to decide on:
– (i) the source of funds: Euro Tax (new or old) vs. revenue sharing mechanisms
– (ii) the use of funds: the European Stabilization Fund
– Fiscal rules for the Euro Zone,
• Rationale: To avoid national policies impeding adequate functioning of
common monetary policy
• Implication: A binding restriction on national budgetary aggregates
• Evolution: Complex structural rules increasing implementation risk
© Fernando Fernández, 2013
A note on Spain
 The case of Spain is an euro crisis
• It could not have happened without the euro
• It will not be solved without addressing the mistakes in Maastricht
 Spain adjustment is work in progress.
• A proven willingness to reform, however reluctantly
• A significant turn around in banks solvency and profitability, fiscal
consolidation and external competitiveness.
• Foreign Investment, both debt and equity flows, coming in
• Institutional stability
• But employment growth remain and will remain elusive.
 Challenges and priorities for the future
• Restore and maintain fiscal balances in a highly decentralized state
• Job creation and additional labor market and education reform
• And creating a more business friendly environment
© Fernando Fernández, 2013

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