Cocos for European Banks

Everyone agrees on the need for big changes to bank resolution mechanisms both in Europe and in the USA. The problems with bank resolution differ in Europe and the USA, and the appropriate solutions differ too. Coco bonds make great sense for the Eurozone but are less appropriate for the USA. European regulators need to think for themselves on cocos, not just ape the muted response of US regulators. Contingent convertible (coco) bank bonds have a trigger point (such as a minimum equity/asset ratio) which when reached immediately forces a conversion of the liability from a debt to an equity claim. So when the bank gets into trouble, junior-grade debt liabilities immediately disappear and are replaced by diluted equity. Coco bank bonds are a very partial solution (at best) to the TBTF bank resolution problem in the USA. For all but the very biggest banks, the harsh and effective resolution system in the USA can close and re-open troubled banks very quickly. This type of super-fast bank resolution will never happen in the fragmented multi-national banking system of the Eurozone. Also, the technical competence of bank oversight in the USA will never be matched across all seventeen countries of the Eurozone, some of whom have long histories of weak and ineffective bank regulation. Cocos can partly substitute for weak regulatory oversight by encouraging greater market discipline emanating from bank bondholders.  Cocos would fit well into the design of a politically-feasible banking union for the Eurozone. 

If the euro survives, some type of contingent convertibility for bank debts in the Eurozone is likely to be part of the new banking system.  Ireland as a small economy in the Eurozone would particularly benefit from a coco feature imposed on bank bonds, and should encourage this regulatory policy innovation.

Richard Tol and the ESRI

It has been a strange few days for Richard Tol and the ESRI. A working paper co-written by Richard and released by the ESRI was later withdrawn, because there were “serious concerns about the methodologies used in the paper“.

Brian Lucey has a useful summary of all of the back and forth on his blog, including some rebuttals of Tol’s paper.

This episode is unfortunate for everybody, but in a lot of the coverage it is clear the ‘working paper’ status of the document is not well understood. Working papers exist to facilitate discussion and dissemination of ideas. Just about every working paper series carries a disclaimer to the effect that any paper within the series has not been peer reviewed and so the conclusions are not to be taken as read. In fact a disclaimer is at the bottom of the first page of the working paper.

Really what the author is saying to their colleagues in the scientific community when they publish a working paper is “here, have a look, tell me what you think.” The working paper status of the document is overlooked in several pieces I’ve read, with many calling it an ‘ESRI Report’, as if Tol et al’s working paper was like the Quarterly Reports which do, in fact, speak for the ESRI.

In my opinion, the correct thing to do now is to organize a half day talk around these issues with contributions invited from interested participants. Rather than stifling the debate around what is obviously an important topic, explore the idea properly and with the minimum of drama.

Bundesbank on Banking Union

‘Talk of a banking union in the euro zone is premature, a key member of the executive board of Germany’s Bundesbank said Tuesday, arguing that such a plan could only follow deeper fiscal union.

“The recent proposals of a so-called banking union appear to be premature,” Bundesbank board member Andreas Dombret told an audience of bankers at a conference in London.’

Fiscal union, in Bubaspeak, means political union, which takes forever. So Dombret is arguing for a continuation of a currency union without banking union for many years to come. He presumably believes that this will prove sustainable.
Courtesy FT.Com:
‘Sabine Lautenschläger, vice-president of the Bundesbank, said banking union could only work in tandem with fiscal union – meaning some common cross-border binding rules on how countries could set budgets.

Banks in Germany have already signalled opposition to having their existing deposit guarantee schemes potentially used to rescue banks in other countries.The “decisive question” of banking union was the “interplay between liability and control” because a crisis in one country’s banks could require financial help from taxpayers in other countries, Ms Lautenschläger said. “Whoever accepts liability also has to have a right to control, especially when it is potentially a question of very large sums as in the case of a banking crisis.”

Speaking at a Bundesbank conference in Frankfurt, she said banking union without fiscal union would, in particular, benefit banks in weaker economies with higher refinancing costs. If those banks then bought more of their own countries’ sovereign bonds, they would, in effect, pass on cheaper refinancing costs to their domestic governments, Ms Lautenschläger said.

“The extremely important discipline of the market would be partially lost. Even more seriously, joint liability for banks would, at least, partially extend to the sovereign bonds of these countries,” she said. “The result would be joint sovereign liability through the back door – without the possibilities for intervention and control, and therefore the protection, of a fiscal union.”

Ms Lautenschläger also cast doubt on how quickly any banking union could be implemented, saying “comprehensive EU treaty changes” would be needed.

Readers will be greatly encouraged to learn of the Buba’s late conversion to the merits of market discipline. Does this mean market discipline only for sovereigns or for banks also?. Did the Bundesbank oppose the policy of the ECB on this matter in October 2010 when the Irish government was coerced into payouts on zombie bank bonds by the other central bank in Frankfurt?

There have been some flaky versions of the ‘banking union’ notion, including mutualised moral hazard for banks. Banking union means (funded) deposit insurance, centralised bank supervision and, critically, proper bank resolution, including the de-commissioning of the ECB’s moral hazard machine. Without bank resolution the sovereign debt crisis is not soluble. Could the Bundesbank be prevailed upon to address two questions:

(1) Can the sovereign debt crisis be resolved with permanent moral hazard for banks and indefinite contingent liability for their sovereigns?

(2) What suggestions can the Bundesbank offer to resolve the current undercapitalisation of the Eurozone banking system?

The perception is inescapable that people who continually rule out the measures needed to rescue the common currency project are indifferent to its fate.

 

 

The wisdom of Charles Kindleberger

Brad DeLong and Barry Eichengreen have a really nice piece on the lessons today’s policy makers might usefully draw from the work of the great Charles Kindleberger.

It prompted the following two thoughts on my part, neither of which is perhaps relevant to Kindleberger.

The first is that the extremes are gaining in Europe because centrist parties are offering voters no meaningful choices. Pasok and ND are an egregious example, but the same is true in all the other programme countries, and to a lesser extent in other countries as well. So if you want to vote against the status quo policies, you have no alternative but to vote for Syriza, or whomever.
Second, right now in Europe, support for international institutions means, de facto, support for the current policy mix, just as being an internationalist in the interwar period, in too many cases, meant support for gold. And this is killing support for the very international institutions that, as Brad and Barry say, are in principle a solution to the crisis.
Update: Brad has a great response to this post here. Read it.

The possible shape of a second bailout for Ireland

..is discussed in the Irish Times today by my UL colleague Donal Donovan. From the piece:

The prospects for Ireland being able to access sufficient market funding by late 2013 do not appear favourable. The lending environment for sovereigns in much of the euro zone has worsened steadily and, barring miracles in Greece and Spain, is unlikely to improve sharply soon. Notwithstanding Ireland’s Yes vote and continued adherence to the troika programme, we can’t avoid being affected by the general market nervousness. Ireland’s budget deficit, at 8-9 per cent of gross domestic product, remains the highest among debt-distressed euro zone members.

Even under favourable assumptions, without specific debt-alleviation measures, the debt to GDP ratio will be over 100 per cent – second only to Greece – for some time.

Despite encouraging words from European Central Bank president Mario Draghi, it is hard to be confident that the estimated €40 billion needed to cover the budget deficit and repay maturing debt obligations in 2014-2015 can be obtained at affordable market terms.

Ireland and Spain: Twins?

It is obvious that the banking crises in Ireland and Spain share many similarities.   However, it is also clear that the Spanish banking crisis is quite a bit smaller relative to its GDP (even if it is bigger relative to euro area GDP).

  • The credit boom was not quite as strong in Spain as in Ireland.  The credit/GDP ratio in Ireland rose from 104 percent in 2002 to 210 percent in 2008; the increase in Spain was from 100 percent in 2002 to 188 percent in 2008
  • A recent DB report calculates that real estate loans peaked at 77 percent of GDP in Ireland but only 29 percent of GDP in Spain, while estimated non-performing loans stand at 52 percent of GDP in Ireland but only 17 percent of GDP in Spain
  • Ireland’s Troika funding of 67.5 billion euro is equivalent to 43 percent of Irish GDP, the Spanish funding of 100 billion is equivalent to about 9 percent of Spanish GDP.

The European Redemption Fund Proposal

The proposal for a Debt Redemption Fund made by the German Council of Economic Experts seems to be gaining a bit more traction (see here).   This working paper from February provides a useful overview.   Given that this is the only “eurobonds” proposal with anything approaching momentum, it is worth debating its merits. 

Some of the basic elements:

·         Countries would be able to finance an amount of debt (as a share of GDP) equal to the difference between current levels and 60 percent of GDP through the fund.   This would occur as new funding needs (deficits/redemptions) arise

·         The fund would have joint and several guarantees

·         Repayments would be a constant share of GDP, equal to the ERF interest rate plus one percent divided by initial GDP.   The repayment schedule is designed to fully repay fund borrowings in 20 to 25 years

·         Countries would have to commit to reduce their total debt to below 60 percent of GDP.   Longer term, it doesn’t appear that there would be additional commitments beyond the revised Stability and Growth Pact and Fiscal Compact.   However, during the “roll-in” phase, countries would have EFSF-style adjustment programmes

·         Would only apply for current programme countries after they had exited their programmes. 

Continue reading “The European Redemption Fund Proposal”

Karl Whelan on the Burden of Bank Debt

Karl Whelan has a very useful post on options relating to reducing the burden of banking-related debt (see here).   Of particular interest is his comparison of the present discounted cost of the current promissory notes/ELA arrangement and a low-interest (3 percent) long-term (30-year) financing deal with the ESM to immediately payoff the ELA.   This calculation shows that that ESM alternative has a lower NPV by a wide margin.  

We could perhaps quibble with some of the assumptions used in the calculation.   Karl assumes the ECB’s main refinancing rate rises to 4.5 percent by 2016, which would require a strong euro zone recovery (see Table 7 here).   Also, in a world where official financing remains available as an option over the longer term, the assumed discount rate of 7 percent (based on current secondary-market bond yields) could be considered high.   (I am also not sure from the calculations if Karl is allowing for Irish Central Bank profits on outstanding ELA.)  But Karl’s basic conclusion seems robust to reasonable relaxations of these assumptions.    

Karl notes that I am “neutral” with regard to whether the long-term refinancing via the ESM would be a good deal, waiting to see the details.   Based on his numbers, I am happy to agree that a 30-year deal at 3 percent is likely to result in a substantial reduction in the burden of this debt.

Spain, Ireland, and austerity.

Spain’s banks are getting a series of loans. Hooray. The rather vague Eurogroup statement on Spain is here. It’s being reported that Spain will require up to 100 billion euro for its banks, which will be added to its national debt. The money will come in tranches, first from the EFSF, and then later from the ESM. There aren’t specific austerity measures attached to this series of loans. People in Ireland are sure to lose their minds over the fact that there won’t be specific conditionality attached to these loans, and the IMF will be ‘observers’ rather than actually part of a Troika of funders. The talk generally is likely to be something like ‘why couldn’t we get such a deal’, and apparently Minister Noonan will be bringing this up with his colleagues at a later date.

It should be noted however that Spain is already enduring a fair bit of austerity, has already signed up to the Fiscal Treaty, and so will have to produce a `programme’ of sorts under its own steam. Spain’s economy is also in pretty rough shape. I made the chart below from FRED to show household debt as a percentage of GDP (left hand axis) and unemployment in Spain (right hand axis), two variables we should be interested in. Clearly with an unemployment rate heading for 25%, a very indebted household sector, and a set of bunched bank balance sheets, the Spaniards have their work cut out for them even without a further programme of adjustment.

A few things to consider:

1. Will treating Spanish banks separately (in some sense) to the sovereign prevent its bond yields from spiking?

2. What will the effect on the EFSF and ESM balance sheets from a large scale Spanish ‘withdrawal’?

3. Will everyone now immediately target Italy (or Belgium) as the next domino to fall?

More evidence of Irish success

The CSO press release on the latest Irish employment and unemployment statistics is here. They are pretty terrible.

As Colm has frequently pointed out, it is very difficult to credibly ask for a new deal on bank-related debt when you are simultaneously telling the people in charge in Brussels and Frankfurt how well we are doing (i.e. how successfully their strategy has been working in Ireland).

Perhaps it’s time to ignore Johnny Mercer and start accentuating the negative, even at the risk of a little pandemonium?

Seamus Coffey on Resolving the Euro Zone Banking Crisis

Seamus Coffey has an excellent article on resolving the euro zone banking crisis in today’s Irish Independent (HT DOCM).   For the Irish situation, Seamus puts the proper focus back on the case for extending the maturity of the promissory notes/ELA arrangements as the correct focus of negotiations.   The idea that the ESM would retrospectively cover already crystallised losses in the Irish banking system looks fanciful, and only serves to create confusion about what Ireland needs – and could realistically be provided – in order to further the shared objective of getting Ireland off external assistance.  

In the certainty of attracting vitriol in comments, I think Seamus is being a bit hard on the ECB.    The problem that the ECB faces is a bank creditworthiness crisis across a significant part of the euro zone.    In fairness, they have been willing to meet their proper function of acting aggressively as a lender of last resort to stem deposit flight.   But they can only do this if the banks they are lending to are solvent.   They have insisted that the banks be recapitalised, preferably directly from centralised bailout funds, but failing that by governments, with money borrowed from those funds.  

I think most analysts agree that the future stability of the euro zone will require a form of banking union, with centralised supervision, centralised deposit insurance and a centralised resolution regime that allows for losses to be imposed more broadly on certain classes of bank creditors.   The challenge is how to get from here to there.  In the short term, putting creditors at greater risk of losses reduces bank creditworthiness further, potentially causing the crisis to escalate.   Moreover, given the differences in the solvency of the banks in different euro zone countries, any move towards centralised deposit insurance has potentially large distributional implications across euro zone countries.   If a deposit insurance regime could be agreed behind a “veil of ignorance”, with negotiators not knowing which country they represented, it should be relatively easy to agree to such arrangements.   But alas this “ignorance” is not available.   The messy and fragile two-way process involving greater risk sharing and more credible assurances of mutual discipline will continue. 

Daniel Gros, Dirk Schoenmaker: a Sense of Urgency

Today’s proposals from the EU Commission on banking union offer a draft directive whose operative date would be January 1st. 2015, by which time the game will be well and truly over. It would also apply to the EU as a whole, and has that familiar, watered-down, look to it. 

Here’s a slightly more urgent suggestion from Daniel Gros and Dirk Schoenmaker:

http://www.voxeu.org/index.php?q=node/8069

In Greece, they argue, the sovereign has brought down the banks, while in Spain the banks are about to bring down the sovereign, as happened in Ireland, with a little help from the ECB.

The new ESM needs to be deployed to re-capitalise the Spanish banking system, pronto, as soon as the stress tests have been completed. Placing the burden on the sovereign, before the stress tests, is insane. We have been here before.

They also have a better idea for stopping the bank run in Greece.

The measured rise in Irish inequality

I have been meaning to comment on the results of the Survey of Income and Living Conditions (SILC) 2010, but hadn’t got around to it with all the excitement on fiscal matters.   As has been widely reported, the survey showed a dramatic increase in income inequality, with the quintile ratio (the ratio of the incomes of the highest income quintile to the lowest income quintile) rising to 5.5 from 4.3 in 2009.   The Gini coefficient also jumped dramatically, from 29.3 to 33.9.   (A Gini of 0 represent perfect equality; a Gini of 100 represents perfect inequality – i.e. one household having all the income.)  These increases more than reversed the measured declines since the middle of the decade.  

Although these increases took place at a time of wrenching adjustment in the Irish economy, the magnitude of the increases in measured inequality is still surprising.  All the more so since the ESRI’s analysis of the 2010 budget indicated that the changes were progressive (see here for an analysis of the period 2008 to 2012).  (See also page 17 of this European Commission report on Ireland.)

The SILC is an extremely carefully constructed survey.    However, as noted in the survery report, sampling variation is unavoidable, and results must be always be interpreted carefully.   One indication that sampling variation may be an issue is the fact that the number of “household heads” with a third-level qualification or higher increased to 1,830 from 1,505 (p. 83).   This increase occurred despite the total number being surveyed falling to 11,587 from 12,641.   Thus the proportion of survey respondents with a household head with a third-level education or higher – a fraction that changes relatively slowly over time – increased to 15.8 percent from 11.9 percent.  This suggests that sampling variation may explain part of the measured increase. 

My purpose here is most certainly not to diminish the importance of inequality as an issue – quite the contrary.  And it may well be true that inequality will turn out to have risen over this recession after balancing market and post-market factors.   But those concerned with inequality might be unwise to put too much emphasis on one year’s survey results.   To the extent that the increase in inequality partly reflects sampling variation, there is a greater likelihood that it will fall again in the next survey release.   This could too easily be interpreted as indicating that recession-related inequality effects are not an issue.   Perhaps of greater concern than the results in SILC 2010 is the breaking of the recent trend of progressive budgets in Budget 2012 (see Figure 1 here).   However, we will need to see more than one budget to accurately gauge the distributional implications of Government policies. 

Germany: No Deal on Ireland’s Bank Debt

Despite ratifying the Fiscal Compact by a sizable margin, which boosts the case for the Compact in other EU member states, it appears any concessions Enda Kenny hoped for on our bank debts on foot of the ratification may not materialize. Apparently any renegotiation would send a “negative signal”. From the Irish Times piece:

“We see no need for movement at the moment,” said Martin Kotthaus, spokesman for finance minister Wolfgang Schäuble.

Super.

A better deal on bank debt: What is achievable?

In the wake of the referendum result and speculation of the ESM directly injecting capital into Spanish banks, there is a lot of discussion about the possibility of Ireland “getting a better deal on its bank debt”.    It would help if people were more explicit about what they had in mind.   I would not be surprised that many in the public believe that it means there would be retrospective collective European absorption of already crystallised losses in the Irish banking system.  Although I would love to be wrong, I believe that the odds of this happening are approaching zero.   Failure to deliver such absorption would increase the sense of grievance on Ireland’s treatment in relation to the bank and bondholder/depositor rescues.   Some might argue that a sense of grievance is useful in strengthening Ireland’s bargaining position.   I doubt it; and any benefits are unlikely to outweigh the costs in reduced domestic support for Ireland’s necessary adjustment efforts.    

It is worthwhile to consider what an extension of the ESM’s role could realistically mean for Ireland.  I consider some possibilities below.   I would be interested in people’s views. 

First, if additional capital injections are needed, Ireland would have a strong case for these injections coming via the ESM.   However, this would not be a direct transfer, but a capital injection in return for a fair stake in the bank.    The advantage would be that it would reduce the uncertainty around the value of balance sheet of the State relative to State making such injections. 

Second, it is possible that the ESM could take over some or all of the State’s existing ownership stakes in the banks.  Again, I think it would be unrealistic to expect the ESM to pay more than fair value.   The advantage would again be reduced uncertainty over the value of the State’s balance sheet.   But it is again important to recognise that this would be of considerably less value than any absorption of already crystallised losses. 

Third, the fact that Ireland’s bank-rescue efforts preceded any development of the ESM as a mechanism for recapitalising banks could help Ireland get more traction on the extending the repayment schedule for the promissory notes/ELA.   (It does seem unfair to be disadvantaged for faster recognition of the reality of bank losses.)

In considering the likelihood of a deal on the promissory notes, it is worthwhile to recognise the reason for the ECB’s strong opposition.   The provision of ELA to IBRC effectively amounts to temporary monetary financing of a government.   The euro system has allowed the Irish central bank to print money to temporarily finance IBRC, but on the understanding that the funds will be repaid by the Irish State, and the money creation eventually reversed.   A monetary union could not survive with individual countries printing money on a permanent basis, as it amounts to a transfer to the country printing the money from other countries in the system.   We would and should be firmly opposed to other countries engaging in such a practice.   The ECB is therefore extremely uncomfortable with even temporary money creation.   Extending the ELA beyond the agreed schedule has, so far, been a bridge too far.   The question is whether the advantages of facilitating Ireland’s return to market creditworthiness by reducing medium-term funding needs means that they are willing to hold their noses a bit tighter and allow a longer repayment schedule.   I think there is a strong case to be made for such extended repayment schedule, but we should not be surprised that it has been so difficult. 

Fourth, an alternative to extending the maturity is for ESM to make long-term loans to the State to allow it to redeem the promissory notes.   The ECB would certainly be happy with this arrangement.   However, the benefits in terms in terms of longer maturity would have to be weighed against the higher interest rate, recognising the ultimate interest cost to the State from the promissory notes/ELA arrangement is very low.   We would have to see the details to assess whether this would be a good deal. 

What Kind of Banking Union?

It has become almost fashionable to call for a banking union to complete the monetary union. This is what I had to say in today’s Sunday Independent:

The referendum result is a relief rather than an achievement. A No vote would have made a bad situation worse. The government needs to move on quickly in exploiting whatever opportunity has been created to reduce the burden of bank-related debt imposed on the Irish Exchequer. The misfortune of Spain presents an opening, since an Irish-style response to the Spanish banking crisis is clearly unwise. The banking crisis in Spain needs a European solution and the European leadership appears to understand that Spain cannot be cut adrift to embrace unknown, and unknowable, liabilities for the debts of mismanaged banks. Ireland was SETF (Small Enough to Fail) but thankfully Spain and Italy cannot be dismissed as peripheral. It is a shocking state of affairs when European countries can see the misfortune of others as a welcome development, but this is the sad reality which has been fashioned in pursuit of the single currency project.   

 

The European Union is not structured in a way which encourages decisive management of crises. The intergovernmental nature of the Union and the inevitable reversion to national political priorities when crisis strikes create a predisposition to muddle, delay and half-measures. These features have been prominently on display since the Eurozone banking and sovereign debt crises erupted in 2008 and have seen both sets of problems intensify. One of the unambiguous lessons of history is that the costs of financial crises magnify when the policy response is too slow.

 

There have however been some potentially promising developments in the weeks leading up to the Irish referendum which received little public attention here, drowned out by the torrent of referendum babble.

 

The president of the European Central Bank, Mario Draghi, made an important speech at the European Parliament on Thursday. He described the existing Eurozone structure as ‘unsustainable’, and called for the creation of a banking union to under-write the failing currency union. The currency union has clearly lost the confidence of the markets and, more importantly, of the public, as evidenced by continuing deposit flight in several countries. Draghi is to be congratulated on his candour, a sharp contrast to the waffle and evasions of his predecessor, Jean-Claude Trichet.

 

Draghi’s remarks come in the wake of a series of speeches from ECB executive board members drawing attention to the need for centralised bank supervision and resolution, the absence of which helped to propel this country into a blind alley back in October 2010. The ECB’s behaviour on that occasion, insisting that a sovereign unable itself to borrow, should repay unguaranteed and unsecured holders of bonds issued by insolvent and closed banks, will come in time to be seen as an appalling misjudgement. Without helping the bank bond market in any discernible way, this ECB policy choice helped to undermine confidence in Eurozone sovereign debt across the board. This discretionary action by Trichet’s ECB was resisted at the time by IMF officials, whose judgement has been thoroughly vindicated by subsequent events.  

 

The popular narrative that the sovereign debt problems derive from fiscal excess may be a reasonable characterisation in the case of Greece, but Ireland and Spain ran budget surpluses through the pre-crisis period, and had amongst the lowest debt ratios in the Eurozone in 2007. It has taken far too long for European decision-makers, in particular ECB officials, to acknowledge that this is mainly a banking crisis. Regional banking crises are to be expected in a currency union. They have been a recurring feature in the United States but are dealt with at federal level, without bankrupting individual states. The failure to anticipate regional banking crises in Europe and the subsequent decision of Trichet’s ECB to prohibit haircuts for unsecured senior bank debt has turned banking crises into sovereign debt crises, weakening banks which hold sovereign bond portfolios and inserting a new short-circuit into Europe’s financial system. A circuit breaker in the form of bank resolution would have been the better option.          

 

ECB executive council member Peter Praet, speaking in Milan on May 25th. last, concluded that

 

“…….more is needed for the euro area to break the link between fiscal imbalances, financial fragmentation and financial instability. Europe needs to move towards a “financial union”, with a single euro area authority responsible for the supervision and resolution of large and complex cross-border banks. This authority should also be responsible for a euro area deposit insurance scheme. With bank resolution and deposit insurance funded primarily by private sector contributions, taxpayers would be shielded from picking up the bill for future banking crises. Essentially, I envision an authority similar to the Federal Deposit Insurance Corporation in the United States”.

Two other Executive Council members, Jorg Asmussen and Benoit Coure, have expressed similar sentiments in recent speeches. The EU commission has also been working on bank resolution proposals according to newspaper leaks and a definitive document is due to be released later in June. EU Commission president Barroso has also stressed the desirability of a banking union.

Whether Europe’s single currency needs a fiscal union, for which there is little political support, is unclear, but a currency union unaccompanied by a banking union is inherently unstable (‘unsustainable’, in the admirably concise judgment of ECB president Draghi). With free capital movement, no perceived currency risk, freedom of establishment for banks and a worldwide liquidity bubble, it is clear that bank balance sheets expanded far too rapidly in several countries, including Ireland, through the pre-crisis decade. The delegation of bank supervision to national authorities and the imposition on them of the no-bank-bondholder-left-behind policy is, Greece excepted, the principal source of the sovereign debt crisis. It is also a moral hazard machine, removing market discipline from banks in countries still solvent and capable of spawning further crises in the years ahead.

The solution is not a Europe-wide bank rescue fund, which could make the moral hazard problem worse, through substituting more credible backstops for the next round of banking excess. The solution is the restoration of market discipline through exposing bank bondholders to the risk of loss. Europe’s single financial market has been sundered through deposit flight and nation-by-nation re-matching of assets and liabilities. This is no longer a monetary union in any meaningful sense – no country has departed the Euro but it has already ceased to be a trusted common currency. Further financial dis-integration can be avoided only if bank deposits in all Eurozone countries are seen as equally secure, which means a Europe-wide deposit insurance scheme, ideally funded through risk-reflective and fair premiums. Banks, including those deemed too big to fail, should be required to carry substantial bond liabilities which can be bailed-in should the banks get into trouble. If this means more expensive funding for banks, so be it. This is hardly an unintended consequence.

The common currency introduced in 1999 was poorly designed, and the failure to build a banking union to accompany the single currency was the principal weakness. It is enormously important that both the EU Commission and the ECB are now persuaded that the monetary union project is incomplete pending new structures to deal with this omission. It is Ireland’s misfortune to have been the first casualty of this design failure, largely our own fault of course, but no country should face punishment to the point of national insolvency for the sins of bank mismanagement and poor bank supervision. It is too late to lament Ireland’s decision to join the Eurozone in the first place. There is no option of painless exit, as Greece may be about to discover. Countries not already in the Eurozone are thinking twice about joining and those who stayed out are silently thankful for the foresight of their politicians. The best outcome for those already in the common currency is that the design flaws are admitted and remedied, sooner rather than later. The referendum result is welcome but the flood of admissions that the common currency needs to be re-designed is far more significant.

Creating a Europe-wide deposit insurance scheme on the hoof is challenging and there are numerous difficult issues to be addressed in the design of a new bank supervision and resolution regime. One tough question for policymakers is whether a banking union can be confined to the Eurozone or must embrace the full European Union. The banking union cannot however be long-fingered until things get back to normal. Its absence is at the heart of the current crisis.   

Vacancies at Department of Finance: Chief Economist / Head of Banking Policy

Details below.  The new position of chief economist is especially relevant in the context of the Fiscal Treaty, since key implementation issues (assessing level of potential output, evaluating feasible speed of fiscal adjustment) will require considerable technical input from the Department of Finance.