Keywords

Although the initial sentiment in continental Europe was that the financial crisis that started in 2007 was “Made in America”, possibly with the connivance of those perfidious “anglo-saxons” on both sides of the Irish Sea, it did not take long before the depth of the threats to all the economies in the European Union became clear. Since then, the EU has sought, collectively and at the level of individual Member States, to put in place a new approach not just to financial regulation, but to economic governance more generally. In a context of crisis management, these governance reforms have been difficult to agree.

Along the way, the breadth and intensity of the problems have multiplied as the indebtedness of sovereign states in the EU interacted with continuing weaknesses in the banking sector, accentuating the systemic threats and bringing the continuing viability of the euro itself into question. Yet in finding ways to contain the problems, institutional responsibilities have been blurred and the rest of the world has often looked on in dismay at the procrastination and prevarication exhibited by Europe’ leaders. Part of the problem is, as former European Central Bank (ECB) President Trichet noted,Footnote 1 that “central banks often have an explicit mandate in the area of financial stability. But typically this mandate is formulated in very general terms, and it would have been written before growing recognition of the key role of macro-prudential oversight”.

The governance reforms are still a work in progress and have revealed differences of philosophies, preferences and interests that are proving hard to reconcile. Progress has been hampered by the complexities of the EU institutional structure and, especially, by the fact that ten out of twenty-seven Member States remain outside the euro area. One result is that the ECB, among the most significant actors in dealing with the crisis and developing a new approach, always has to take care not to intrude in areas of policy that national central banks or supervisory authorities of (to use the EU jargon) “non-participating” Member States jealously guard as “mine”.

The financial crisis has forced policy-makers to distinguish more clearly between macro- and micro-prudential risks and, as a consequence, to look afresh at the balance of prudential supervision. A concise definition of the two forms of supervision is provided in a House of Lords reportFootnote 2:

Macro-prudential supervision is the analysis of trends and imbalances in the financial system and the detection of systemic risks that these trends may pose to financial institutions and the economy. The focus of macroprudential supervision is the safety of the financial and economic system as a whole, the prevention of systemic risk.

Micro-prudential supervision is the day-to-day supervision of individual financial institutions. The focus of micro-prudential supervision is the safety and soundness of individual institutions as well as consumer protection. The same or a separate supervisor can carry out these two functions.

The de Larosière report (2009), based on the deliberations of a high-level group appointed by the European Commission, offered a persuasive analysis of the origins of the financial crisis and the flaws in the regulatory framework that warranted attention. An equally trenchant analysis was provided by the Turner Review (FSA 2009) and these and other contributions point to the following factors that lay behind the financial crisis:

  • An extended period of loose monetary policy and rapid financial innovation

  • A misplaced belief in the ability of markets to self-regulate in a way that would forestall overly risky behaviour

  • Inadequate recognition of growing macroeconomic imbalances, despite the evidence of unsustainable trends in, for example, current account imbalances and asset prices

  • Failings in corporate governance and oversight of senior management

  • Misjudgements by ratings agencies and too great a reliance on their verdicts, at the expense of due diligence

  • Failures by regulators to recognise the immediacy and intensity of problems.

This chapter first reviews the different phases of financial and economic crisis in Europe since 2007. It then presents an overview of the regulatory and governance responses and how they are building into a new approach. Section 3 explores the extent to which the new approach addresses the challenges, and concluding comments complete the paper.

1 Phases of the Crisis

The perception that the regulatory system was partly to blame for the crises led to a search for both an accurate diagnosis of what had gone wrong and an approach that would avoid a recurrence. Although, in Europe, there were different viewpoints among the Member States on where the faults lay, there was a degree of consensus on the remedies and on the need to ensure that a recurrence be prevented. Yet what has also emerged is that too far too little attention has been paid to the determinants and causes of systemic risk. According to a definition put forward by the Institute for International Finance (2010):

Systemic risk is different from other risks, being defined by its effects rather than its cause. It is multiform, mutating, rapidly developing, and unpredictable. It has to do with interconnectedness as well as with individual entities, with smaller entities as well as larger, and with financial firms of many different types and scope of activities. Systemic risk is not national in nature and whether an event has systemic consequences will often depend crucially on circumstances and context. [emphasis in original]

If there were any doubts about whether systemic risk could emerge, the events of the autumn of 2008 proved they were only too real. Following the collapse of Lehman Brothers in September 2008, four main phases of the crisis (crises in the plural is probably a more accurate term) can be identified, all of which affected the interactions between the state and the financial sector. These phases partly overlapped and the political urgency around them has fluctuated. Indeed, even before then, there had been a pre-crisis phase in which the ECB led the way by pumping large amounts of liquidity into the system from August 2007 onwards. Over the next year, the fallout from the US sub-prime crisis appeared to have been contained and the inflationary threat from a surge in oil and other commodity prices even led the ECB to decide in July 2008 on a small increase in its policy interest rate.Footnote 3

Following Lehman, the extent of the systemic perils became increasingly clear and urgent over the next 3–6 months and gave rise to a phase of response that can best be described as fire-fighting. Ireland was quick to offer a blanket guarantee to depositors in a very over-extended Irish banking system, a decision which the current government no doubt now regrets. In the UK, equity injections, guarantees and central bank liquidity were all used to prop up several of the largest banking groups, and a shotgun marriage was arranged between the relatively sound Lloyds TSB and the hugely over-lent HBOS. A number of smaller former building societies were either nationalised or absorbed (for example, by the Spanish bank Santander).

Elsewhere, the picture was more mixed. In France, Italy and Spain, few problems arose, partly because bank regulation had been more robust and, in several cases, banks were less international in their outlook. However, the Benelux bank, Fortis, had to be rescued and was broken up and sold. In Germany, Hypo Bank had to be rescued and there were fears for some of the Austrian and Nordic banks that had been especially active in central Europe and the Baltics, respectively. In much of central and eastern Europe, the high degree of foreign ownership, almost paradoxically, limited exposure with the result that most of the countries were only mildly affected (Latvia being an extreme exception). During the fire-fighting phase more than 40 financial intermediaries had to be recapitalised, requiring permission from the European Commission to overlook standard competition rules governing state aids to competitive companies.

A second phase of the crisis can be dated from late in 2008 to roughly the London G20 meeting at the beginning of April 2009, in which the focus was on measures aimed at macroeconomic stabilisation, but with a strong emphasis on shoring-up the solvency of the financial sector (especially the banks). There was a coordinated fiscal recovery package, accompanied by further measures to underpin the financial sector through various guarantees and extensive provision of liquidity by the ECB and other central banks. On the whole, these macroeconomic measures succeeded in stabilising output and saw many Member States edge back towards growth in the second half of 2009.

With the publication of the de Larosière report, the Turner report in the UK and other analyses of the causes of the crises and how to ensure “never again”, a third phase that can be dated from early spring 2009 was about how to consolidate recovery, to recast financial regulation and to rein in banks. This phase exposed a number of differences of emphasis among EU actors. For example, Germany and France sought to include hedge funds, private equity and tax havens among the targets of regulatory reform, and have been highly critical of the role of what they see as US dominated ratings agencies. Others were much more concerned about the capital adequacy of the largest banks. Control of remuneration, especially the incentives around bonuses, was prominent in the discourse of many protagonists and a number of countries imposed ad hoc taxes on bonuses.

From the autumn of 2009 onwards, a fourth, initially slow-burning phase of the crisis can be identified. Following the change of government in Greece in October, it was revealed that the indebtedness of the Greek state had been substantially under-stated, leading to a steady rise in the premium Greece had to pay to sell sovereign bonds. In the end, the Greeks had to throw in the towel and accept a complex rescue package to which the IMF, the EU as a whole and the euro area subscribed separate pools of funding. Subsequently, fears about the sustainability of sovereign debt mounted, leading to the creation of the European Financial Stability Facility (funded by the euro area members), backed up by further commitments from the IMF and from the EU as a whole through the European Financial Stabilisation Mechanism.

The sovereign debt phase continued to bubble away during the rest of 2010 and saw further rescue packages for Ireland in November 2010 and Portugal in February 2011, amid continuing fears about Italy and Spain. Although Europe’s leaders continued to resist calls for default or euro exit, markets intensified the pressures on the euro area and the gravity of the Greek position led to a further rescue package initially agreed in July 2011. Market doubts dogged the package as it underwent ratification across the EU and led to a more extensive package agreed at the end of October 2011. For the first time, an explicit resort to default was part of the package, with banks eventually being asked to take a haircut of 74%, after difficult and protracted negotiations, on their holdings of Greek debt.

By the autumn of 2011, the turmoil in the markets for bonds of euro sovereigns was being seen as a source of systemic threat to the stability of the EU banking system. German and (especially) French banks had sizeable amounts of Italian sovereign debt. British banks have high exposures to the Irish banking system which is at the root of the Irish meltdown, with the debts of the banks having been taken over by the state, while the sheer size and interconnectedness of the Spanish system puts creditors from several other Member States at risk.

2 A Rapidly-Evolving Governance Agenda

As the crisis has unfolded, so too has the governance agenda, with a number of themes especially prominent as different phases have been assimilated. Some of the emphasis has been on reform of financial regulation, but there has also been a search for wider recasting of the governance arrangements at EU level and, especially, within the euro area. Europe’s financial system had been developed around a number of core principles (especially the doctrine of home country control) that inevitably came under scrutiny in the aftermath of the crisis, but as events have shown, the thrust of governance reforms could not be limited to financial regulation and has widened significantly.

In the EU, an additional level of complexity arises because of the tensions between the national and the EU level, and the conflicts that they engender. Europe is much more than a loose grouping of countries of the sort seen in many parts of the world, where trade is the principal motivation for integration. But it does not have the coherence and common purpose of a large federation: it is not the United States of Europe. The distinctive character of the EU always has to be borne in mind as an explanation for seemingly strange compromises, incomplete frameworks and some of the delays or apparently eccentric objections to policy proposals that might appear persuasive to an outsider.

2.1 The Supervisory Framework

The de Larosière group produced a series of proposals which effectively provided the template for the new European approach to supervision of financial services. Its core recommendations were for a new European Systemic Risk Board (ESRB—initially labelled as Council) and a European System of Financial Supervisors (ESFS). After rather difficult negotiations between the Council of Ministers and the European Parliament over a number of aspects, agreement was reached in November 2010 on the details of these new bodies and a new system became operational in January 2011. It is portrayed in Fig. 1, which shows that the ESRB is made up of a mix of central bankers, representatives of the three sectoral European supervisory authorities and the European Commission. Its primary role is to assess macro-prudential risk and will include monitoring of Member States budgetary positions as well as developments in the financial sector as such.

Fig. 1
figure 1

The new supervisory architecture in Europe

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The ESFS consists of the three EU level supervisory authorities and their respective national counterparts. The focus of the ESFS will be on micro-prudential supervision of individual financial entities. As the chart shows, there will be close concertation between the two new bodies in assessing systemic risk.

Although the sectoral European Supervisory Authorities (ESAs) will not, in general, directly supervise financial companies, on the grounds that the national authorities will be closer to their respective regulates, there are special provisions for credit ratings agencies. Early in December 2010, the legislation setting up a new pan-European supervisory authority was agreed. It included provisions for directly supervising credit rating agencies by the ESMA, and there is scope for fining agencies which breach rules within prescribed limits and subject to specific procedures.

One outcome of the legislative process that followed the initial proposals was an agreement to empower the new ESAs to impose temporary bans or restrictions on activities that might imperil financial stability, for example on uncovered short selling. A reason for this power is to avoid piecemeal action by individual Member States, although the EU authorities are at pains to suggest that they anticipate a cooperative model of coordination and, indeed, will be pleased if their preventative role means that emergency measures can be avoided. An implication is that it is going to be much more a reserve power than something that will be used routinely. A much more technical orientation of the new approach will be a drive to establish common rules across the EU and, in so doing, to reduce some of the differences that currently both add to costs of compliance where companies operate in multiple markets and constitute conditions that reduce transparency in a way that can also lead to less stability.

The limits of European integration always have to be borne in mind in assessing the EU approach. Tensions between the national and EU levels are a feature of much that goes on in the European Union and one of the more delicate issues that had to be resolved for the ESAs was establishing the circumstances in which they could intervene in national decisions. These are:

  • Where arbitration is needed between Member States that cannot agree

  • Where a national authority is applying EU regulations incorrectly

  • In an emergency, subject to the Council agreeing that the course of action is justified

Any such intervention on a decision applicable to financial entities will only arise if the national authority concerned does not comply with a recommendation addressed to it by the ESA. In addition, the scope of intervention is limited to areas directly covered by EU regulations. The ESAs will not have the power to order a bank rescue or recapitalisation on the grounds that this is a competence reserved for Member States. The reason for this is, quite simply, that the risk would be borne by tax-payers and there is no EU-level tax-payer. This is recognised in a fiscal safeguard clause in the legislation which prevents the ESAs from taking decisions that have budgetary ramifications for the Member States, a clause which includes an adjudication procedure with Member States able to decide.

2.2 Stress Tests and Other Measures

One of the most high profile policy interventions since the formal start of the new system has been the carrying-out of stress tests on the banks. A first round of tests, completed in the summer of 2010, had found little cause for concern, identifying only five banks that needed to recapitalise their balance sheets. These results were widely derided and shown by the time of the Irish rescue package to have been far too soft.

A second round, published in the summer of 2011 under the responsibility of the newly constituted European Banking Authority (EBA), was tougher and resulted in a much larger number of banks being asked to seek additional capital (European Banking Authority 2011). The purpose of the 2011 tests was to appraise the resilience of the banks against what is described as an “adverse but plausible scenario” of a four percentage point drop in GDP compared with a baseline scenario. Although 20 banks had tier 1 capital below a 5% threshold at the start of the year, many had since raised new funds. The exercise identified eight banks (out of 90 tested in 21 countries) that needed to boost their tier 1 capital ratios above the 5% threshold, and a further 16 that are vulnerable because their capital ratio is between 5% and 6%.

However, as the sovereign debt crisis deepened, the methodology of the stress tests was, once more, subjected to criticism, notably that they had not made enough allowance for possible default by sovereigns, especially Greece. Although the EBA methodology included some allowance for direct exposure to Greek sovereign debt, it was criticised for neglecting second-order effects stemming from the problems that might arise if a bank holding substantial amounts of Greek debt were itself a risk for counterparties in other banks.

At both EU and national levels, diverse measures have been taken to lessen the stresses in the financial system. Spain, for example, has responded robustly to the threats hovering over its “cajas”—the savings banks, many of which are local and also subject to control by local politicians—from the bursting of the property bubble. The measures have included forced mergers to reduce the number of such banks, intensified reporting obligations and the creation of a special fund to assure liquidity. These measures are still evolving, like so many others, but initially appeared to have dealt with the most immediate dangers, but the position deteriorated during 2012 and led to a need to bail out Bankia—the new bank that had been created out of several cajas. However, there can be little doubt that the financial system in much of continental Europe (in contrast to the UK where a major effort went into recapitalising the banks) remains fragile. It might be able to withstand default by a small country like Greece, but would be in deep trouble if it had to cope with much more.

A further strand of governance reform is to hold the financial sector to account through a variety of interventions affecting the taxation of the sector and its conduct of business, as well as more direct supervisory action. Elements under consideration include:

  • Curbs on bonuses

  • Seeking new revenue sources that rely on finance as a tax base, whether through changes in how the activity of the sector is assessed (finding ways of taxing its value added) or possible financial transaction taxes (FTT)

  • Restrictions on recruitment, especially of senior and key workers.

2.3 Resolution Procedures

The Commission stated in a communication on resolution of failing financial firms, its third on the subject in the space of 12 months, that new procedures are needed to ensure that a tax-payer bailout of major financial intermediaries does not happen again, arguing that “a credible regime is needed to re-instil market discipline associated with the threat of failure and to reduce moral hazard—the implicit protection from failure that those in the banking sector currently enjoy”. The Commission is working closely with the Financial Stability Board and in the context of the G20, with other leading governments. A proposal for new legislation on crisis resolution in the financial sector was promised for spring 2011, following a consultation exercise that was launched at the beginning of that year and ran until March 2011, with a summary of results published two months later.

The initial focus was to be on credit institutions and certain investment firms, but extension to the rest of the financial sector is envisaged subsequently. The core aim is to allow intermediaries to fail without triggering systemic problems. This will involve three governance orientations:

  • Preparatory and preventative measures designed to avoid the emergence of problems

  • Early supervisory intervention to ensure corrective action is taken expeditiously

  • Tools and powers to facilitate orderly resolution of problems

The communication stresses the importance of adaptation to national systems, where they currently exist, but also of clarity about what the system is. Under each heading, the communication sets out the components of the anticipated policy responses, including (under the first) what the trigger for action should be. Its approach to resolution is set out in Fig. 2.

Fig. 2
figure 2

Resolution and insolvency

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The proposed approach also stresses the need for powers to arrange the sale of the business (or parts of it) as a going concern, and highlights the rights of shareholders—if appropriate—to compensation. In common with other governance reforms, the communication argues that because systems already exist in many Member States, the EU approach should not be overly prescriptive. Instead, the emphasis should be on the outcomes, hence a single model is not proposed.

A particular concern that the communication addresses is how to resolve crises where more than one Member State is involved, recognising that there is no single EU level supervisor. The proposed answer is to have a coordinated system akin to that which is being established for supervision; specifically:

  • The creation of resolution colleges is proposed, to be chaired by the home supervisor of the intermediary in question.

  • A group level resolution authority would determine whether resolution at the level of the group or on a national basis should be undertaken.

2.4 Complementary Macroeconomic Coordination Changes

The shockwaves from the Greek crisis have impelled the EU towards comprehensive reforms of policy coordination aimed at assuring macroeconomic stability, which will fundamentally change the governance of the EU economy. These have been through their main legislative procedures and are now being put into operation. The main elements of these reforms include

  • Improving surveillance of Member State fiscal positions (including a somewhat beefed-up Stability and Growth Pact which will add a debt criterion as well as the current deficit one)

  • The introduction of a process for assessing excessive imbalances that could result in instability, such as asset bubbles, risky developments in competitiveness or rigidities on the supply-side

  • Greater oversight by the EU level, through a two-semester system, in which the first semester in national budgets is “European”, allowing scrutiny and coherence, then the second is national

  • A requirement to introduce national fiscal frameworks that assure better disciplined fiscal policy

  • More effective sanctions.

There has also been agreement to put in place a permanent crisis management mechanism to replace the ad hoc responses that were cobbled together in dealing with the Greek and Irish bailouts, enacted via a limited treaty reform.

3 The Challenges and Next Stages

The regulatory and governance frameworks affecting the financial sector, financial stability and macroeconomic management are all shifting rapidly in Europe and there is an evident sense of urgency about completing the reforms. Indeed, in its February 2011 progress report on Regulating Financial Services for Sustainable Growth, the European Commission stresses the importance of rapid adoption of its extensive legislative package and states that it expects all the proposals in the package to enter into force early in 2013. The latest major proposal is for a reform of the EU Directive (MIFID) covering securities markets and products, with a draft having been published in October 2011. According to the European Commission, adoption of this legislation will mean that the EU will be quite closely aligned with the US system following the Dodd Frank Act. More fundamentally, proposals made during 2012 for a ‘banking union’ are now making progress, and plans are now on the table for a significant EU level role, led by the ECB, in prudential supervision.

The new supervisory system introduced from the beginning of 2011 has to contend both with a volatile (and still risky) environment, and with the fact that Europe’s institutional complexity and political constraints restrict the scope for radical change. It is also arguable that after the bank rescues of 2008/9, EU governments have far less room for manoeuvre: the European Commission (2010a) asserts that public aid committed to financial rescues was 30% of EU GDP, of which 13 percentage points were used.

Nevertheless, the new architecture for governance is being gradually put in place and an assessment of its prospects can be attempted. It undoubtedly addresses many of the shortcomings of the previous system, notably by acknowledging the imperative of more effective and disciplined coordination, both between Member States and across policy domains. There is also growing evidence that inadequate compliance with agreed rules and a cavalier attitude to commitments can no longer be tolerated if future trouble is to be avoided.

3.1 Accommodating Different Interests

Even so, the outcome is, as is so often the case in Europe, a delicate compromise between competing interests and preferences. Members States generally agree on many of the broad aims, such as enhancing financial stability or having a system of macroeconomic surveillance that is better at preventing the emergence of imbalances, but will disagree on details. These disagreements stem, on the one hand, from genuine differences in philosophies of regulation, such as how much reliance to place on the market in disciplining financial intermediaries or, indeed, governments. A prominent German politician, for example, characterised private equity as “locusts” and there is an enduring suspicion of free-wheeling finance in France.

On the other, there are long-standing rivalries and competitive considerations to take into account. Thus, London’s pre-eminence as a financial centre in Europe is a prize that Paris and Frankfurt would like to wrest away. For the City of London, heavier regulation of some segments of the financial sector (hedge funds or private equity, for instance) would be counter-productive not only because it would be potentially damaging to an important source of activity, but also because it would leave a gap in the market that might be filled by competitors outside Europe.

The debate around a FTT is a good example of an issue that has shown an ability to polarise opinion, with strong positions being adopted in favour of an EU level FTT (France and Germany) and opposition from the UK. Such a tax has also been proposed by the European Commission (2011a) as a solution to the perennial problem of identifying a genuine “own resource” to fund the EU budget. Protagonists of FTT see it as a desirable rebalancing of taxation that will extract revenue from a sector which is under-taxed, and may also help to curb excessive speculation. Opponents worry that it is not a well-conceived tax, as it would be easily avoided unless imposed at global level and would risk a fall in yield if it succeeded in deterring speculation. It could, therefore be seen, in effect, as a form of political grandstanding, though clearly one capable of generating considerable acrimony, despite it being of relatively minor economic significance (its yield might be around one quarter to one half of a percentage point of EU GDP). A minority of EU countries agreed early in 2013 to proceed with an FTT.

3.2 The Role of the ECB

A sensitive issue for financial regulation is what the precise role of the European Central Bank should be. The House of Lords (2009, p 38) reports that most of the witnesses it heard from “agreed that the ECB should play a role in macro-prudential supervision, although there was much disagreement over its precise role. Mr Trichet, President of the ECB, argued that the ECB should play a strong role in EU macro-prudential supervision. He argued that macro-prudential supervision would be a ‘natural extension’ of the ECB’s mandate, given that the ECB already undertakes monitoring and analysis of financial stability. He went on to argue that central banks had the best access to supervisory information that is necessary for financial stability assessments. He concluded that the ECB ‘stands ready’ to perform additional macroprudential supervisory tasks”.

Latterly, there have been disputes about the role the ECB should play in both crisis management and in the longer term economic and financial governance or the euro area, amid reports of divisions on the ECB’s Governing Council. The resignations of two German members,Footnote 4in particular, was widely interpreted as a sign of dissent inside the ECB, and chimed with wider German unease. France, by contrast, has pushed for the ECB to act decisively as the lender of last resort to banks and (even if still indirectly, to respect constitutional niceties) to sovereigns, an orientation that has at least partly been satisfied by the announcement in September 2012 of plans for outright monetary transactions.

Objections to a more extensive regulatory role for the ECB range from whether it has sufficient capabilities in the area to whether it should concentrate on its core mandate of assuring price stability. Buiter (2006), for example believes that the supervisor function and the lender of last resort function require different forms of accountability and greater political oversight. He is also adamant that there is no case for the ECB being assigned the leading role in euro area-level prudential supervision that it wanted to acquire, yet is sympathetic to the idea that there should be an EU-wide (as opposed to just euro area) supervisor. In the proposals for banking union, it has nevertheless been accepted that the ECB should have a core role in supervision, staring with the largest banks. Whether this should then extend to all 6,000 banks in the EU is an issue that divides the member States.

In addition, there is an evident political problem around the ECB, which stems form the difference in membership between the euro area and the ECB. Countries to which the ECB is not so directly accountable (certainly the UK) would be uncomfortable with assigning it greater powers, although it is worth noting that there is an enabling clause in the Treaty (Art. 127.6, TFEU) which states:

The Council, acting by means of regulations in accordance with a special legislative procedure, may unanimously, and after consulting the European Parliament and the European Central Bank, confer specific tasks upon the European Central Bank concerning policies relating to the prudential supervision of credit institutions and other financial institutions with the exception of insurance undertakings.

What is intriguing about this article, which has not changed substantively from its predecessor version in the Maastricht Treaty (and thus from 20 years ago) is that only the ECB is mentioned in this context, but also the exclusion of insurance. With many member states having moved towards integrated supervision of the different segments of the financial sector (see Begg 2009), there is a prospect of institutional confusion. One possible solution, for example in relation to resolution of failing banks and the oversight of the ESRB is to exploit the fact that the ECB has two separate governance bodies: the 23 member (six Executive Board members and the 17 euro area central Bank Governors) Governing Council which is the main decision-taking body and which decides on monetary policy, and the General Council which comprises the governors of all 27 EU Member States. The latter can provide a way round some of the objections.

3.3 Unfinished Business

On of the more pressing concerns at present is how best to structure crisis management and resolution procedures. The “Greek” crisis was a costly wake-up call for Europe’s leaders and the fact that it was still rumbling on, with ever more costly packages under discussion, well into 2012, with Cyprus and (to a lesser degree) Spain also seeking financial support, emphasised how severe it had become. As noted above, it showed that financial stability and fiscal policy were far more intimately linked than had been presumed, A disorderly default on its sovereign debt by Greece would immediately have triggered systemic threats to Europe’s banking system. Exhibiting the opposite chain of causality, Ireland’s banking crisis very rapidly metamorphosed into a sovereign debt problem, and the position in other Member States such as Portugal has elements of both phenomena. But as the tensions of 2011 and 2012 showed, Europe has struggled to find timely and effective answers.

Having finally conceded the principle that private holders of Greek bonds should take a large haircut on existing debt, a major dilemma in Europe today is the extent to which the financial sector should share in any future crisis resolution mechanism. Following an agreement concocted at Deauville in October 2010, the French and German governments made clear that future bailouts could not rely on the state alone, and must entail some loss for bond-holders. In a medium- to longer-term perspective, this is undoubtedly the correct answer, but there is also little doubt that the announcement rapidly triggered bond market volatility that was only calmed down when Ireland was pushed to accept a bailout.

Euro-bonds of some description also elicit divergent views. There is an attractive interpretation in which, by pooling risk, a bond backed by the entire euro area will be much sounder than the average of the bonds of individual Member States. Just as a US Treasury bond is regarded as sounder than individual state bonds, this would appear to offer an alluring solution for funding debt in euro area countries. However, there are two major obstacles. First, the coupon on a euro bond is likely to be higher than has to be paid by the most credit-worthy governments—traditionally Germany—and would thus penalise the most disciplined Member States while giving a free (or freer) ride to the least disciplined. Leading German politicians have, so far, opposed the creation of such a bond precisely on the grounds that it would remove one of the incentives for the more reckless governments to adopt sound budgetary policies. This can be viewed as a moral hazard problem.

Second, the fact that there is no European (or even euro area) tax-payer means that there is an uncertainty about where ultimate responsibility for redeeming a euro bond would lie in bad times. The answer lies in mutualising the debt obligations through joint and several guarantees which, if called, would mean that any Member State would be liable not only for its own share, but potentially the total liability. Only Germany, in practice, could pay. It is not particularly hard to imagine a differentiated burden depending on the extent to which a Member State draws on the funding pool.Footnote 5But the challenge is how to design a euro bond that will be sufficiently resilient to crisis, as opposed to normal times, yet have sufficiently robust conditions attached to it to deter unsafe borrowing by weaker sovereigns.

The European Commission (2011b) has now published a discussion paper about options, and makes a rather crass attempt to forestall German antagonism by eschewing the term Eurobonds in favour of “Stability bonds”. While the label is unlikely to fool anyone, the paper has the merit of putting the issue firmly on the table, forcing Germany, the Netherlands and other net creditor Member States to explain why it will not work.

4 Conclusions

The pace of financial reform in Europe at present is both frenetic and wide-ranging. It can reasonably be expected to result in extensive changes in how the financial sector is regulated, as well as in the nature of the connections between the sector and the real economy and the sector and the state. There is a strong sense in Europe that finance owes everyone else “reparations” for the damage it has inflicted and that “never again” should be a watchword to guide policy. It is also clear that enduring solutions must be found to problems such as: “too big to fail”; the excessive, ostentatious rent-seeking exemplified by the bonus culture; and the cavalier attitudes to risk that have been exposed.

The lack of a European tax-payer severely constrains what might be envisaged as a European approach, with the consequence that optimal solutions—especially if they involve assignment of powers to the EU level—are often out of reach, irrespective of constitutional or political objections. A statement by the UK FSA to the House of Lords inquiry underlines the point: “until the EU has fiscal powers which permit it to raise the funds needed to rescue distressed banks, or until there is a system of mandatory burden sharing between Member States for fiscal support, supervision will and should remain the responsibility of Member States”.

The elaboration of a new approach to financial regulation is not, however, occurring in isolation, and much of the reform effort in the last year has been devoted to recasting the broader governance architecture within which finance functions. This is partly complete and promises to constitute a more effective means of preventing future problems by reducing the risk and likely extent of financial instability. But before then Europe has to navigate its way out of the present crisis and, although the latest initiatives to put in place a banking union and to deepen political integration offer promise, the challenges remain formidable. For the EU and the euro area these are undoubtedly tricky times.