The reforms in the EU’s economic and financial governance structure in response to the Euro crisis have been put to the test by the Coronavirus pandemic. While the resurfacing of the sovereign debt crisis has highlighted the inadequacies of the Union’s fiscal policy reforms, the relative stability of the banking system so far hints at a partial success of the banking union. Philipp Lausberg argues that the EU recovery fund is a step in the right direction, while a completion of the banking union needs priority to prevent a banking crisis should the EU face a post-pandemic recession period.
The Coronavirus crisis as a replay of the Euro crisis?
For many, the last few months came as a replay of events lying back 10 years ago, as the Coronavirus pandemic and its economic implications have raised the spectre of a renewed Euro crisis. Sovereign bond spreads in Italy, Spain and other highly indebted southern Eurozone countries rose sharply, as doubts in their ability to pay back their debts was fuelled by fear of a new recession. Bond yields could be stabilised by European Central Bank (ECB) bond buying for now. But most experts agree that some form of resource sharing is needed to save the Euro in the longer run. This reignited the debate on Eurobonds and recreated the old perceived fault-lines of frugal northern creditor states versus overspending southern debtor states.
But while the focus has been on fiscal and monetary policy, the main culprit of the last crisis has so far not made any headlines – the banks. Financial institutions across the Eurozone have remained remarkably stable despite the heavy shock hitting the economy because of the lockdown measures. Nicolas Véron has suggested that the introduction of a Banking Union is a major reason for this. My doctoral research confirms that reforms in banking policy introduced in response to the last Eurozone crisis are relatively successful compared to reforms in the fiscal sphere.
Fiscal policy: Inadequate reforms after the Eurozone crisis
The EU’s fiscal policy response to the Eurozone crisis had two main elements: the European Stability Mechanism (ESM), which is a permanent, 500 billion Euro rescue fund to assist Eurozone states threatened by default, and the strengthening of EU budget rules. Apart from providing help for countries with acute solvency issues, this was to create trust in the financial markets, avoiding sovereign defaults, that is, governments failing to pay back their debt. The Stability and Growth Pact (SGP) based on a 3 per cent deficit and a 60 per cent debt limit for EU member states was bolstered by heightened surveillance through the European semester (six-pack) and facilitated rule enforcement by anchoring fiscal discipline in national constitutions (fiscal compact).
But the strengthened SGP has had a mixed record. Its rules kept being broken and none of the offenders were fined. This did not help to increase trust in the financial markets in the EU’s economic and monetary union. While southern EU countries’ efforts to save have been impressive, this was not enough to rise from debt levels as high as 135 per cent in Italy or 176 per cent in Greece. Thus, the vulnerability of some Euro states’ finances has remained high despite the reforms.
Once the Coronavirus crisis hit, the trust of the financial markets quickly dissipated, as doubts on the sustainability of Italian debt resurfaced. The ESM’s 500 billion lending capacity was clearly not enough to guarantee the solvency of a country like Italy with debt almost five times that amount. Like in the Eurozone crisis, it was the ECB that had to save the day through sovereign bond purchases.
Need for a larger recovery fund
What is needed now is a much larger common fiscal instrument based on real burden sharing. Otherwise it will be impossible for indebted southern countries to cope with their debt loads and to save the Euro. The European Council agreement on a 750 billion recovery fund, fully financed by EU-issued debt, of which 390 billion are based on grants rather than loans is a step in the right direction. But the volume of this fund and especially its grant segment should be increased significantly to ensure the stability of Eurozone finances in the long run.
While the weak link in the Coronavirus crisis has been member-state finances, banks have so far proven to be resilient, much due to reforms introduced after the Euro crisis.
Banking policy: Effective supervision but unfinished banking union
The Eurozone crisis had its origins mainly in an under-regulated banking sector. Without strict European regulation, individual states often allowed their banks to engage in risky operations to be able to compete globally. After the collapse of Lehmann Brothers in 2008, overextended banks crashed or had to be bailed out all over the Eurozone. The subsequent debt crisis in the Eurozone periphery was primarily a result of states incurring too much debt while trying to save their banks.
The Banking Union was to remedy this fateful embrace between state finances and banks, and prevent risky banking operations in the future. The Banking Union’s first pillar, a single supervisory mechanism based on the ECB was equipped with the necessary powers to assert common rules for Eurozone banks. This has largely been a success. Unlike the toothless fiscal rules, capital requirements were enforced on Europe’s systemically important banks. By 2020, capital buffers have starkly increased and non-performing loans have more than halved, making banks significantly more resilient than they were before the Eurozone crisis. This can help explain the relatively good performance of financial institutions during the Coronavirus crisis so far.
Completing the Banking Union
But this positive performance might be compromised if a prolonged recession will lead to a spike in corporate bankruptcies and loan defaults that could eat away capital buffers and drive major banks into ruin. The Banking Union’s Single Resolution Mechanism so far only holds a single resolution fund of 55 billion Euro. This is only enough to help ensure orderly resolutions of one or two systemic banks and thus prevent contagion to other banks and the need for bailouts by Eurozone states. Especially since the fund has not yet been backed up by a larger fund like the ESM, as initially planned. The lack of the Banking Union’s third pillar, a European deposit insurance is equally worrying. The European bank recovery and resolution directive prescribes that some loans of a failing bank are left to default (bail-ins) to prevent costly bailouts and assert market discipline. Without a credible insurance of deposits, this could cause depositors to withdraw their money in a bank run which would threaten the entire financial system.
It is therefore imperative to complete and strengthen the Banking Union. As this involves large-scale sharing of resources among member states and their banks, this is however unlikely to happen soon without the pressure of a major banking crisis. Ironically, it is precisely the lack of a completed banking union that could cause this crisis and ultimately push policy makers to make the necessary institutional reforms.