Europe seems to be gradually shedding the long-held tenets and taboos of its post-war, rules-based liberal order. National borders are closing. Personal liberties are being curtailed. Governments are ruling by decree, with hasty rubber-stamping by deserted parliaments. Fiscal limits are being overstepped.
Few noticed when, days ago, the European Union suspended its stability pact and Germany approved a mammoth budget deficit plan. The European Central Bank has launched a massive monetary attack using all its instruments, and made no secret of its readiness to trespass its ‘red lines’ on which and how many assets it can buy.
This is exactly what should happen. Against a fearsome and unknown enemy, the sensible strategy is to overwhelm by speed and size. This applies to health and the economy. ‘Whatever it takes’ in present circumstances means, ‘More than what is sufficient’. Acting quickly and boldly is of the essence.
The only exception to the prevailing war-like approach is banking regulation. This is surprising. Banks provide financial oxygen to the economy. Not even the ECB’s big bazooka can work properly if banks cease to function or fail on a massive scale. Yet this is precisely the risk the euro area faces, if a real economy in freefall – as it will be for the foreseeable future – results in a surge of credit defaults and massive losses on market exposures. The latter has already occurred; the former is a virtual certainty.
Regulators – the EU, national governments, law-makers and supervisors – must act decisively and urgently to block this doom scenario. Following a logic applied in other areas – from labour markets to corporate subsidies – the goal should be to ensure that banks overcome the critical phase relatively unscathed. Normal prudential rules therefore should not apply to the effects of the virus on their balance sheets. These should instead be offset with public support – capital injections, guarantees, and for what is left, supervisory forbearance. The attack needs conducting on three fronts: bank assets, bank liabilities and bank governance.
On the asset side, ECB supervisors have promised ‘to allow banks to fully benefit from guarantees and moratoriums put in place by public authorities’. However commendable, this intention places responsibility at the feet of national authorities – not all of which are willing or able to play their part.
The Italian budget package approved last week, dubbed ‘cura Italia’ (‘cure Italy’), contains no mention of such guarantees. It concentrates – understandably given local conditions – on supporting families and the health and other priority sectors. In contrast, Germany has earmarked €400bn for corporate loan guarantees. As currently set, the combination of conditional forbearance by the ECB and wide differences across borders risks increasing bank fragmentation and penalising ‘southern front’ countries which are hit hardest by the virus.
Protecting the liability side requires propping up both funding and capital. The actions undertaken by the ECB through its long-term and conditional open market operations aim to keep funding sources open. Their effect, however, depends on banks having enough ‘adequate’ collateral – a requirement set in the EU treaty. The availability of such collateral is likely to be highly asymmetric, exacerbating the aforementioned fragmentation.
Capital will also become a constraint. ECB supervisors have pledged leniency in administering their Pillar 2 Guidance, but P2G is only a small fraction of the overall capital requirement. European law contains no escape clauses to reduce capital obligations in case of emergency or downturn. The only flexibility lies in the so-called macro-prudential buffers, which unfortunately were barely raised during the preceding cyclical upturn. At the present juncture, the much-needed capital flexibility can only come either from a suspension or deferment of existing legal capital requirements, or from injections of capital by the public sector, banned under EU state aid rules. But this was not one of the virus-related relief measures featured in the ‘temporary framework’ presented on 17 March by European Commission Executive Vice-President Margrethe Vestager.
The suspension of prudential norms, asset guarantees, and public ownership, all needed under present circumstances, would bring the euro area’s banking framework for a limited but indefinite period close to wartime conditions. Restrictions in certain bank managerial decisions would be inevitable, particularly in the distribution of bonuses and dividends, as recommended by the Systemic Risk Council. Intervention in other areas on a temporary basis may also ensue. While free market diehards may turn up their nose, this is probably a lesser evil. The return to normality we all crave requires, with other things, also that banks be saved. That cannot happen without adequate regulation and public support.
Ignazio Angeloni is Senior Fellow at the Harvard Kennedy School and former member of the European Central Bank Supervisory Board.