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SPEECH/10/701

Olli Rehn

European Commissioner for Economic and Monetary Affairs

Next steps for securing Financial Stability in Europe

Reducing Systemic Risk in the Financial System – Conference organised by the AFME, Association for Financial Markets in Europe

Brussels, 30 November 2010

Ladies and Gentlemen,

Thank you very much for the invitation to speak on the next steps to secure financial stability in Europe. Let me first take a quick look into the past and present developments in the field before addressing the next steps to be taken.

During last decade, economic divergences were built up among EU member states. Some saw domestic demand thriving with credit booms and increasing wages and prices, harming competitiveness. Other countries experienced slow growth in domestic demand while gaining competitiveness through falling relative costs vis-à-vis their competitors.

To some extent, this reflected the normal functioning of the globalised and integrating EU economy, as some member states are catching up. For this purpose, the euro allowed better access to international capital markets. But neither markets nor politics provided the necessary discipline to prevent the accumulation of harmful imbalances.

Those divergences were at a peak when the financial crisis struck in 2008. The financial sector could not absorb the risks it had taken, which now materialised in a downward spiral, making it impossible to unwind the economic imbalances slowly and orderly. As a result, major financial risks materialised, with seriously damaging ramifications on the real economy and public finances.

This is particularly the case for Ireland, whose public debt was very low before the crisis. Last week, Ireland requested assistance form the European financial backstops.

On Sunday, a decision was made to provide such assistance accompanied by a three-pillar programme: by a comprehensive overhaul of the banking system; by restoring fiscal sustainability and correction of the excessive deficit by 2015; and by growth enhancing structural reforms.

Moreover, the crisis hit particularly hard those countries whose public finances were not in a good shape, and where there was the pressing need for structural reform. This is the case for Greece. In agreement with the EU and IMF, Greece is now taking unprecendented steps on economic reform.

Ladies and Gentlemen,

Our economies are linked through the single market. Without question, the single market is the foundation for growth and prosperity in the EU. But also the excessive imbalances in the EU have been financed through the integrated financial market, and the shockwaves from the sudden burst of these bubbles are travelling back through the very same channel.

This is why the integrated capital market requires an integrated approach to financial regulation and supervision. In this respect, the report recently published by the AFME on Prevention and Cure: Securing Financial Stability after the Crisis raises the right kind of issues.

Take regulation. I refer here to the proposals of the Basel Committee, which aim to enhance capital and liquidity regulation to improve loss-absorption capacity and increase resilience of the financial sector to shocks, and to mitigate the pro-cyclicality of bank capital standards.

As you know, the G20 in the Seoul Summit some weeks ago endorsed the new capital and liquidity requirements for the banking sector. Banks should shore up higher and better regulatory capital, and strengthen liquidity buffers. Problems related to the interconnectedness are addressed, for instance, through central clearing and specific approaches on systemically important institutions.

Up to this point, I think there is a consensus between the financial industry and policymakers. Financial stability is a common good. Everybody stands to benefit from better standards.

However, some voices in industry seem to have apocalyptic views about the costs of higher equity capital, and they warn of increased lending cost and a reduction in credit supply to the economy.

I can respond to these warnings. I have four responses.

First, if you have a lot of debt, that makes each euro of equity very risky, because the creditors are first to be paid from the bank's revenues. If the debt level is high, shareholders want a high risk premium. Reducing leverage from high levels (by putting in more equity capital) should reduce the required risk premium.

Second, higher equity capital can also lower the cost of debt funding. The debate around the stress tests illustrates this well. What the market now demands from banks in order to provide debt funding to them, are capital ratios above the regulatory limits. In other words, reducing leverage by injecting equity lowers the risk to the bank's creditors and gives the bank better (less costly) access to funding.

Both arguments remind us that the debate should look at the total cost of funding, not only at the cost of equity capital. – If someone notices in these arguments a certain resemblance to the Modigliani-Miller theorem, I don’t mind at all!

These arguments seem to have been considered in the quantitative impact assessment done by the Basel Committee, confirmed by our own calculations, which points to a rather moderate impact on lending cost.

Third, the social cost of high leverage – that is, the too low levels of equity capital – has surfaced in the present crisis and needs to be part of any cost comparison.

Fourth, there are transitional periods. New capital does not have to be raised at once. Some new regulatory measures will have a phase-in period to see how they perform.

The new rules need to be enforced uniformly and risks to be early identified. Therefore, the EU has implemented the new European System of Financial Supervision.

The new micro-prudential European Supervisory Authorities (ESAs) will improve coherence and credibility of regulation and supervision of individual entities. And although I think that the July stress tests provided much useful information, it is good that the European Banking Authority has been given the powers to coordinate EU-wide stress-tests, which should enable a more coherent and rigorous conduct of them.

However, the crisis is not only the consequence of the failure of systemically important institutions. Rather, vulnerable financial positions have been accumulated across the highly interconnected economy, including in the non-financial sector that has borrowed from the financial institutions. Therefore, in order to reduce systemic risk, you have to look at the system. It sounds trivial, but this was not done before.

For such macro-prudential analysis we have established the European Systemic Risk Board (ESRB). Its role will be to identify and assess risks, and issue warnings and recommendations for remedial action. The warnings and recommendations can be addressed to the Union as a whole, to individual Member States, and to supervisory authorities. The identification of emergency situations is important also because, if confirmed by the Council, the micro-prudential authorities have some more direct powers.

The ESRB thus commands mostly "soft" power, but its importance should certainly not be underestimated.

What remains to be done?

We are working on a framework for crisis management and on rules for the resolution of financial institutions, to the extent that enhanced regulation and supervision cannot be expected to prevent all future crises.

I note with pleasure that the AFME report has put forth proposals on the recovery and resolution of financial institutions. These are indeed very welcome.

But as we all know, major financial crises affect sovereign borrowers as well. Therefore, the necessary backstops at EU level were established to address system-wide crises.

These financial backstops established in May are temporary. On Sunday, the the Eurogroup agreed on the principles and features of the European Stability Mechanism (ESM), based on a proposal made by the Commission in close cooperation with President Herman van Rompuy.

The key principles and features of the ESM are as follows:

First, its financing will be based on the principles of the current EFSF.

Second, the participation of private sector creditors will be decided case-by-case, fully in line with the IMF rules.

Third, a distinction is made between liquidity and solvency problems, based on the debt sustainability analysis done by the Commission and the IMF in liaison with the ECB.

Forth, to facilitate the process of negotiations between the creditors and the debtor country, standardized and identical collective action clauses will be included in all new euro area government bonds as of June 2013.

Let me repeat once more that private sector involvement in the resolution of sovereign debt problems will not apply before the new system will be in place as of mid-2013.

Ladies and Gentlemen,

Before concluding, let me say that in the current market climate, some facts seem to get lost in the prevailing nervousness. First: No EU sovereign has defaulted on its debt. Instead, the EU Member States have put up massive resources to back up any Member State facing liquidity problems. Furthermore, there is a strong political will in all countries concerned to bring the houses in order. The most affected countries are going through unprecedented reforms.

Our proposals on financial regulation, prepared by my colleague Michel Barnier, have all been subject to extensive public consultation. I have heard from many market participants that the EU took a careful, transparent and constructive approach to the reform. There were no sudden surprises. This is the best proof that politicians do spend much effort in understanding the markets, of course without losing sight of the interests of society as a whole.

Ladies and Gentlemen,

To wind up, I trust that the market forces do appreciate the fact that, while correcting market failures, we are in parallel addressing the policy failures of the crisis. I am confident that, by next summer, the new system of reinforced economic governance will be in force, which will include a seriously more robust Stability and Growth Pact and an effective toolbox to correct macroeconomic imbalances.

This matters to all, including the financial industry, since as we have learnt, the resilience of the financial system cannot be separated from the soundness of the fiscal balances.

These are the reforms of financial and economic architecture needed to make the Economic and Monetary Union function properly, in line with the rules-based market economy, which is the essence of the European societal model.

If the 1990s was the decade of constructing the EMU and the 2000s the decade of turning it into a reality, we are now in the beginning of the decade of its fundamental reform.

These reforms will supplement the monetary union by finally creating a real and functional economic union.

It is indeed high time to do so, if we want to create a solid foundation for the euro, and thus for European integration.

Thank you for your attention.


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