EU as a Framework for National Governments ’ Intervention

23 March 2009 - Bruegel

The Future Face of Europe’s Financial System

1

EU as a Framework for National Governments’ Intervention

Vitor Gaspar(with Joep Konings)

Bureau of Economic Policy Advisers, European Commission

Workshop on The Future Face of Europe’s Financial System, Bruegel, 23 – 24 March 2009

http://images.google.lu/imgres?imgurl=http://www.euro.cauce.org/images/flags/eu-flag.gif&imgrefurl=http://www.euro.cauce.org/en/countries.html&h=349&w=519&sz=4&hl=en&start=3&um=1&tbnid=tIl_Su9kO7IeFM:&tbnh=88&tbnw=131&prev=/images%3Fq%3DEuropean%2Bunion%26um%3D1%26hl%3Den%26lr%3Dlang_en%26sa%3DN



2

Disclaimer

The views expressed are my own and do not necessarily reflect those of the

European Commission



3

Introduction and Motivation

• Global crisis and many policy responses:– Central bank’s liquidity provision and

aggressive lowering of interest rates;– Extension of guarantees on banks’ liabilities.– Capital injections and (in some cases) state-

control– Treatment of impaired assets.– Discretionary fiscal stimulus.– A review of the regulatory and supervisory

framework in Europe



4

In this presentation I concentrate on:

• Global crisis and many policy responses:– Central bank’s liquidity provision and aggressive lowering of

interest rates;

– Extension of guarantees on banks’ liabilities.

– Capital injections and (in some cases) state-control

– Treatment of impaired assets.– Discretionary fiscal stimulus.

– Regulatory & Supervisory Framework.



5

Outline

• A/ Common framework for public intervention: linking gains of co-operation to spillovers

• B/ Single Market: Functioning of competition and State Aid Rules Example: Using the banking crisis to illustrate the risk of

negative spillovers and the need for co-ordinated action in the context of the internal market

• C/ A new EU framework for crisis prevention and crisis management



6

A/ Common framework for public intervention: linking gains of co-operation to spillovers

(Berrigan, Gaspar, Pearson, 2008)

• Coase Theorem as a benchmark to identify the gains from co-operation:

In an environment with perfect information, well-defined property rights an costly bargaining:

- Private provision of public goods is not pareto efficient in case of non-cooperative interactions (Nash).

- inefficient as individuals do not take into account the externality to other economic agents

- Pareto-improved outcomes can be achieved through collective action (bargaining; co-ordination)



7

-Let the units of public good that individual i contibutes to the provision of the public good be denoted by - Individuals have preferences for the public good and one private good

2,1, iq i



8

Relevance of this framework in the EU context

• Across the border spillovers as a result of public intervention are much clearer when they materialize in the areas in which the European Union has core competence, such as aspects related to the working of the internal market, including regulation and supervision.

• In times of crises conditions of the Coase theorem are not met (e.g. costless bargaining, symmetric information,…) and therefore there is increased pressure for decentralised and uncoordinated actions.

• Legal framework of the internal market is therefore a very powerful tool: Member States have delegated authority to the European Commission to have legally binding procedures governing the working of the internal market.

• These legal and binding procedures have fostered the working of the internal market to the benefit of market integration, which in turn has forced further political integration.



9

B/ Single Market: Functioning of competition and State Aid Rules – key features

Internalising negative spilloversState aids rules are designed to prevent un-coordinated government

interventions to interfere with the functioning of the Single Market and also to improve the effectiveness of public intervention.

Proportionality,non-discriminatory and conditionality of the measuresThe EU framework guarantees that measures taken by Member States

comply with the key principles in state aid rules

Reconciling short term imperatives with longer term considerationsDesign of the intervention of the intervention should reconcile short

term imperatives (safeguarding financial stability, underpinning bank lending) with longer term considerations (avoiding fragmentation of the Single Market, distortion of competition, emergence of a structurally weak banking sector, unsustainable public finances)



10

Example: The Banking Sector

• EC provided (ex-ante) guidelines on the application of State aid rules to measures taken in relation to financial institutions in the context of the current global financial crisis.

• Guidelines on six classes of measures since the start of the crisis (Com 2008/C 270/02):

Guarantees covering the liabilities of financial institutions Recapitalisation of financial institutions Controlled winding-up of financial institutions Provision of other forms of liquidity assistance Rapid treatment of state investigations Treatment of impaired assets



11

Key features of guidelines common across measures (background)

- Non discriminatory coverage (to avoid undue distortive effects on neighbouring markets and the internal market as a whole)

- Minimum private sector contribution (fees charged for the provision of the scheme should come as close as possilbe to that could be considered a market price)

- Temporal scope

- Behavioural commitments to avoid distortions of competition (including compulsory restructuring plans)



12

Background: Communication (2008/C 270/02) :The application of State aid rules to measures taken in

relation to financial institutions in the context of the current global financial crisis

• Article 87(3)(b) of the Treaty the Commission may allow State aid "to remedy a serious disturbance in the economy of a Member State". In the present circumstances: legal basis for aid measures undertaken to address this systemic crisis.

• general support measures have to be:

- well-targeted in order to be able to achieve effectively the objective of remedying a serious disturbance in the economy,

- proportionate to the challenge faced, not going beyond what is required to attain this effect, and

- designed in such a way as to minimize negative spill-over effects on competitors, other sectors and other Member States.



13

Background: Communication (2008/C 270/02), contd. Guarantees covering the liabilities of financial

institutions eligibility: non-discriminatory so as to avoid undue distortive effects on

neighbouring markets and the internal market as a whole types of liabilities covered: mainly depositors’ guarantees to avoid

bank runs and contamination Temporal scope of guarantee scheme Aid limited to minimum-private sector contribution: fees charged for

the provision of the scheme should come as close as possilbe to that could be considered a market price.

Avoidance of distortions of competition: negative effects on non-beneficiary banks must be avoided by:- behavioural constraints- restrictions on commercial conduct (e.g. advertising using guarantee status)- prohibitions of conduct incompatable with the purpose of the guarantee scheme (e.g. new stock options for management)



14

Background: Communication (2008/C 270/02), contd.Recapitalisation of Financial Institutions

• Used to support financial institutions that are fundamentally sound but may experience distress because of extreme conditions in financial markets strengthen capital base to avoid negative systemic spillovers.

• considerations in relation to general guarantee schemes apply, mutatis mutandis, also to recapitalisation schemes.

• The particular nature of a recapitalisation measure gives rise to the following considerations:- objective criteria, to avoid unjustified discriminatory treatment- minimal capital injection and must include private participation- Member State concerned should, in principle, receive rights, the value of which corresponds to their contribution to the recapitalisation + consider claw back mechanisms or better fortunes clauses



15

Background: Communication (2008/C 270/02), contd.Controlled winding up of financial institutions

• considerations in relation to general guarantee schemes apply, mutatis mutandis

• Other considerations:- Minimise moral hazard, notably by excluding shareholders and

possibly certain types of creditors from receiving the benefit of any aid

- Liquidation phase should be limited to the period strictly necessary for the orderly winding-up to avoid competitive distortions

- Sales process should be open and non-discriminatory- Sale should take place on market terms- Maximise sales price for the assets and liabilities involved



16

Background: Communication (2008/C 270/02), contd.Provision of other forms of liquidity assistance

• Provision of central banks’ funds to finanicial institutions are not considered as aid when:

- The financial institutions is solvent at the moment of the liquidity provision

- Fully secured by collateral- Central bank charges a penal interest rate to the beneficiary- Measure is taken by the central bank’s own initiative



17

Most member states appealed to the revised guidelines on timely and coordinated state aid in the financial sector since

last September

Total number of cases of state aid for the financial sector, by country

AS

BEDK

FI

F

DE

HU IRIT LV NL

PT

SI ESSW

UK

0123456789

10

Total per country



18

The Irish banking crisis triggered the awareness among the member states to have a co-ordinated response across Europe, given the potentially large negative spillovers undermining the working of the internal market

Total number of cases of state aid for the financial sector

02468

10121416

month that the Commission adopted the decision



19

Economic Rational for Co-ordinated Intervention: Internalising negative spillovers

1. Guarantees covering the liabilities of financial institutions:

In volatile markets, need to reassure depositors that they will not suffer losses and therefore to avoid bank runs.

Potential negative spillovers:

- Bank run can cause contamination of healthy banks

- If decentralised and uncoordinated national measures are taken, increased risk of a disturbing impact on deposit shifting from non- beneficiary banks to beneficiary banks (e.g. Irish case). Deposit shifting has the effect of contaminating healthy banks in neigbouring countries



20

2. Recapitalisation of Financial Institutions

Financial sound institutions may experience distress because of extreme conditions in financial markets (falling asset prices, deposit runs, etc.)

Potential negative spillovers:

- When the compensation scheme does not reflect market prices, banks in other member countries not benefiting from the capital injection are put at a disadvantage.

- Irreversible nature of capital injections can trigger in a later stage expansion of the beneficiary bank at the expense of non- beneficiary banks in the same or other countries



21

3. Treatment of impaired assets

Reducing uncertainty about exposure of banks to financial losses is key to restoring investor confidence (resolving the information problem!)

Impaired asset relief is required to get credit markets functioning again

Potential negative spillover:

Introducing asset relief measures by a first-mover Member State results in pressure on other member states to follow suit, risking a subsidy race between Member States



22

C/ Towards a new EU framework for crisis prevention and crisis management

• To have an efficient internal market in financial markets, there is a need for further procedural agreement between the Member States

• de Larosière group formulates recommendations towards (i) a new regulatory agenda, (ii) stronger coordinated supervision and (iii) effective crisis management procedures

• In particular: European System of Financial Supervision (ESFS)

create a network of EU financial supervisors, based on the principle of partnership, cooperation and strong coordination at the centre

European Systemic Risk Council (ESRC)decide on macro-prudential policy, provide early risk warnings to EU supervisors, compare observations on macro-economic and prudential developments and give direction on these issues.



23

Important Role for the EU in achieving global solutions

• Solutions at the European level can only have full effect if they are part of a global effort to improve stability

• Benefits of openness, non-protectionism and the internal market have been clear in the past

• Financial system is global, so the EU must work also with third countries to foster global co-ordination and to obtain the best regulatory framework.

• G20 initiative is essential to enhance regulatory and supervisory standards

• It is therefore important that the Commission is a permanent member of the G20 & the Financial Stability Forum to properly represent EU interests



24

Conclusions

• Coase theorem is a useful framework for analysing public intervention

• Existing EU State-aid rules & ex-ante guidance of the EC have played a major role in ensuring a minimum degree of consistency between the measures taken by Member States and therefore to minimise non-cooperative outcomes.

• Key characteristic of intervention: Reconciliation of short-term and longer-term perspectives of public intervention is crucial to reach a sustainable and competitive banking sector and hence financial sector basis for the real economy.

• But to prevent and manage future crises, further progress in the area of regulation, coordinated supervision and crisis management procedures (as put forward in the ESRC & the ESFS recommendations) is essential, within a global context (G20)



25

THANK YOU FOR YOUR ATTENTION!

• You can find more details at:

• http://ec.europa.eu/competition/sectors/financial_services/financial_crisis_news_en.html

http://ec.europa.eu/competition/sectors/financial_services/financial_crisis_news_en.html





26

EU as a Framework for National Governments’ Intervention

Vitor Gaspar(with Joep Konings)

Bureau of Economic Policy Advisers, European Commission

Workshop on The Future Face of Europe’s Financial System, Bruegel, 23 – 24 March 2009

http://images.google.lu/imgres?imgurl=http://www.euro.cauce.org/images/flags/eu-flag.gif&imgrefurl=http://www.euro.cauce.org/en/countries.html&h=349&w=519&sz=4&hl=en&start=3&um=1&tbnid=tIl_Su9kO7IeFM:&tbnh=88&tbnw=131&prev=/images%3Fq%3DEuropean%2Bunion%26um%3D1%26hl%3Den%26lr%3Dlang_en%26sa%3DN

Documents

EU as a Framework for National Governments ’ Intervention