The Pernicious Paradox of EU Financial Policy

There’s one big paradox, inconsistency, contradiction within the EU Financial policy. The paradox is related to the management of systemic risk.

500 euro note (source: ECB)

500 euro note (source: ECB)

Within financial supervision, the adagium is: if banks are too big to fail, they are too big. This has been said literally by Bank of England governor Mervyn King in 2009. If banks become too big, the bail-out risk becomes intolerably large for governments and due to external effects the financial system at large is at risk. This risk is called systemic risk. It is often represented by falling dominoes.

Banks are more and more interconnected. This interconnectedness also contributes to systemic risk. They depend on each other due to their interconnected assets, liabilities and payment flows. Apart from size, interconnectedness is an important factor for the designation of a bank as a Global Systemically Important Bank (GSIB). GSIBs need to have more loss absorbing capital for this systemic risk (the GSIB capital add on).

However, do we witness the same concern for systemic risk in the eurozone as a whole? I don’t think so.

As of November 2012, the Financial Stability Board (FSB) has identified 28 global systemically important banks, among others Citigroup, Deutsche Bank, HSBC and JP Morgan Chase.

Also, G-SIBs need to comply with higher risk management standards according to the FSB:

G-SIFIs (Global Systemically Important Financial Institutions, MF) are required to meet higher supervisory expectations for risk management functions, data aggregation capabilities, risk governance and internal controls.

The bottom-line is that large, interconnected banks pose a specific risk to the financial system as a whole and regulators react to this by intensively monitoring these systemically important banks and encouraging them to break up. In the meantime, they have to comply with a higher standard for risk management.

This policy makes sense: the financial system as a whole is safer as a combination of loosely connected systems (from which a weak link can easily be discarded) than as a single, integrated whole, in which a weak link can contaminate the rest of the system.

The pernicious paradox

The paradox is this: if we accept that loosely connected systems are stronger than heavily interconnected systems, how does this relate to the eurozone? The eurozone is not an Optmum Currency Area. Some countries badly need devaluation, others need revaluation. Internal current account imbalances could be countered by higher inflation rates in the northern countries and lower inflation rates in the southern countries, so the countries need opposite monetary policies; however, this cannot be implemented due to the single currency. Since devaluation is not an option, countries such as Spain and Portugal suffer from the severe hardship of internal devaluation leading to massive unemployment. Today, April 25, 2013, Spain’s unemployment hits a record high of 27.2% of the workforce in the first quarter of 2013. It is more than twice the EU average.

In their 2012 report Persistent Macroeconomic imbalances in the euro area: causes and consequences, three Dutch researchers (Nils Holinski, Clemens Kool and Joan Muysken) point out that:

We argue that growing current account imbalances within the euro area indicate an ongoing process of economic divergence rather than convergence among euro area countries. The divergence process started with the introduction of the common currency in 1999 and cannot be confined only to the public sector. As a result, cumulative current account imbalances have substantially grown between northern and southern euro area countries. So far, euro area governments have treated these imbalances with benign neglect. In our view, this is inappropriate and unsustainable.

They also confirm the painful internal devaluation process of southern countries if adjustment does not take place through increases in productivity and competitiveness:

Alternative adjustment paths toward more sustainable current account positions within the euro area are not easy to achieve because of the design of the euro area itself. Because all euro area countries use the same currency, a nominal exchange rate devaluation of South relative to North to quickly gain competitiveness is impossible. Without productivity gains, the burden of adjustment falls on prices and wages that need to fall and real interest rates that need to rise in southern relative to northern Europe. That is, southern countries can restore international price competitiveness and thus their external balances through a prolonged period of disinflation. Such a process is accompanied by a painful period of economic contraction and will take a number of years to resolve.

Orderly exits are not possible within the eurozone, there are no official scenarios for such exits. It is shaped as a Hotel California: check out any time, but never leave.

So how does the design of the eurozone relate to the management of systemic risk? The answer is: it doesn’t.

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Over Folpmers
Financial Risk Management consultant, manager van een FRM consulting department, bijzonder hoogleraar FRM

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