Lessons for Risk Management from the Euro

Lessons for Risk Management from the Euro

More than four years have passed since the financial crisis broke out, and during this time key European reforms for the financial markets have been discussed intensively. However, only a few have been initiated.  Coherent implementation is missing and the delay hampers crisis management.  These are some of the issues discussed in German report After the Euro Area Summit: Time to Implement Long-term Solutions (Special Report, German Council of Economic Experts, July 30^th).

The Euro area faces three severe and closely interrelated crises: a sovereign debt crisis, a banking crisis and a macroeconomic crisis. What is especially dangerous here is that these crises are mutually reinforcing through a negative feedback loop, thus culminating in a crisis of confidence that casts into doubt the very existence of the monetary union itself.  The increasing uncertainty among and investors and countries destabilized by dampening economic conditions have increased financial distress.

At present, finding a comprehensive solution to the European debt crisis is complicated by the absence of effective and European-wide procedures for restructuring and winding-up banks, in particular large credit institutions that have cross-border activities. Priority should therefore be given to reforms in these areas.

Essentially, the statement of the 29 June 2012 summit rightly focuses on the inter-linkages between banks and sovereigns and the need for European wide financial reforms. What will be decisive are the concrete measures to be taken and the speed with which the necessary reforms are implemented. In the opinion of the Council of Economic Experts, policy makers should take their cue from a Three Point Plan that contains the following elements.

Acute crisis management - A solution to the problems in the Spanish banking sector cannot wait until a long-term regulatory framework for the European banking system has been established. That said financial markets need clarity as quickly as possible on how the funding Spain has applied for will actually be used to recapitalize banks. The focus must be on avoiding the mistakes of past crises. Recapitalization and restructuring must follow clear criteria.

Long Term - An effective supervisor at the European level should ensure that the probability and the scale of crises decline. Higher bank capital will play a key role in this context because this will enhance their ability to bear risk. Parallel to this, mechanisms for restructuring and winding-up banks need to be established. Should it be necessary to use common financial resources to restructure banks, then common supervisory and resolution mechanisms have to be implemented.

No overhasty moves toward a banking union - Establishing a banking union will take a considerable amount of time. Key issues to be clarified include the location and tasks of the banking supervisor, the introduction of uniform processes for winding-up and restructuring banks, deposit insurance, and not least the attendant financing questions. A long-term system in which liability and supervision are in one and the same pair of hands requires not least that national sovereignty is partly given up. This will invariably take some time; it is therefore all the more important that progress is made now on introducing the regulatory changes required.

A key lesson is that a functionally viable financial system is a key precondition for the necessary sectorial realignment of the economies, as investments need to be financed to spur economic growth.  The failure of politicians and policy-makers to address the crisis when it first surfaced will result in a dramatic surge in lost output and jobs, a prolonged period of economic stagnation as well as billions in investor losses.  Any lessons? 

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