As European leaders gather for an emergency summit in Brussels to tackle the eurozone debt crisis, we consider the issues and possible solutions. In Part B we’ll consider the actual agreement.
There are three key short-term issues that the leaders are addressing.
1. The problem of Greek debt
With fears that the Greek debt crisis could spread to other eurozone countries, such as Italy and Spain, it is vital to have a solution to the unsustainability of Greek debt. Either banks must be willing to write off a proportion of Greek debt owed to them or governments must give a fiscal transfer to Greece to allow it to continue servicing the debt. Simply lending Greece even more provides no long-term solution as this will simply make the debt even harder to service. Writing off a given percentage of debt is known as a ‘haircut’. The haircut on offer before the summit was 21%. Leaders are reportedly considering increasing this to around 60%.
2. The size of the eurozone bailout fund
The bailout fund, the European Financial Stability Facility (EFSF), stood at €440 billion. This is considered totally inadequate to provide loans to Italy and Spain, should they need a bailout. France and other countries want the ECB to provide extra loans to the EFSF, to increase its funds to somewhere between €2 trillion and €3 trillion. Germany before the meeting was strongly against this, seeing it as undermining the rectitude of the ECB. A compromise would be for the EFSF to provide partial guarantees to investors and banks which are willing to lend more to countries in debt crisis.
3. Recapitalising various European banks
Several European banks are heavily exposed to sovereign debt in countries such as Greece, Italy and Spain. It is estimated that they would need to raise an extra €100 billion to shield them against possible losses from haircuts and defaults.
But there is the key longer-term issue as well.
Achieving long-term economic growth
Without economic growth, debt servicing becomes much more difficult. The austerity measures imposed on highly indebted countries amount to strongly contractionary fiscal policies, as government expenditure is cut and taxes are increased. But as the economies contract, so automatic fiscal stabilisers come into play. As incomes and expenditure decline, so people pay less income tax and less VAT and other expenditure taxes; as incomes decline and unemployment rises, so government welfare payments and payments of unemployment benefits increase. These compound public-sector deficits and bring the possibility of even stronger austerity measures. A downward spiral of decline and rising debt can occur.
The answer is more rapid growth. But how is that to be achieved when governments are trying to reduce debt? That is the hardest and ultimately the most important question.
Articles
Brussels summit: the main issues to be resolved The Telegraph (25/10/11)
EU crisis talks in limbo after crucial summit is cancelled The Telegraph, Louise Armitstead (25/10/11)
Euro zone summit likely to give few numbers on crisis response Reuters, Jan Strupczewski (25/10/11)
Factbox: What EU leaders must decide at crisis summit Reuters (24/10/11)
Hopes low ahead of EU summit Euronews on YouTube (25/10/11)
Euro crisis: EU leaders hope to reach debt plan BBC News (26/10/11)
The deadline Europe cannot afford to miss BBC News, Nigel Cassidy (26/10/11)
Why EU summit is crunch day for the eurozone BBC News, Paul Mason (26/10/11)
Southern European banks need most capital BBC News blogs, Robert Peston (23/10/11)
Will Germany insure Italy against default? BBC News blogs, Robert Peston (26/10/11)
Plan B for the eurozone? BBC News blogs, Stephanie Flanders (26/10/11)
‘No such thing as Europe’ BBC Today Programme, Stephanie Flanders and Martin Wolf (26/10/11)
Markets to eurozone: It’s the growth, stupid BBC News blogs, Stephanie Flanders (24/10/11)
Fears euro summit could miss final deal Financial Times, Peter Spiegel, Gerrit Wiesmann and Matt Steinglass (26/10/11)
Time to unleash financial firepower or face euro breakup Guardian, Larry Elliott (25/10/11)
The Business podcast: eurozone crisis Guardian, Larry Elliott, David Gow and Jill Treanor (25/10/11)
Why is Germany refusing to budge on the eurozone debt crisis? Guardian blogs, Phillip Inman (26/10/11)
Questions
- In terms of the three short-term problems identified above, compare alternative measures for dealing with each one.
- To what extent would the ECB creating enough money to recapitalise European banks be inflationary? On what factors does this depend?
- Does bailing out countries create a moral hazard? Explain.
- What possible ways are there of achieving economic growth while reducing countries sovereign debt?
- Would you agree that the problem facing eurozone countries at the moment is more of a political one than an economic one? Explain.
- What are the arguments for and against greater fiscal integration in the eurozone?
In the blog Has Merlin lost his magic, the issue of banks failing to meet their lending targets as set by the government was considered. Small businesses have been finding it difficult to obtain bank loans to help their business grow. Vince Cable has gone so far as to say: ‘There is a serious problem with lending to good, small companies.’ As a result of this, new sources of finance are being sought and one innovative approach has come to the forefront: crowd funding. People group together by pooling their money and investing in ideas or businesses. The attraction is that it doesn’t require huge amounts of cash, but with enough potential investors, significant amounts of finance can be raised. The following BBC News article looks at this innovative approach to financing a business.
Small firms seek crowd funding BBC News, Catherine Burne (27/5/11)
Questions
- What is the attraction of crowd funding?
- Are there any risks of this method of finance to the investors and to the firm seeking investment?
- What are the disadvantages of crowd funding relative to something like investment from a venture capitalist?
- How important is the size of the firm when it comes to the viability of crowd funding?
We have covered the issue of bank bonuses in previous blogs. See for example: Banking on bonuses? Not for much longer (November 2009); “We want our money back and we’re going to get it” (President Obama) (January 2010); and Payback time (Updated April 2010). But the issue has not been resolved. Despite public outrage around the world over the behaviour of banks that caused the credit crunch and about banks having to be bailed out with ‘taxpayers money’ and, as a result, people facing tax rises and cuts in public-sector services and jobs, bankers’ pay and bonuses are soaring once more. The individuals who caused the global economic crisis seem immune to the effects of their actions. But are things about to change?
The Committee of European Banking Supervisors (CEBS) has confirmed tough new guidelines on bank bonuses applying to all banks operating in the EU. The CEBS’s prime purpose in recommending restricting bonuses is to reduce the incentive for excessive and dangerous risk taking. As it states in paragraph 1 of the Guidelines on Remuneration Policies and Practices:
Whilst institutions’ remuneration policies were not the direct cause of this crisis, their drawbacks, nonetheless, contributed to its gravity and scale. It was generally recognized that excessive remuneration in the financial sector fuelled a risk appetite that was disproportionate to the loss-absorption capacity of institutions and of the financial sector as a whole.
The guidelines include deferring 40–60% of bonuses for three to five years; paying a maximum of 50% of bonuses in cash (the remainder having to be in shares); setting a maximum bonus level as a percentage of an individual’s basic pay; appointing remuneration committees that are truly independent; publishing the pay and bonuses of all senior managers and ‘risk takers’. Although they are only recommendations, it is expected that bank regulators across the EU will implement them in full.
So will they be effective in curbing the pay and bonuses of top bank staff? Will they curb excessive risk taking? Or will banks simply find ways around the regulations? The following articles discuss these issues
Articles
Bankers’ bonuses to face strict limits in Europe BBC News, Hugh Pym (10/12/10)
Bankers’ bonuses to face strict limits in Europe BBC News (10/12/10)
Europe set to link banking bonuses to basic salaries The Telegraph, Louise Armitstead (10/12/10)
Some bankers may escape EU cash bonus limit moneycontrol.com (India) (11/12/10)
Banks to sidestep bonus crackdown by raising salaries Guardian, Jill Treanor (10/12/10)
Bonuses: When bank jobs pay Guardian (11/12/10)
Bank bonuses (portal page) Financial Times
Committee of European Banking Supervisors (CEBS)
CEBS home page
CEBS has today published its Guidelines on Remuneration Policies and Practices (CP42) CEBS news release (10/12/10)
Guidelines on Remuneration Policies and Practices (10/12/10)
Questions
- What are main objectives of the CEBS guidelines?
- Assess the arguments used by the banking industry in criticising the guidelines.
- In what ways can the banks get around these new regulations (assuming the guidelines are accepted by EU banking regulators)?
- What conditions would have to met for a remuneration committee to be truly independent?
- How likely is it that countries outside the EU will adopt similar regulations? How could they be persuaded to do so?
It doesn’t seem that long ago when Greece was in the news regarding its deficit and need for bailing out. Back then, countries such as Spain, Portugal and Ireland were being mentioned as the next countries which might require financial assistance from the EU. It is now the Irish economy that is in trouble, even though the Irish government has not yet requested any financial help. The EU, however, is ‘ready to act’.
The Irish economy experienced an extremely strong boom, but they also suffered from the biggest recession in the developed world, with national income falling by over 20% since 2007. Savers are withdrawing their money; property prices continue to collapse; and banks needed bailing out. Austerity measures have already been implemented – tax rises and spending cuts equal to 5% of GDP took place, but it has still not been enough to stabilise the economy’s finances. All of these problems have contributed to a large and unsustainable budget deficit and a significant lack of funding and that’s where the EU and possibly the IMF come in.
If the Irish economy continues to decline and experiences a financial crisis, the UK would probably be one of the first to step in and offer finance. As our closest neighbour and an important trading partner, the collapse of the Irish economy would adversely affect the UK. A significant proportion of our exports go to the Irish economy and, with Irish taxpayers facing troubled times, UK exporting companies may be the ones to suffer.
One thing that this crisis has done is to provide eurosceptics with an opportunity to argue their case and blame the euro for the collapse of Ireland. With one monetary policy, the Irish economy is tied in to the interest rates set by the ECB and low interest rates fuelled the then booming economy. The common currency also increased capital flows from central European countries, such as Germany, to peripheral countries, such as Ireland, Spain and Portugal. In themselves, capital flows aren’t a problem, but when they are used to fund property bubbles and not productive investments, adverse effects are inevitable, as Ireland found to its detriment.
As prices collapsed and banks simply ran out of money, the government stepped in and rescued not only the depositors of Irish banks, but also their bondholders. Unable to devalue their currency, as it’s the euro, the Irish economy was unable to boost exports and hence aggregate demand and in turn economic growth. Although, the Irish government has not requested any financial help, as the French Finance Minister commented about a potential bailout: “Is it six months or a few days away? I’d say it’s closer to days.” The following articles look at this developing situation in Europe.
EU plays down Irish republic bail-out talks BBC News (17/11/10)
Ireland bailout: the European politicians who will decide Telegraph, Phillip Aldrick (17/11/10)
Don’t blame the Euro for Ireland’s mess Financial Times, Phillipe Legrain (17/11/10)
Britain signals intention to help Ireland in debt crisis New York Times, James Kanter and Steven Erlanger (17/11/10)
Ireland will take aid if ‘bank issue is too big’ Irish Times, Jason Michael (17/11/10)
Irish junior party says partnership strained Reuters (17/11/10)
Ireland resists humiliating bail-out as UK pledges £7 billion Telegraph, Bruno Waterfield (17/11/10)
Markets stable as Ireland bailout looms Associated Press (17/11/10)
The implausible in pursuit of the indefensible? BBC News blogs, Stephanomics, Stephanie Flanders (16/11/10)
Ireland bailout worth ‘tens of billions’ of euros, says central bank governor Guardian, Julia Kollewe and Lisa O’Carroll (18/11/10)
The stages of Ireland’s grief BBC News blogs, Stephanomics, Stephanie Flanders (18/11/10)
Q&A: Irish Republic finances BBC News (19/11/10)
Could Spain and Portugal be next to accept bail-outs? BBC News, Gavin Hewitt (19/11/10)
Questions
- Why will the UK be affected by the collapse of the Irish economy?
- If Ireland were not a member of the eurozone, would the country be any better off? How might a floating exchange rate boost growth?
- The Financial Times article talks about the euro not being to blame for the Irish problems, saying that ‘tight fiscal policy’ should have been used. What does this mean?
- Why is the housing market so important to any nation?
- What are the arguments (a) for and (b) against the euro? Would Ireland benefit from leaving the euro?
- Should the UK government intervene to help Ireland? What are the key factors that will influence this decision? What about the EU – should Ireland ask for help? Should the EU give help?
- Austerity measures have already been implemented, but what other actions could the Irish economy take to increase competitiveness?
In the aftermath of the credit crunch and the recession, many banks had to be bailed out by central banks and some, such as Northern Rock and RBS, were wholly or partially nationalised. Tougher regulations to ensure greater liquidity and higher proportions of capital to total liabilities have been put in place and further regulation is being planned in many countries.
So are banks now able to withstand future shocks?
In recent months, new threats to banks have emerged. The first is the prospect of a double-dip recession as many countries tighten fiscal policy in order to claw down debts and as consumer and business confidence falls. The second is the concern about banks’ exposure to sovereign debt: i.e. their holding of government bonds and other securities. If there is a risk that countries might default on their debts, then banks would suffer and confidence in the banking system could plummet, triggering a further banking crisis. With worries that countries such as Greece, Spain, Portugal, Italy and Ireland might have problems in servicing their debt, and with the downgrading of these countries by rating agencies, this second problem has become more acute for banks with large exposure to the debt of these and similar countries.
To help get a measure of the extent of the problem and, hopefully, to reassure markets, the Committee of European Banking Supervisors (CEBS) has been conducting ‘stress tests’ on European banks. On 24 July, it published its findings. The following articles look at these tests and the findings and assess whether the tests were rigorous enough.
Articles
Bank balance: EU stress tests explained Financial Times, Patrick Jenkins, Emily Cadman and Steve Bernard (13/7/10)
Seven EU banks fail stress test healthchecks BBC News, Robert Peston (23/7/10)
Interactive: EU stress test results by bank Financial Times, Emily Cadman, Steve Bernard, Johanna Kassel and Patrick Jenkin (23/7/10)
Q&A: What are the European bank stress tests for? BBC News (23/7/10)
Europe’s Stress-Free Stress Test Fails to Make the Grade Der Spiegel (26/7/10)
A test cynically calibrated to fix the result Financial Times, Wolfgang Münchau (25/7/10)
Europe confronts banking gremlins Financial Times (23/7/10)
Leading article: Stressful times continue Independent (26/7/10)
Europe’s banking check-up Aljazeera, Samah El-Shahat (26/7/10)
Finance: Stressed but blessed Financial Times, Patrick Jenkins (25/7/10)
Were stress test rigorous enough? BBC Today Programme, Ben Shore (24/7/10)
Banks’ stress test ‘very wooly’ BBC Today Programme, Peter Hahn and Graham Turner(24/7/10)
Stress test whitewash of European banks World Socialist Web Site, Stefan Steinberg (26/7/10)
Stress tests: Not many dead BBC News blogs: Peston’s Picks, Robert Peston (23/7/10)
Not much stress, not much test Reuters, Laurence Copeland (23/7/10)
Stress-testing Europe’s banks won’t stave off a deflationary vortex Telegraph, Ambrose Evans-Pritchard (18/7/10)
European banking shares rise after stress tests BBC News (26/7/10)
Euro banks pass test, gold falls CommodityOnline, Geena Paul (26/7/10)
Report
2010 EU-wide Stress Testing: portal page to documents CEBS
Questions
- Explain what is meant by a bank stress test?
- What particular scenarios were tested for in the European bank stress tests?
- Assess whether the tests were appropriate? Were they too easy to pass?
- What effect did the results of the stress tests have on gold prices? Explain why (see final article above).
- What stresses are banks likely to face in the coming months? If they run into difficulties as a result, what would be the likely reaction of central banks? Would there be a moral hazard here? Explain.