The financial crisis and its aftermath
THE euro area has been through a crisis of almost unprecedented drama and severity. Like the Great Depression of the 1930s, this will most likely provide rich material for economic historians for decades to come. It will be studied and analysed, its causes and consequences debated and revised. So it is interesting for us to imagine, when the dust has settled, where the various accounts of the euro area debt crisis will locate its turning point. Some historians may locate it in individual policy measures taken during the crisis; others may place it in a future that we have not yet reached. In my view, the turning point has passed, and it came in the summer of 2012. What changed at that point was that crisis management shifted towards the development and execution of a consistent recovery strategy. It is this strategy that I am going to outline in my remarks today.
First, I will describe the initial development of the crisis, illustrating how policy choices made under the pressure of events and that were commendable by themselves, but that were sequenced in the wrong order, made dealing with the consequences of the debt overhang more difficult. This interacted with features of the euro area's institutional structure to postpone the recovery.
Thereafter, I will describe how the right sequence of steps after June 2012, when the banking union project was first agreed, has put the euro area back on a trajectory towards recovery. The first step was 'rebooting' the financial system, which is a necessary condition of a sustained recovery, not least because it helps monetary policy to manage aggregate demand. But it is not a sufficient condition: policies of structural reform that lift the level of potential growth are an equally important part of the recovery strategy.
In describing this strategy, I am not only talking about the past, but also about the present and the future. The crisis is not over. To be successful, the recovery strategy is being, and must continue to be, executed with commitment and perseverance.
The early phase of the crisis followed roughly the same pattern across advanced economies. Most had been through a long period of excessive debt accumulation, with private debt levels in several jurisdictions reaching historical highs. In some countries this fuelled over-investment in unproductive sectors, including real estate, which is the sector associated with most of the severe financial crises in history. The mirror image of this development was a credit bubble in the banking sector, as banks financed both housing supply, i.e. loans to real estate developers, and housing demand - that is, mortgages.
When the crisis broke out, this debt build-up quickly became a debt overhang. Many advanced economies entered a prolonged period of deleveraging as firms, households and banks attempted to reduce their debt levels. For firms, this meant less investment. For households, less consumption. And for banks, less credit. Moreover, the collapse of Lehman Brothers sent shockwaves through the global financial system leading to an unprecedented rise in uncertainty and risk aversion. This led to a further retrenchment in investment, trade and hiring and a globalised "Great Recession". Government budgets went deep into deficit to offset this massive shock to nominal spending.
These events were not only shared across major economies, but they were also largely consistent with historical experience. There have been several episodes in economic history of large build-ups followed by periods of debt deleveraging. Serious financial crises tend to be followed by slow economic recoveries.
Nevertheless, by mid-2010, most advanced economies were showing signs of returning to growth, albeit at a slow pace. At this point, however, the trajectory of the euro area departed from others. While the recovery gained ground in the US in particular, the euro area entered into a second recession that lasted until the second quarter of 2013. Why did this divergence happen?
For two reasons that were specific to the euro area. First, the sequencing of policy responses after the first bail-out for Greece aggravated concerns about bank and sovereign debt sustainability. Second, these concerns interacted with an incomplete institutional framework in a self-reinforcing way.
In addressing the situation in mid-2010 - and with the benefit of hindsight - one could have legitimately expected the following sequence of actions. First, agree on a solid backstop for dealing with sovereign and banking sector problems. Thereafter, conduct a stress test and recapitalise banks where necessary. Then, with banks in a stronger position to absorb losses and a sovereign backstop in place, construct a consistent framework for dealing with sovereigns with excessive debt. Finally, apply that framework to countries that were deemed to need it. For example, this sequence from backstop to stress test to recapitalisation was applied in the US, once the lessons from the Lehman Brothers shock had been drawn, and it accelerated the clean-up of the country's banking system.
However, in 2010 and 2011 it was almost the reverse sequence that took place in the euro area. The Deauville agreement on private sector involvement in October 2010 and the Greek debt restructuring in July 2011 were announced while an effective backstop for solvent governments was still being constructed. And the initial stress testing of banks in 2011 and the capital raising exercise in October that year were conducted without any clear backstop for solvent banks. The effect was to cause many banks and some governments to come uncomfortably close to losing market access, or to lose it altogether. As a consequence, instead of acting as a shock absorber, both banks and governments began to act pro-cyclically.
This situation then interacted negatively with two features of the euro area's institutional structure. The first was the euro area's incomplete financial integration. While prices had converged in many asset classes prior to the crisis, it turned out that the euro area had not in fact created the conditions for deep cross-country financial integration. Integration was largely based on shortterm interbank debt, rather than on equity or direct cross-border lending to firms and households, and under stress it quickly unravelled. Indeed, the build-up of financial imbalances in the euro area periphery had in part been financed by short-term lending from banks in the core. Those banks then quickly reversed their exposures in what amounted to a "sudden stop", analogous to crises experienced by emerging economies. This contributed to the fragmentation of the euro area banking sector and economy along national lines, a phenomenon which had not been visible in the early stages of the crisis.
The second feature was the euro area's fiscal framework, which was not strictly enforced. That framework was explicitly designed to ensure fiscal responsibility, with two resulting benefits. First, if strictly applied, it would create fiscal space ex ante for governments to absorb exceptional shocks, such as the one experienced worldwide. And second, by anchoring confidence in the medium-term soundness of public finances, it would allow governments to run those countercyclical policies while retaining market access. In such a situation, there is no need for fiscal risksharing or a fiscal backstop.
Yet, as the fiscal framework was not strictly enforced, the two benefits were reversed: a number of governments either did not have the fiscal space to absorb the shock they faced in the early stage of the crisis (consider Belgium or Italy); or they were unable to maintain the trust of the market while doing so (consider Portugal or Ireland). Fiscal policy in these countries therefore had to switch from providing a counter-cyclical buffer to convincing investors of debt sustainability.
Under these circumstances, it was unavoidable that fiscal consolidation was front-loaded. But it also meant that fiscal policy changed from being a tailwind to a headwind, and added to the drag coming from deleveraging across the private sector. In particular, as the banking sector had not yet been cleaned up and strengthened, lower growth produced a further deterioration in balance sheets and added to pro-cyclicality.
In managing the crisis, European policymakers faced an unprecedented set of circumstances. They were making decisions in real time in the face of political and institutional constraints. So the aim of my comments is not to criticise. Rather, it is to highlight the fact that the sequencing and consistency of policy decisions matter. Policymakers dealt with the immediate situation without simultaneously addressing all its consequences. It was only when this began to change in June 2012 that we returned to the path of recovery.
What happened at this time was that European policymakers acknowledged the need to complete the euro area's institutional architecture, the initial stage of which was setting up the banking union. And in doing so, they initiated what I believe was the necessary first step of a consistent strategy for a sustained recovery.
The banking union had to be the first step of a longer sequence, for two reasons. First, because it was necessary to consolidate the single currency. Second, because it provided an opportunity to "reboot" the euro area banking system, which in turn is a pre-condition for the recovery.
Money, it has to be remembered, is a liability of the banking system. Banknotes represent only a fraction of the money we use daily. The bulk of money is deposits, which are a liability of commercial banks. So for there to be a truly single money among sovereign countries, there has to be fungibility of deposits across borders.
Yet, this fungibility came under threat during the crisis. It was threatened initially by the fragmentation of financial markets in the euro area, and then exacerbated by the emergence of redenomination risk in financial prices. Those unfounded fears of redenomination put price stability at risk, which the ECB had to alleviate through the creation of its Outright Monetary Transactions ( OMT) programme. Our actions underlined the irreversibility of the single currency and were decisive in restoring confidence.
But the underlying drivers of fragmentation still remained, especially the emergence of credit risk premia at the national level that mirrored the perceived credit risk of sovereigns, in particular after the Greek debt restructuring. This link between sovereign and bank risk reflected, first and foremost, the perception that the ultimate guarantor of deposits in the banking system is the state. Hence, where perceptions of sovereign creditworthiness diverged, so did confidence in their respective banking systems.
In essence, what these developments were highlighting was that we did not have a truly single banking system in the euro area; we had a juxtapositionof national banking systems, which is why they fragmented so easily. To ensure that the single currency truly is single, therefore, the only realistic option was to bring together those national systems into one single system, so that the fungibility of deposits was re-established. This is where the banking union comes in.
Banking union means three things: it means a single supervisory framework that minimises equally the risk that a euro area bank takes excessive risk and runs into failure. It means a single resolution framework, so that if a bank does still fail, it can be resolved in the same way, with limited use of taxpayer money, irrespective of where the bank is located or the fiscal strength of its government. And it means a system of deposit protection that provides depositors with equal confidence that their deposits are skafe, regardless of jurisdiction.
We are now well advanced in the process of unifying the banking system in this way. The Single Supervisory Mechanism (SSM) will begin operating in November. A deal was reached last week on a Single Resolution Mechanism and Single Resolution Fund. And a harmonised approach to the level and funding of deposit guarantee schemes across the euro area has been agreed, as a first step towards a single deposit guarantee scheme. Deposits of individuals and small- and medium-sized enterprises (SMEs) will also have seniority in any future bank resolutions. Together, this goes a long way towards creating a genuine banking union, although some important details, such as the backstop for European resolution financing, still need to be clarified.
By reinforcing the singleness of money, the banking union provides the conditions for a lasting reintegration of the single financial market. It is therefore a pre-requisite for the recovery. It does not, however, by itself generate a recovery, nor does it put banks in a position to properly support that recovery. This brings me to the second step in the sequence of events required to achieve that goal: the role of the SSM in cleaning up the banking system.
Prior to the crisis, euro area banks had entered a rapid period of balance sheet expansion. From the start of that expansion in 2005 to its peak in 2012, banks assets increased by more than 60 percentage points of GDP. This was associated with the development of unsustainable bank business models. Banks relied too much on debt to finance their lending, and that debt depended too much on wholesale market funding and too little on deposits.
This model was only able to develop because of the perception of an implicit state guarantee for bank debt - a perception that reinforced the link between sovereign and bank risks that I described above. The deterioration of sovereign credit, on the one hand, and the clarification of the rules regarding bail-in of bank debt, on the other, have both helped to bring to an end a funding model that was neither desirable nor sustainable.
The euro area banking system is therefore now undergoing a process of restructuring and deleveraging. As this is a necessary correction, it is not a process that policymakers should seek to prevent. However, it is a process that needs to be properly managed.
Deleveraging can essentially take two forms: a "good" form and a "bad" form. The "good" type is where banks quickly carve out non-performing or non-core assets and raise equity, allowing them to restart lending to new, creditworthy clients. The "bad" type is where they sell good assets and hold on to non-performing assets in the hope that their value recovers. This tends to create so-called "zombie banks" and leads to a prolonged period of low credit growth. And this can be even more damaging if, due to fears about counterparty credit and liquidity hoarding, liquidity dries up and banks have to sell assets at distressed prices. Such an interaction of market risk and funding risk can cause a systemic crisis, with an outright credit crunch as the consequence.
Historical precedents suggest that - all other things being equal - a quick, "good" deleveraging tends to bring about an earlier recovery.
In the euro area we have largely avoided the worst form of deleveraging, thanks to ECB interventions to provide liquidity to banks at key moments of the crisis, notably our move to unlimited liquidity provision in 2008 and our two longer-term refinancing operations (LTROs) in late 2011 and early 2012. In this environment banks have made progress in deleveraging and restructuring. However, as late as last year there was still uncertainty as to the true extent and quality of this deleveraging. This was shown by persistent investor doubts about bank asset valuations, and low credit growth for the real economy. It was in this context that the creation of the SSM became critical.