Blog Post

With Cyprus, Europe risks being too tough on banking moral hazard

Europe has long been far too tolerant of moral hazard in its banking system. But with the Cyprus plan, the pendulum may now be swinging too far in the opposite direction.

By: Date: April 2, 2013 Topic: Macroeconomic policy

Europe has long been far too tolerant of moral hazard in its banking system. But with the Cyprus plan, the pendulum may now be swinging too far in the opposite direction.

This danger was made clear when Jeroen Dijsselbloem, the Dutch president of the eurogroup of finance ministers, rocked financial markets on Monday by hinting at a new doctrine that would put the full burden of future bank restructuring on creditors and depositors rather than taxpayers. In his words, “where you take on the risks you must deal with them, and if you can’t deal with them then you shouldn’t have taken them on”. This hardline stance echoes the memorable advice of Andrew Mellon, US Treasury secretary in the early 1930s, as reported by then President Herbert Hoover: “Liquidate labour, liquidate stocks, liquidate farmers, liquidate real estate… It will purge the rottenness out of the system… People will work harder, live a more moral life.”

In July 2007, the opposite position was enunciated by Jochen Sanio, then Germany’s top financial supervisor. As IKB, a medium-sized German bank, revealed massive subprime-related losses, he argued that not bailing it out would trigger “the worst financial crisis since 1931” – an intentionally frightening reference. EU countries have since then implemented the “Sanio doctrine” by scrupulously reimbursing all creditors, including junior ones, of almost all failed banks with few and rather small exceptions in Denmark, Ireland and the UK. That this consistent dismissal of moral hazard originated in a German decision is ironic in light of later events.

Then change has come, gradually. In Deauville in October 2010, Angela Merkel, German chancellor, and President Nicolas Sarkozy of France announced that holders of euro area sovereign debt could face losses, but soon afterwards Ireland was still forbidden from “burning” senior bank bondholders. However, policy makers slowly realised that guaranteeing all bank liabilities reinforced a damaging “doom loop” between banks and sovereigns. In July last year, Mario Draghi, president of the European Central Bank, noted that “the question of burden sharing with senior bond holders is evolving at the European level”. Spain’s bank restructurings later that year imposed losses on many subordinated creditors. Earlier this year Ireland negotiated a deal that involved a loss for some senior bank bondholders. A largely silent revolution was instilling more market discipline into the financing of Europe’s banks.

This gradual shift was welcome. But in Cyprus it accelerated out of control, all the way to full “Mellon doctrine”. The island’s two biggest banks are now being liquidated, even though the process is administrative rather than judicial, with no government financial assistance. In an echo of Deauville, European leaders signalled on March 16 that deposits were no longer safe, after which the German finance minister Wolfgang Schäuble confirmed that deposit guarantees were “only as good as a state’s solvency”. This move annihilated trust in Cypriot banks and made the imposition of capital controls inevitable.

Just as the Sanio doctrine was made unsustainable by moral hazard and fiscal constraints, the Mellon doctrine is made unsustainable by the reality of systemic risk – today as in the 1930s. In fairness to Mr Dijsselbloem, he acknowledged that governments may not impose full financial discipline “in times of crisis”, but then implied that we are in no such times right now: a heroic claim. Governments have a responsibility to protect their citizens from catastrophic meltdowns. This is why a chastened US government had to bail out AIG, the insurance group, a day after letting Lehman Brothers go bankrupt.

As the US learnt the hard way, predictability is essential in such matters but also difficult to attain. Europe must now chart a path between untenable Sanio and unrealistic Mellon.

The trade-off is not only between moral hazard and systemic fragility, but also between national fiscal responsibility and European integration. The eurogroup’s new insistence that “all insured depositors in all banks will be fully protected” may or may not be seen as a form of “deposit reinsurance”, meaning that a deposit guarantee can indeed be stronger than a member state’s own solvency. But this declaration will have little impact on depositors’ behaviour unless a European backing of national deposit guarantee systems is made explicit.

Similarly, the insistence on orderly bank restructurings in an integrated market calls for a centralised process, which should be in place before the ECB conducts a comprehensive balance sheet assessment of all 150-odd banks transferred under its direct supervisory authority, a deadline now planned around mid-2014. The clock is ticking.

This article was first published in The Financial Times.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Read about event More on this topic
 

Upcoming Event

May
25
14:30

How can we support and restructure firms hit by the COVID-19 crisis?

What are the vulnerabilities and risks in the enterprise sector and how prepared are countries to handle a large-scale restructuring of businesses?

Speakers: Ceyla Pazarbasioglu and Guntram B. Wolff Topic: Macroeconomic policy
Read about event More on this topic
 

Upcoming Event

May - Jun
31-1
10:30

MICROPROD Final Event

Final conference of the MICROPROD project

Speakers: Carlo Altomonte, Eric Bartelsman, Marta Bisztray, Italo Colantone, Maria Demertzis, Filippo di Mauro, Wolfhard Kaus, Steffen Müller, Gianluca Santoni, Verena Plümpe, Andrea Roventini, Valerie Smeets, Nicola Viegi, Markus Zimmermann and Javier Miranda Topic: Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event
 

Past Event

Past Event

[Cancelled] Shifting taxes in order to achieve green goals

[This event is cancelled until further notice] How could shifting the tax burden from labour to pollution and resources help the EU reach its climate goals?

Speakers: Niclas Poitiers and Femke Groothuis Topic: Green economy, Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 12, 2022
Read about event More on this topic
 

Past Event

Past Event

How are crises changing central bank doctrines?

How is monetary policy evolving in the face of recent crises? With central banks taking on new roles, how accountable are they to democratic institutions?

Speakers: Maria Demertzis, Benoît Coeuré, Pervenche Berès, Hans-Helmut Kotz and Athanasios Orphanides Topic: Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 11, 2022
Read article Download PDF More by this author
 

Book/Special report

European governanceInclusive growth

Bruegel annual report 2021

The Bruegel annual report provides a broad overview of the organisation's work in the previous year.

By: Bruegel Topic: Banking and capital markets, Digital economy and innovation, European governance, Global economy and trade, Green economy, Inclusive growth, Macroeconomic policy Date: May 6, 2022
Read article Download PDF
 

Policy Contribution

European governance

Fiscal support and monetary vigilance: economic policy implications of the Russia-Ukraine war for the European Union

Policymakers must think coherently about the joint implications of their actions, from sanctions on Russia to subsidies and transfers to their own citizens, and avoid taking measures that contradict each other. This is what we try to do in this Policy Contribution, focusing on the macroeconomic aspects of relevance for Europe.

By: Olivier Blanchard and Jean Pisani-Ferry Topic: European governance, Macroeconomic policy Date: April 29, 2022
Read article Download PDF More on this topic
 

Working Paper

The low productivity of European firms: how can policies enhance the allocation of resources?

A summary of the most important policy lessons from research undertaken in the MICROPROD project work package 4, related to the allocation of the factors of production, with a special focus on the weak dynamism of European small and medium-sized enterprises (SMEs).

By: Grégory Claeys, Marie Le Mouel and Giovanni Sgaravatti Topic: Macroeconomic policy Date: April 25, 2022
Read article More on this topic
 

External Publication

What drives implementation of the European Union’s policy recommendations to its member countries?

Article published in the Journal of Economic Policy Reform.

By: Konstantinos Efstathiou and Guntram B. Wolff Topic: Macroeconomic policy Date: April 13, 2022
Read article Download PDF More on this topic More by this author
 

Working Paper

Measuring the intangible economy to address policy challenges

The purpose of the first work package of the MICROPROD project was to improve the firm-level data infrastructure, expand the measurement of intangible assets and enable cross-country analyses of these productivity trends.

By: Marie Le Mouel Topic: Macroeconomic policy Date: April 11, 2022
Read about event More on this topic
 

Past Event

Past Event

Macroeconomic and financial stability in changing times: conversation with Andrew Bailey

Guntram Wolff will be joined in conversation by Andrew Bailey, Governor of the Bank of England.

Speakers: Andrew Bailey and Guntram B. Wolff Topic: Macroeconomic policy Date: March 28, 2022
Read article
 

Opinion

European governance

How to reconcile increased green public investment needs with fiscal consolidation

The EU’s ambitious emissions reduction targets will require a major increase in green investments. This column considers options for increasing public green investment when major consolidations are needed after the fiscal support provided during the pandemic. The authors make the case for a green golden rule allowing green investment to be funded by deficits that would not count in the fiscal rules. Concerns about ‘greenwashing’ could be addressed through a narrow definition of green investments and strong institutional scrutiny, while countries with debt sustainability concerns could initially rely only on NGEU for their green investment.

By: Zsolt Darvas and Guntram B. Wolff Topic: European governance, Green economy, Macroeconomic policy Date: March 8, 2022
Read article More on this topic More by this author
 

Opinion

The week inflation became entrenched

The events that have unfolded since 24 February have solved one dispute: inflation is no longer temporary.

By: Maria Demertzis Topic: Macroeconomic policy Date: March 8, 2022
Load more posts