The Global Crisis: a European Perspective

1. The Global Crisis: a European Perspective Vitor Gaspar, Director General of BEPA (Bureau of European Policy Advisers) RTD Debate – 17 March 2009 The views expressed are my own and do not necessarily reflect those of the European Commission.

2. BOTTOM LINE 1. The crisis has spread globally through strong economic and financial linkages. The crisis is global in character. 2. Experience of Great Depression shows unilateral national approaches lead to negative spillovers and retaliation deepening and prolonging the crisis. It is necessary to engage multilaterally to preserve open trade. 3. Europe is the largest economic entity in the world and the most integrated. Nowhere else is coordinated action so justified to explore synergies and to avoid negative spillovers.

3. BOTTOM LINE The European Economic Recovery Plan is based on the judgment according to which the current financial and economic crisis is a unique, unprecedented, historical event that justifies exceptional responses.

4. Outline • Factors contributing to the current global crisis. • Events in economic and financial markets after October 2008. • Policy responses to the global crisis. • The European Economic Recovery Plan. • Conclusion.

5. Outline • Factors contributing to the current global crisis. • Events in economic and financial markets after October 2008. • Policy responses to the global crisis. • The European Economic Recovery Plan. • Conclusion.

6. 1. Factors contributing to the current global crisis • There have been several elements that led to the financial turmoil that started in August 2007: • Macroeconomic factors - The great moderation : low volatility of macroeconomic aggregates, low inflation, housing market bubbles, widening and unsustainable international imbalances • Microeconomic factors - Financial innovation: new financial instruments of unprecedented complexity, development of the “originate and distribute” complementing the “originate and hold” model of bank operations, excessive risk taking not always by those who could best bear risk, poor risk management, inadequate regulatory and supervisory surveillance.

7. Outline • Factors contributing to the current global crisis. • Events in economic and financial markets after October 2008. • Policy responses to the global crisis. • The European Economic Recovery Plan. • Conclusion.

8. 2. Events in economic and financial markets after October 2008 • The economic outlook deteriorated sharply as the global crisis intensified last autumn : • The Commission interim forecasts 2009-2010 published on January 19 and updating the autumn 2008 forecast project world GDP growth to slow down to 0.5% in 2009 from 3.3% in 2008. • For the EU, GDP is forecast to contract by 1.8% in 2009 before recovering to 0.5% in 2010. • In the euro area, the respective estimates are -1.9% and 0.4%. • The Commission forecasts are in line with the IMF's January 2009 ad-hoc update of the November 2008 World Economic Outlook.

9. 2. Events in economic and financial markets after October 2008

10. 2. Events in economic and financial markets after October 2008 • Financial systemic-risk pressures have abated since September-October 2008 as the result of unprecedented and continuing government financial support. • Nevertheless, markets have not yet returned to normalcy and risk-perceptions—as reflected in interest-rate spreads—are still well above early-crisis and especially pre-crisis levels.

11. 2. Events in economic and financial markets after October 2008 Figure 1. Average Libor interest rate in Euro Area, UK, US - as of Mar 4, 2009

12. 2. Events in economic and financial markets after October 2008 Figure 2. 3-month Libor spreads to Overnight Index Swaps – as of Mar 4, 2009

13. 2. Events in economic and financial markets after October 2008 Figure 3. 3-mo US TED Spread: T-bill vs. Libor - as of Mar 3, 2009

14. 2. Events in economic and financial markets after October 2008 • However, pressures are still strongly present in the credit markets that directly finance the real economy. Figure 4. Commercial MBS spreads as of Mar 3, 2009

15. 2. Events in economic and financial markets after October 2008 Figure 5. Spreads in consumer finance sectors as of Jan 12, 2009

16. 2. Events in economic and financial markets after October 2008 Figure 6. CDS spreads for US and European corporates as of Mar 3, 2009

17. Outline • Factors contributing to the current global crisis. • Events in economic and financial markets after October 2008. • Policy responses to the global crisis. • The European Economic Recovery Plan. • Conclusion.

18. 3. Policy responses to the global crisis • In today’s conditions of financial turmoil the transmission mechanism cannot be relied to operate as in normal circumstances; hence the responsibility for stabilization shifts towards budgetary policy. Fiscal policy initiatives are needed to complement monetary policy action. • The spillovers across nations can be very significant in the present circumstances – hence the steps to strengthen international policy coordination. • Inter-linkages and interdependence are particularly strong in the EU and, in particular, in the euro area.

19. 3. Policy responses to the global crisis Member States are faced with a common disturbance, experience strong spillovers in their policy actions and share central common interests: • The Single Market and the Single Currency. • Structural Adjustment and Sustainable Growth. • Financial Stability and overall Macroeconomic Stability. • Multilateral governance for the global economy.

20. 3. Policy responses to the global crisis • Central bank’s liquidity provision and aggressive lowering of interest rates; • Extension of guarantees on banks’ liabilities. • Capital injections and (in some cases) state-control • Treatment of impaired assets. • Discretionary fiscal stimulus. • A review of the regulatory and supervisory framework in Europe

21. 3. Policy responses to the global crisis • Monetary easing in a concerted joint policy action on October 8, 2008. • EU leaders agreed on the principles for an unprecedented concerted action in the EU. • The European Economic Recovery Plan (EERP) adopted on November 29 is the cornerstone of the policy response. • The Commission has presented on January 28 proposals to invest €5 billion in key energy and internet broadband infrastructure projects in 2009-2010.

22. Outline • Factors contributing to the current global crisis. • Events in economic and financial markets after October 2008. • Policy responses to the global crisis. • The European Economic Recovery Plan. • Conclusion.

23. 4. The European Economic Recovery Plan EERP rests on two pillars: • Discretionary fiscal stimulus • Priority areas for Lisbon strategy Fiscal stimulus should be in line with the following criteria: coordinated; timely; targeted; temporary.

24. 4. The European Economic Recovery Plan Policy action to respect the rules of the Single Market and the Stability and Growth Pact. Policy action should follow the priorities of the Lisbon Agenda and the urgency of structural reform. Crisis are moments of opportunity. Hard questions are posed and traditional forms of operation are challenged. The EERP leads us not only from crisis to recovery but from crisis to long run sustainable prosperity.

25. Outline • Factors contributing to the current global crisis. • Events in economic and financial markets after October 2008. • Policy responses to the global crisis. • The European Economic Recovery Plan. • Conclusion.

26. 5. Conclusion • Existing EU State-aid rules & ex-ante guidance of the EC have played a major role in ensuring a minimum degree of consistency between the measures taken by Member States and therefore contribute to stay close to a co-ordinated, co-operative outcome (Single Market). • Key characteristic of intervention: Reconciliation of short-term and longer-term perspectives of public intervention is crucial to reach a sustainable and competitive banking sector and hence financial sector basis for the real economy. • Reconcialiation between the short and long run perspectives is also present in fiscal policy. Discretionary expansion must be (co-ordinated) timely, targeted, and temporary (SGP).

27. 5. Conclusion • Building the ground for sustainable recovery requires (as a necessary, albeit not sufficient condition) the restoration of financial stability. • But to prevent and manage future crises, further progress in the area of regulation, coordinated supervision and crisis management procedures (as put forward in the ESRC & the ESFS recommendations) is essential. • The same applies in the global context (G20). The de Larosière Report is also a EU contribution to the G-20.

28. The Global Crisis: a European Perspective Vitor Gaspar, Director General of BEPA (Bureau of European Policy Advisers) RTD Debate – 17 March 2009 The views expressed are my own and do not necessarily reflect those of the European Commission.

29. EU as a Framework for National Governments’ Intervention Vitor Gaspar (with Joep Konings) Bureau of Economic Policy Advisers, European Commission Workshop on The Future Face of Europe’s Financial System, Bruegel, 23 – 24 March 2009

30. Disclaimer The views expressed are my own and do not necessarily reflect those of the European Commission

31. Introduction and Motivation • Global crisis and many policy responses: • Central bank’s liquidity provision and aggressive lowering of interest rates; • Extension of guarantees on banks’ liabilities. • Capital injections and (in some cases) state-control • Treatment of impaired assets. • Discretionary fiscal stimulus. • A review of the regulatory and supervisory framework in Europe

32. In this presentation I concentrate on: • Global crisis and many policy responses: • Central bank’s liquidity provision and aggressive lowering of interest rates; • Extension of guarantees on banks’ liabilities. • Capital injections and (in some cases) state-control • Treatment of impaired assets. • Discretionary fiscal stimulus. • Regulatory & Supervisory Framework.

33. Outline • A/ Common framework for public intervention: linking gains of co-operation to spillovers • B/ Single Market: Functioning of competition and State Aid Rules  Example: Using the banking crisis to illustrate the risk of negative spillovers and the need for co-ordinated action in the context of the internal market • C/ A new EU framework for crisis prevention and crisis management

34. A/ Common framework for public intervention: linking gains of co-operation to spillovers (Berrigan, Gaspar, Pearson, 2008) • Coase Theorem as a benchmark to identify the gains from co-operation: In an environment with perfect information, well-defined property rights an costly bargaining: • Private provision of public goods is not pareto efficient in case of non-cooperative interactions (Nash). • inefficient as individuals do not take into account the externality to other economic agents • Pareto-improved outcomes can be achieved through collective action (bargaining; co-ordination)

35. Let the units of public good that individual i contibutes to the provision of the public good be denoted by - Individuals have preferences for the public good and one private good

36. Relevance of this framework in the EU context • Across the border spilloversas a result of public intervention are much clearer when they materialize in the areas in which the European Union has core competence, such as aspects related to the working of the internal market, including regulation and supervision. • In times of crises conditions of the Coase theorem are not met (e.g. costless bargaining, symmetric information,…) and therefore there is increased pressure for decentralised and uncoordinated actions. • Legal framework of the internal market is therefore a very powerful tool: Member States have delegated authority to the European Commission to have legally binding procedures governing the working of the internal market. • These legal and binding procedures have fostered the working of the internal market to the benefit of market integration, which in turn has forced further political integration.

37. B/ Single Market: Functioning of competition and State Aid Rules – key features • Internalising negative spillovers • State aids rules are designed to prevent un-coordinated government interventions to interfere with the functioning of the Single Market and also to improve the effectiveness of public intervention. • Proportionality,non-discriminatory and conditionality of the measures • The EU framework guarantees that measures taken by Member States comply with the key principles in state aid rules • Reconciling short term imperatives with longer term considerations • Design of the intervention of the intervention should reconcile short term imperatives (safeguarding financial stability, underpinning bank lending) with longer term considerations (avoiding fragmentation of the Single Market, distortion of competition, emergence of a structurally weak banking sector, unsustainable public finances)

38. Example: The Banking Sector • EC provided (ex-ante) guidelines on the application of State aid rules to measures taken in relation to financial institutions in the context of the current global crisis. • Guidelines on six classes of measures since the start of the crisis (Com 2008/C 270/02): • Guarantees covering the liabilities of financial institutions • Recapitalisation of financial institutions • Controlled winding-up of financial institutions • Provision of other forms of liquidity assistance • Rapid treatment of state investigations • Treatment of impaired assets

39. Key features of guidelines common across measures (background) • Non discriminatory coverage (to avoid undue distortive effects on neighbouring markets and the internal market as a whole) • Minimum private sector contribution (fees charged for the provision of the scheme should come as close as possilbe to that could be considered a market price) • Temporal scope • Behavioural commitments to avoid distortions of competition (including compulsory restructuring plans)

40. Background: Communication (2008/C 270/02):The application of State aid rules to measures taken in relation to financial institutions in the context of the current global crisis • Article 87(3)(b) of the Treaty the Commission may allow State aid "to remedy a serious disturbance in the economy of a Member State". In the present circumstances:legal basis for aid measures undertaken to address this systemic crisis. • general support measures have to be: - well-targeted in order to be able to achieve effectively the objective of remedying a serious disturbance in the economy, - proportionate to the challenge faced, not going beyond what is required to attain this effect, and - designed in such a way as to minimize negative spill-over effects on competitors, other sectors and other Member States.

41. Background:Communication (2008/C 270/02), contd.Guarantees covering the liabilities of financial institutions • eligibility:non-discriminatory so as to avoid undue distortive effects on neighbouring markets and the internal market as a whole • types of liabilities covered: mainly depositors’ guarantees to avoid bank runs and contamination • Temporal scope of guarantee scheme • Aid limited to minimum-private sector contribution: fees charged for the provision of the scheme should come as close as possilbe to that could be considered a market price. • Avoidance of distortions of competition: negative effects on non-beneficiary banks must be avoided by: - behavioural constraints - restrictions on commercial conduct (e.g. advertising using guarantee status) - prohibitions of conduct incompatable with the purpose of the guarantee scheme (e.g. new stock options for management)

42. Background:Communication (2008/C 270/02), contd.Recapitalisation of Financial Institutions • Used to support financial institutions that are fundamentally sound but may experience distress because of extreme conditions in financial markets  strengthen capital base to avoid negative systemic spillovers. • considerations in relation to general guarantee schemes apply, mutatis mutandis, also to recapitalisation schemes. • The particular nature of a recapitalisation measure gives rise to the following considerations: - objective criteria, to avoid unjustified discriminatory treatment - minimal capital injection and must include private participation - Member State concerned should, in principle, receive rights, the value of which corresponds to their contribution to the recapitalisation + consider claw back mechanisms or better fortunes clauses

43. Background:Communication (2008/C 270/02), contd.Controlled winding up of financial institutions • considerations in relation to general guarantee schemes apply, mutatis mutandis • Other considerations: • Minimise moral hazard, notably by excluding shareholders and possibly certain types of creditors from receiving the benefit of any aid • Liquidation phase should be limited to the period strictly necessary for the orderly winding-up to avoid competitive distortions • Sales process should be open and non-discriminatory • Sale should take place on market terms • Maximise sales price for the assets and liabilities involved

44. Background:Communication (2008/C 270/02), contd.Provision of other forms of liquidity assistance • Provision of central banks’ funds to finanicial institutions are not considered as aid when: • The financial institutions is solvent at the moment of the liquidity provision • Fully secured by collateral • Central bank charges a penal interest rate to the beneficiary • Measure is taken by the central bank’s own initiative

45. Most member states appealed to the revised guidelines on timely and coordinated state aid in the financial sector since last September

46. The Irish banking crisis triggered the awareness among the member states to have a co-ordinated response across Europe, given the potentially large negative spillovers undermining the working of the internal market

47.  Economic Rational for Co-ordinated Intervention: Internalising negative spillovers • Guarantees covering the liabilities of financial institutions: In volatile markets, need to reassure depositors that they will not suffer losses and therefore to avoid bank runs. Potential negative spillovers: - Bank run can cause contamination of healthy banks - If decentralised and uncoordinated national measures are taken, increased risk of a disturbing impact on deposit shifting from non- beneficiary banks to beneficiary banks (e.g. Irish case). Deposit shifting has the effect of contaminating healthy banks in neigbouring countries

48. 2. Recapitalisation of Financial Institutions Financial sound institutions may experience distress because of extreme conditions in financial markets (falling asset prices, deposit runs, etc.) Potential negative spillovers: - When the compensation scheme does not reflect market prices, banks in other member countries not benefiting from the capital injection are put at a disadvantage. - Irreversible nature of capital injections can trigger in a later stage expansion of the beneficiary bank at the expense of non- beneficiary banks in the same or other countries

49. 3. Treatment of impaired assets Reducing uncertainty about exposure of banks to financial losses is key to restoring investor confidence (resolving the information problem!) • Impaired asset relief is required to get credit markets functioning again Potential negative spillover: Introducing asset relief measures by a first-mover Member State results in pressure on other member states to follow suit, risking a subsidy race between Member States

50. C/ Towards a new EU framework for crisis prevention and crisis management • To have an efficient internal market in financial markets, there is a need for further procedural agreement between the Member States • de Larosière group formulates recommendations towards (i) a new regulatory agenda, (ii) stronger coordinated supervision and (iii) effective crisis management procedures • In particular:  European System of Financial Supervision (ESFS)create a network of EU financial supervisors, based on the principle of partnership, cooperation and strong coordination at the centre  European Systemic Risk Council (ESRC)decide on macro-prudential policy, provide early risk warnings to EU supervisors, compare observations on macro-economic and prudential developments and give direction on these issues.