In the run-up to the credit crisis, many conversations throughout the world were fascinated with property prices. The general consensus was that there was a bubble and something had to give. And so it proved. Nowadays and in recent years, there have been many similar conversations taking place around the sustainability of the Euro. The Euro when initially developed was a visionary concept to eliminate foreign exchange costs and increase cross-border business in Europe. However, economically and legally, it also presents an uncomfortable half-way house between a multiple sovereign and municipal framework, which brings with it unique risks and challenges.
I – The Eurozone and its structural difficulties– the ingredients for systemic risk
Eurozone debt poses risks, both in terms of the amount owed by some countries and their structural ability to repay. For instance, Italian debt stands at 132% of GDP. Spain, Italy, Greece and Portugal owe $1tn to the European Central Bank through the Target2 system. Italy owes 23% of its GDP through that system.
This is all the more concerning when one considers the risks posed by the EU’s regulatory treatment of Eurozone member states’ Euro-denominated sovereign bonds – as essentially risk-free. This feature introduces systemic risk into global financial markets in a way that could be magnified if significant financial business is relocated to the Eurozone after Brexit. The issue arises because, in law and regulation, the sovereign bonds of Eurozone member states are currently treated as high quality assets, akin to cash, rather than in a manner that properly reflects their inherent risks. Moreover, the regulators in Eurozone member states have considerable discretion in their supervision of local financial institutions and national champions, which are among the main purchasers of local sovereign bonds, while the European Central Bank (the ECB) aims to sustain matters using imperfect monetary and regulatory levers. There is essentially a conflict of interest that arises between a system that is supposed to be risk-free and each individual state’s need to issue its debt on the most attractive terms.
This matter has not so far been widely identified or discussed to any meaningful degree. Because various Eurozone states are now trying to encourage more financial businesses to locate into their states post-Brexit, the in-built conflict becomes impossible to ignore. The failure to identify and to avoid systemic risks arising from US sub-prime mortgages was a key cause of the 2007-8 financial crisis. The result of a Eurozone crisis could be just as – if not more – significant.
II – The Euro: A ‘half way house’ currency – not sufficiently linked to a sovereign state
The systemic regulatory risk arises from the dangerous “half-way-house” position of the Euro: a currency which is not linked to a single sovereign state. Rather than the traditional, well-understood and minimum-risk model of currencies being linked to single sovereign entities, the Euro relies on a network of sovereign entities in the Eurozone, with coordinating efforts and some centralisation of certain powers at the ECB level, but with no Eurozone sovereign.
Individual member states, unlike sovereign states in control of their own currency, do not have the array of monetary policy tools available to them to deal with potentially destructive fiscal and monetary problems. In particular, they cannot unilaterally print money to repay debts denominated in their own currency. This is a key attribute of the own-currency debt instruments of a sovereign state, which means the sovereign is never in a position where it is forced to default on that debt. The effect of such a lack of control is exacerbated by the regulatory framework as follows:
1. Bonds issued by Eurozone sovereign states and denominated in Euros are, as a matter of EU law, given the same 0% risk capital treatment that applies to genuinely sovereign bonds, so they can be purchased by EU financial institutions for cash without incurring a regulatory capital charge for credit risk. Regulatory capital requirements would normally mandate that a certain amount of equity or subordinated debt, issued by the financial institution, must be held against the institution’s exposure to the possibility of the bond issuer defaulting on its repayment obligations.
In the case of sovereign bonds of leading industrial countries issuing in their own currency, a 0% risk weighting for credit risk can be justified and is established under international Basel standards and the EU’s Capital Requirements Directive IV, on the basis that bonds issued in a sovereign’s own currency are effectively akin to cash. Ultimately, control over the central bank’s printing presses means that the sovereign need never default. Bonds denominated in Euros lack this justification. Local Eurozone states do not control the ECB and cannot print more Euro. As a result, the sovereign bonds of such issuers ought to be subject to a risk weighting. Under the Basel standards and EU standards, counterparty credit charges are imposed on both municipal debt and on the debt of countries issuing in a currency other than their own. These should be considered as more appropriate benchmarks for some Eurozone sovereign debt, which should be risk weighted at a level commensurate with the creditworthiness of the sovereign issuer. The problem is further aggravated by the fact that EU regulation also requires EU clearing houses to accept sovereign bonds, including Eurosystem bonds, as if they were risk-free collateral and mandates the investment of cash held by clearing houses into such assets.
Not only does this discrepancy cover over the manifest differences in viability of debt issued by, for example, Germany as compared with that issued by, for example, Greece. It has also led to a significant ability for less robust economies to issue debt they could not realistically repay. Many clearing houses and banks have developed their own more restrictive list of acceptable sovereign debt, but this has been voluntary and does not apply across the board.
2. Local Eurozone member states and their regulators may find themselves at the centre of irreconcilable conflicts of interest. The tension lies between protecting their own state’s economy and national champions while at the same time participating in a pan-Eurozone system where it is envisaged that their local financial institutions should be allowed to fail in order to protect the system and Euro as a whole. There is therefore an incentive for national regulators to perpetuate the existence of local financial institutions beyond their justifiable life since otherwise there would be no ready market for new issuances of their member state’s government bonds at a reasonable price.
This conflict between the interests of the national regulator and the natural course of what would otherwise be the market solution is an inevitable result of the Eurosystem not being that of a genuine sovereign.
The ECB directly supervises systemically significant Eurozone banks in conjunction with local member state regulators, applying local regulation and using the local court system. Local regulators supervise non-systemic banks, with indirect supervision from the ECB and under harmonised standards set by the European Banking Authority. In reality, the views and decisions of local regulators are key in both cases and are left subject to considerable de facto autonomy. Even if the ECB operates in an apolitical manner in its supervisory role, there is a risk that local supervisory practices may be constrained as a result of the conflicts of interest faced by the local regulator. Institutions have already been kept going when they fail to meet capital standards, on several occasions, and normal regulatory judgments as to the propriety of key actions (and inactions) by financial institutions are skewed.
The local member state politicians and legislatures can also influence the supervisory process. National legislation has been adopted and leveraged to “bail in” creditors of banks and investment firms, as happened in the cases of Greece and Italy. This local legislation permits the member state to recapitalise failing local institutions at the expense of international creditors by writing off the equity and converting debtholders’ interests into equity – a bail-in. Some regimes have permitted themselves to do this on the basis of a private settlement and valuation conducted locally and not subject to the restrictions of the pan-EU Bank Resolution and Recovery Directive (BRRD), which was crafted to ensure the fairness of bail-ins across the EU.
The BRRD was also developed in order to prevent the recycling of state money into financial institutions before existing creditors have largely been wiped out. It requires there to be a bail-in of 8% of an institution’s overall liabilities before state monies can be made available. Many local institutions have not been able to take such an 8% write-down without giving rise to significant local issues because of the impact on domestic investors and in some cases depositors. Under some national legislation, the state will permit itself to inject new, state monies into the bank or investment firm on a more discretionary basis than permitted under the BRRD, without the 8% restriction and on the basis of its local (non EU-controlled) valuation.
The final feature of the BRRD is that decisions taken under it have to be recognised and given effect across the EU. This feature is unavailable to local states implementing their own legislative measures. However, a quirk of a separate pan-EU law nevertheless requires a local state authority’s decision under its domestic statutory resolution framework to be given effect across the EU as a whole – including, at present, in the UK under English law, which is the regime that governs many sovereign bond issuances because it is trusted by the international financial markets.
3. The new, pre-funded pan-EU deposit guarantee scheme mutualises risks by sharing losses to deposit-takers across the banking community operating in the EU. Losses incurred by retail and certain other depositors are generally made whole by the scheme, rather than using funds levied locally within the member state. UK banks considering relocating deposits to the EU should consider the relative risks of their contributions to deposit protection schemes being used to pay off depositors of failing local banks in southern Europe and elsewhere. This factor also adds to the moral hazard for national regulators. It is not necessarily their member state’s money or institutions that will bail out local savers.
III – London and New York: Established Safety
The cycle of member state debt issuances, extensive purchases by local financial institutions and the inherent conflicts of interest for local regulators creates unappreciated risks for financial institutions doing business in the Eurozone.
The extent of that risk is masked while the Eurozone maintains its current membership and in advance of a member default. The possibility of banking collapse only materialises in full if a country leaves the Eurozone, devalues its debt and the assets of its banks that are invested in that debt or a moratorium or repudiation of its Euro-denominated debt occurs. If one state were to do so, this would raise the possibility of other countries doing the same, ultimately devaluing assets held by other banks and the ECB in the form of government debt of devaluing countries. This is by no means out of the question and is precisely the sort of risk that the regulatory capital rules and regulatory supervision should be intended to protect against.
This underlying, if somewhat hidden, risk resulting from the structure of the Eurozone could be exacerbated by the response of some international financial institutions to Brexit. Prior to the Brexit vote, the international markets have been somewhat insulated from Eurozone systemic risk since they are located principally in London and New York and subject to largely autonomous regulation.
However, with the advent of Brexit, there is an attempt in some quarters to create business movement to the EU in order to continue access to EU customers or to maintain the convenience of the EU passport. In reality, the passport has only been fully in operation for investment services since 2007 and is not a feature of other global financial centres. A perceived lack of available time properly to engage in the required, highly intricate cross-border legal analysis to continue EU service delivery from the City to the ongoing EU, is driving some short-term thinking. Some institutions appear to feel pushed to have contingency plans which involve relocating certain business within the Eurozone, which for the reasons above may have other business consequences.
These issues and risks with doing business in the Eurozone should be taken into account and properly addressed by financial institutions considering relocating businesses or staff into the EU. Financial institutions would be well advised also to consider some of the various innovative techniques now being developed to mitigate steps needed for contingency planning on a “no deal” outcome from Brexit negotiations, to ensure that this is minimally disruptive in terms of resources required to maintain service delivery to EU customers.