Session 1: How did Europe cope with the first phase of the crisis

Jun 28th, 2010 | Category: Session 1

11 June 2010

The session looked at the responses to the financial crisis in the new Member States (NMS) and at the responsibility of and challenges for financial regulation.

Downturn but not breakdown in NMS. Amongst emerging economies, NMS have been the mostly affected, even if the banking sector’s exposure to toxic assets was minimal. Still, this did not lead to the breakdown that some had predicted. The intensity of the crisis was here correlated with the size of the previous imbalances. Most NMS have been going through a boom-bust cycle as a consequence of the crisis. They benefited from sustained growth rates before the crisis and suffered from significant negative growth after the outbreak. Latvia was a case in point.

Structural and macroeconomic conditions explain the dramatic economic downturn. In particular:

• Financial integration played an important role in the spreading of the crisis from core Europe to the NMS. EU financial assistance had the perverse effect of supporting just subsidiaries.

• Heavy reliance on capital imports was part of the problem. It was premature.

• Monetary and exchange rate arrangements may have not been appropriate. Currency boards are useful in that they guarantee price stability but also facilitate boom and bust cycles due to capital imports.

• There was a steady appreciation of the exchange rate with a Dutch disease in some of the new MS. Some had macroeconomic imbalances with a similar divide between creditor and debtor countries that is present in old Europe.

• Some others were pursuing pro-cyclical fiscal policies.

The worst case scenario was avoided due to the fact that the banking sector was relatively sound, financial assistance prevented a liquidity crisis, in Romania in particular, the IMF accepted larger budget deficits. As to the future prospects, it will very much depend upon the pace of EU recovery, which in fact remains uncertain.

Financial regulation. Part of the problem is that there is not an optimal general model in financial regulation and supervision. Without a theoretical benchmark it is more likely that the whole system becomes victim of capture by politicians. It is now generally accepted that the drivers of the crisis were a too relaxed monetary policy and bad regulation supervision, both were very much intertwined in the US.

The lessons one can learn from the crisis are as follows:

• Common accounting rules are needed to get rid of shadow banking systems.

• Missing markets should be taken care of meaning that it is necessary to regulate markets for any financial transaction starting with markets for derivatives. These types of markets provide in fact no information, with the result that incentives are misaligned.

• Prudential regulation failed. Banning is not the solution.

• As to the regulatory architecture, there was a trend towards consolidation before the crisis but then it stopped. By way of example, the US introduced a new authority for consumer protection. Lack of consolidation creates serious coordination problems. The US approach is that by having more authorities we increase competition. It was observed that the crisis showed we need more consolidation.

• The ECB was highly specialised. It was purely in charge of monetary policy. The responsibility for financial supervision rested instead with national central banks. The crisis has put a halt to this specialization. Some noted that central banking and regulation should in fact go together but it was objected that the whole EMU project would have not gone ahead if the ECB was given supervisory powers.

The EU was largely unprepared in the face of the type of crisis we had. From an institutional perspective, the crisis was dealt through a combination of ad hoc intergovernmental coordination and community instruments. But there was no integration of community instruments and the EU failed the opportunity to clean up the banking sector in the second half of 2009. It remains to be seen what the European Systemic Risk Board will fulfill its mandate as its functioning seems dependent upon its ability to gain power over tax policies.

Rapporteur: Benedicta Marzinotto, Bruegel

• Daniel Daianu, “NMS’s Hard Landing But No Breakdown”

• Donato Masciandaro, “Reforming Regulation and Supervision in Europe: Five (Missing?) Lessons from the Financial Crisis.”