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Banking Union as a Shock Absorber
Lessons for the Eurozone from the US
By Daniel Gros, Ansgar Belke Rowman & Littlefield International, Ltd.
Copyright © 2015 Centre for European Policy Studies
All rights reserved.
ISBN: 978-1-78348-595-6
CHAPTER 1
Introduction and motivation
The euro area started as a pure 'monetary union'. It is now in the process of also becoming a 'banking union' (BU). EU leaders have argued that even this step is not enough. In September 2012, close to the peak of the euro crisis, a joint report by the four Presidents of the European Union (the Presidents of the European Commission, the European Council, the Eurogroup and the European Central Bank), entitled "Genuine Economic and Monetary Union", argued that much more was needed (Belke, 2013; Begg, 2014). The four Presidents argued in essence that the establishment of a banking union should also be seen as a first step towards further integration. According to their report, a fiscal union would be the next logical step. Moreover, a fiscal union was held to imply the need for a political union.
There is surprisingly little analytical support, however, for the claim that a banking union needs to lead to a fiscal union (Belke, 2013 and 2013a). The key argument most often heard is simply the observation that the euro area has only a very limited central budget (at least compared with other monetary unions), and that therefore there are almost no fiscal transfers to smooth asymmetric shocks. By contrast, the US, which is similar in size to the euro area, does have a substantial federal fiscal budget. The US experience is thus usually taken as a model of what is needed for a sustainable monetary union.
This study contributes to this debate by illustrating how the 'banking union' of the US provides very tangible insurance against local financial shocks, without major involvement of the 'fiscal union', which undoubtedly also exists in the US.
The transatlantic financial crisis which started in 2007-08 and led to the Great Recession provides a key episode in assessing the importance of mechanisms to absorb regional shocks. The financial shocks quickly became regional in the euro area after 2009-10 when the financial systems of some countries almost collapsed and their sovereigns lost market access, e.g. Ireland, Portugal and Greece. It is often overlooked that the origins of the crisis in the US were also rather concentrated at the regional level. The housing boom was very concentrated in the US. The increase in housing prices varied enormously from state to state and only a few states (Arizona, Nevada, Florida and California) tended to account for most of the sub-prime lending, overbuilding and thus the subsequent economic distress and losses from delinquent mortgages.
However, the US experienced 'only' a system-wide crisis in 2007-09. There was no specific crisis involving only those states where the real estate excesses had been most marked (Nevada, Florida and California). The main thrust of this study is that the US was better equipped to deal with these regional shocks because it is a fully fledged banking union.
The euro area officially has a banking union, but most observers would agree that it is incomplete if one starts with the three 'canonical' elements of a banking union (IMF, 2013a and b):
1) Common supervision. This has been achieved since the ECB, under the heading of the Single Supervisory Mechanism (SSM), has become the ultimate supervisor for all banks in the euro area, and the direct supervisor of about 130 of the largest banks accounting for about two-thirds of banking assets.
2) A common mechanism to resolve banks. This has also been achieved with the creation of the Single Resolution Mechanism (SRM), which will be able to rely on a common fund, i.e. the Single Resolution Fund (SRF), after a transition period. The SRM will cover all banks in the euro area (and in those other EU countries wishing to join the SSM).
3) Common deposit insurance. No agreement has been reached on this point. It remains to be seen how important this lacuna will become.
By contrast, the US has had all three elements in place at least since 1933. The US thus qualifies as having had a banking union for over 80 years. (But one should also not forget that the US monetary union survived almost a century and a half without being a banking union.)
The central theme of this study is that the consequences of the US banking union could be seen during the financial crisis. A simple comparison of the fate of two different members of a large monetary union, after they were hit by a financial crisis, offers a powerful illustration of the importance of an integrated banking system. Ireland and Nevada, in fact, provide an almost ideal test case. These two entities share several important characteristics. For example, they both have similar populations as well as comparable GDP/GSP (gross domestic product/gross state product), and they both experienced an exceptionally strong housing boom. But when the boom turned to bust, the US states did not experience any local financial crisis (nor did any state government have to be bailed out).
We find that the key difference between Nevada and Ireland is that banking problems in the US are handled at the federal level (the US is a banking union), whereas in the euro area, responsibility for banking losses remains national. Moreover, we also find that large banks with a wide footprint can also help to absorb regional shocks (at the cost of transmitting them to the entire system).
This book is organised as follows. The next chapter presents some case studies of the stabilisation properties of a banking union. Chapter 3 then analyses the role of 'foreign-owned banks' as a sort of 'private banking union'. Chapter 4 looks at the institutions that paid for the shock absorption provided by the official US federal banking-related institutions: the Federal Deposit Insurance Corporation (FDIC) and government-sponsored enterprises (GSEs), commonly known as Fannie Mae and Freddie Mac. Chapter 5 speculates on the extent to which European banking union as currently planned could provide comparably strong protection against regional shocks. Chapter 6 presents some considerations on the degree of financial integration in the euro area and discusses how the insurance premia within the SRM should be determined. Chapter 7 contains some general considerations with respect to a fiscal union and financial shock absorbers and the final chapter offers conclusions.
CHAPTER 2
The macroeconomic stabilisation properties of a banking union: Some case studies
In this chapter we analyse the implications of a banking union for macroeconomic stability by making comparisons between countries/states that have experienced similar local boom-bust cycles in real estate, but are part of different federal systems in terms of financial markets.
The comparison pairs are Ireland-Nevada, Spain-Florida and Latvia-Nevada. The first two pairs are part of a larger currency area. The Latvia-Nevada comparison is interesting because Latvia was not in the euro area during its boom-bust cycle, but its banking system was dominated by banks from Nordic countries. In this sense, Latvia benefited from some protection provided within the 'Nordic Banking Union'.
The pairing Ireland-Nevada is the one that comes closest to a natural experiment as these two entities are of a very similar size and had a very similar boom and bust in terms of real estate. The key difference, of course, is that the banks operating in Nevada are part of the fully integrated and wider US banking system to such a degree that one cannot really speak of a 'banking system of Nevada'. The analysis will show that this was decisive for the limited impact of the great recession on the local economy and local public finances in Nevada (and other US states with similar local real estate booms).
Florida can similarly be compared to Spain. Both of these entities represent larger, more diversified economies than either Nevada or Ireland. Somewhat surprisingly (it was stated above that real estate booms tend to bear a regional character), real estate investments seem to have played a larger role in Spain, although the country is somewhat larger than Florida.
Another useful comparison is that between Nevada and Latvia or the other Baltic countries. None of the latter was part of the euro area when the crisis struck them in 2008-09, although they all had fixed their exchange rate to the euro and were thus informally in an (asymmetric) currency union with the euro area. Nevertheless, they weathered the crisis more quickly than Ireland, or other peripheral euro-area countries, because they benefited from the fact that their banks were largely owned by big Nordic banks which were able to absorb the losses that arose when the housing boom collapsed and the Baltic economies experienced a very sharp recession. It is interesting that the only Baltic country that needed a bailout was Latvia, which was also the only country that still had a significant local bank.
Before going more deeply into these comparisons, it is useful to consider the extent to which the boom-bust cycle is different between the US and the euro area at the aggregate level.
2.1 Regional concentration of real estate cycles within a monetary union
The aggregate data on housing prices and construction activity (as a percentage of GDP) reveals a considerable similarity. The boom was actually somewhat more pronounced in the US than in the euro area, at least if one looks at aggregate numbers. Housing prices increased by more in the US and then fell by more, but also recovered earlier, thus ending up at a similar level relative to that of the euro area (EA), if one looks at the period since the start of monetary union (Figure 1, right-hand side).
An even more important indicator of the potential cost of a real estate cycle is the amount of construction activity undertaken (Figure 1, left-hand side). A large stock of unsellable houses often constitutes the main reason for losses on mortgages. Here again, one finds that the cycle was somewhat more pronounced in the US than in the euro area since construction spending fell by about 1.3 percentage points of GDP in the US, but only about 1.1 percentage points of GDP (on aggregate) in the euro area.
How could one then explain that the US recovered earlier from the bust of the housing bubble and that there were very serious difficulties at the national level in Europe, even in countries like Ireland or Spain, where public finance had been under control?
It is tempting to argue that the lack of regional problems in the US was due to a more uniform manifestation of the boom in the US than in the euro area. Within the euro area the average number hides fundamental differences between the peripheral countries Spain and Ireland, where both housing prices and construction activity boomed until 2007, and core countries like Germany where both housing prices and construction activity were relatively weak (again until 2007-08).
However, the boom-bust was also very concentrated in the US. Figure 2 below shows the distribution of the losses sustained by the Federal Deposit Insurance Corporation (FDIC) during the last crisis in each state. It is apparent that the banking problems were highly concentrated in a few states (small dots indicate losses above 3% of GSP, diagonal stripes 1.5-2% of GSP and solid filler, below 0.5% of GSP).
This combination of a similar boom/bust pattern in the aggregate variables and a similar degree of concentration at the regional level already suggests that the structure of the financial system and its backup mechanism must have played a key role in containing regional problems in the US.
2.2 Ireland vs Nevada
Ireland and Nevada share several important characteristics, as reflected in Table 1 below. Their populations are not overly different (2.7 million vs. 4.5 million) and rather similar levels of GDP/gross state product (GSP) ($120 billion vs. $200 billion), at least as a share of the eurozone and US GDP, respectively. Both experienced a strong recession and a very similar level of unemployment. However, the fall in GDP and GSP, respectively, was much larger in Ireland than in Nevada. As will be argued below, this was due to the fact that the losses arising from the real estate bust in Nevada were to a large extent absorbed by the US federal financial system.
The most important similarity is, however, that they both experienced an exceptionally strong housing boom – and bust. The similarity of the boom-bust cycle is shown in Figures 3a to 3d:
• 3a shows (nominal) GSP and GDP increased by a very similar proportion during the boom and then fell.
• 3b shows the evolution of housing prices, which increased until 2007-08 and then fell. This was the first fall in housing prices during peace time for the US.
• 3c shows construction activity as a percentage of GDP (for Ireland) and of GSP (gross state product for Nevada). It is again apparent that the two series follow the same pattern, but construction activity seems to have been much more important to the economy of Ireland than to that of Nevada. However, this difference might be due to a difference in definition of the aggregate 'construction' in the national accounts.
• 3d shows the consequences for the real economy in terms of the unemployment rate, which also follows a similar pattern.
However, there is one fundamental difference between the two: when the boom turned to bust, Nevada did not experience any local financial crisis and the state government did not have to be bailed out. By contrast, the government of Ireland was for some time unable to issue any new debt on the market and had to be supported by a very large loan financed jointly by the IMF and the European rescue fund, i.e. the European Stability Mechanism (ESM) and its precursor, the European Financial Stability Facility (EFSF).
The key difference between Nevada and Ireland is that banking problems in the US are taken care of at the federal level (as the US is a banking union), whereas in the euro area, responsibility for banking losses was national, and will remain partially national until the SRF is fully operational.
Local banks in Nevada experienced huge losses (just like in Ireland) and many of them became insolvent, but this did not lead to any disruption of the local banking system as these banks were seized by the FDIC, which covered the losses and transferred the operations to other, stronger banks. In 2008-09, the FDIC thus closed 11 banks headquartered in the state, with assets of over $40 billion, or about 30% of GSP. The losses for the FDIC in these rescue/restructuring operations amounted to about $4 billion.
Other losses were borne at the federal level when residents of Nevada defaulted in large numbers on their home mortgages. The two federal institutions that refinance mortgages have lost between them about $8 billion in the state since 2008.
The federal institutions of the US banking union thus provided Nevada with a 'shock absorber' of about 8-9% of GSP, not in the form of loans, but in the form of an (ex-post) transfer because losses of this magnitude were borne at the federal level. (Against this transfer one would of course have to set the insurance premia paid by banks in Nevada prior to the bust. But they are likely to have been of a lesser magnitude.)
Of course, a lot of the banking business in Nevada was (and still is) conducted by 'foreign' banks, i.e. out-of-state banks, which just took the losses from their Nevada operations on their books and could set them against profits made elsewhere. This is another way in which an integrated banking market can provide insurance against local financial shocks. One might call this a 'private' banking union (or a truly integrated banking market). It is impossible to estimate the size of this additional shock absorber, but the losses absorbed by out-of-state banks might very well have been at least as large again as the losses borne by the federal institutions. The total write-down of the large US banks, which operate across the entire US, was about $440 billion, twice as much as the $220 billion in losses of the three official institutions (FDIC, Fannie Mae and Freddie Mac). If these losses were distributed in a similar way to the losses of the official institutions mentioned so far, one could conclude that the shock absorption capacity of the large union-wide banks is likely to have been worth about 17% of GDP.
(Continues...)
Excerpted from Banking Union as a Shock Absorber by Daniel Gros, Ansgar Belke. Copyright © 2015 Centre for European Policy Studies. Excerpted by permission of Rowman & Littlefield International, Ltd..
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