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Back to Appendix 9: Key Roles 2000-13: State, Regulators, Banks
As part of our Terms of Reference, the Joint Committee heard evidence on reforms of EU budgetary and fiscal structures. The limited number of witnesses who gave evidence on this aspect did not lead us to make any conclusions or findings. We have however decided to include a narrative summary of the evidence which we heard, which may be of public interest, in conjunction with our publication of witness statements and transcripts.
The reforms introduced since the crisis may be broadly categorised into three areas:
Some of the shortcomings in EU policy in the years prior to the crisis were outlined by Marco Buti1 :
Other witnesses gave evidence on the inherent weaknesses of the pre-crisis framework. Paul Gallagher, highlighted the oversight weaknesses arising from the separation of monetary matters from both fiscal policy and banking supervision:
“…the European legal architecture, which was provided for in the Maastricht Treaty and which set up the European Monetary Union, was significantly lacking in important respects. Control of money matters and, in particular money supply, rested with the ECB. However, the legal responsibility for each member state’s financial system rested with that state. Interest rates were set by the ECB having regard to the overall situation in Europe and not by reference to the individual situation of any member state … Each state, however, was at the time individually in control of, and responsible for, its banking system.”3
Donal Donovan, provided an explanation for the shared failure to identify the growing structural deficit in the Irish economy in the lead up to the crisis:
“In Ireland’s case, the IMF, together with the Department of Finance, went along with the common EU methodology used to calculate the CAB [cyclically adjusted fiscal balance]… The problem was that this methodology assumed that the high output levels reached by Ireland in the first half of the decade of the 2000s, which in turn reflected the massive reliance on the construction sector, were permanent structural features.”4
Marco Buti said:
“It was the incompleteness of the tools to monitor surveillance that we had at the time. Now we are much better equipped. The strengthening of the monitoring system and the co-ordination system have been put in place since the crisis, through the so-called tool box on the banking side and the banking macro balances procedure. We had an incomplete set of tools.”5
He further explained the reforms undertaken since 2008 to correct the deficiencies:
“…the EU immediately launched an important and far-reaching reform process to upgrade and complete its economic governance structure. First, the EU surveillance framework has been strengthened with the so-called six-pack. Secondly, the scope of EU surveillance has been extended to include all relevant instruments beyond public finances; this was achieved with the introduction of the macroeconomic imbalances procedure...Third, the banking union was introduced, including in particular the Single Supervisory Mechanism and the Single Resolution Mechanism.”6
Derek Moran, described shortcomings in the Stability and Growth Pact and the changes subsequently made to enhance its effectiveness. He said:
“…prior to the crisis the EU tended to give the Irish budgetary position a broadly clean bill of health it shouldn’t have had….. It also fell short of pushing other countries through the various levels of the excessive deficit procedure, which may have had a strong signalling effect across the Union”…and “. The changes to the pact have been very significant, its principal elements are enshrined in domestic and constitutional law in member states and it [is] has become much more automatically enforceable - it now has real teeth.”7
The reforms referred to comprise the Fiscal Compact Treaty and two initiatives referred to colloquially as the “Six Pack” and “Two Pack”.
Brian Cowen described the purpose of the Fiscal Compact Treaty and it effects post-crisis. He said:
“In the aftermath of the crisis the European institutions and individual Member States examined the existing fiscal rules and how they could be improved to help limit the possibility of imbalances in the public finances which developed during the 2000s from reoccurring.
We began work aimed at introducing a domestic fiscal framework that would establish fiscal rules, multi-annual fiscal planning and performance budgeting for expenditure. This national process got overtaken by the negotiations on the reform and strengthening of the Stability and Growth Pact… The present Government took up this process of negotiations when it took office in March 2011 which culminated in the strengthening and reform of the Stability and Growth Pact.”8
The Treaty was adopted by Ireland in the Fiscal Responsibility Act 20129 having previously been approved by way of Referendum. The Act introduced a number of significant changes to the management of the national budget:
The objectives of the “Two Pack” and “Six Pack” measures were described by Derek Moran in his statement as follows:
“The six-pack: This is a set of five regulations and one directive that strengthened the sanctions regime and introduced additional features such as the expenditure benchmark that limits the growth in expenditure. Council decisions on interest bearing deposits and fine (0.2% of GDP) under the preventive arm now use reverse Qualified Majority Voting10 which increases the automaticity of such decisions.
Two-pack: These are two regulations that harmonised the budgetary timeline and introduced the requirement for Member States to submit a draft budgetary plan by 15 October each year as well as introducing a requirement that fiscal planning must be based on macroeconomic projections that are produced or endorsed by an independent body (assigned to Irish Fiscal Advisory Council).”11
While the combination of the Six Pack, Two Pack and Fiscal Compact Treaty means that the EU now employs a more comprehensive surveillance of national budgets than previously, the willingness of the Commission to follow through and enforce the new rules has yet to be properly tested, according to Derek Moran’s evidence. He said:
“The one thing about rules is they’re there to be gamed and the real risk is a political risk. What happens when a major European country gets themselves in trouble? How sustainable are they? ...... I’ve been around long enough to know that these things will evolve and not always evolve in the right direction.”12
The view was echoed by the evidence of Philip Lane, who said:
“I think those restraints are not fool proof. If a government really wants to ignore the fiscal council and ignore the fiscal rules, it probably can get away with that for quite a bit. It depends on the political system buying into that rules-based framework. That is for the members, as politicians, to work out.”13
Brian Cowen said: “the domestic fiscal rules were not proceeded with in favour of those that were being devised at EU level so as to ensure there would be no conflict between domestic and EU requirements”.14
A further problem which had to be tackled by the EU, and more particularly the Eurozone Member States, was the sovereign debt crisis which began to emerge in late 2009 following on from the financial crisis of 2008. Philip Lane said:
“During 2010-2012, one source of speculative pressure related to redenomination risk, by which investors feared that some countries might leave the euro and redenominate sovereign debts into new national currencies.”15
The fear of countries exiting the euro was driven by the scale of sovereign budget deficits arising from the crisis. Kevin Cardiff said:
“Since the previous May 2010, led by the difficulties in Greece, markets were taking increasingly sceptical views of a number of countries and were less and less willing to lend to them. Interest rates on their bonds had to rise to provide a sufficient reward for investors willing to invest in these countries’ “risky” sovereign bonds.”16
The EU response to the growing crisis was described in a paper prepared by the NTMA, in which it was stated:
“In May 2010 the EU also agreed a general stabilisation mechanism for the eurozone until mid-2013 for an amount of €750bn. This comprised:
In addition, it was agreed that the ECB could purchase eurozone countries’ sovereign debt on the secondary markets.”17
The EFSM18 and EFSF19 were subsequently utilised to fund assistance programmes for Ireland, Portugal and Greece before being superseded by the European Stability Mechanism (ESM) in 2012. The ESM is now the permanent stability mechanism for Eurozone Member States with a lending capacity of up to €500 billion.20
In his evidence, Alan Gray, said:
“EU fiscal rules provide some constraints on fiscal policies but there is a question mark over their effectiveness in preventing governments in times of economic growth from over expanding an economy. Existing EU rules may be designed to suit larger EU states and this may imply a weakness for smaller open economies. This can lead to boom-bust policies.
For a small open economy such as Ireland, inappropriate fiscal policy can be particularly damaging. Consideration could therefore be given to: Securing all-party agreement on new binding rules to ensure fiscal responsibility.”21
The European Commission Director of Regulation and Prudential Supervision, Mario Nava, said:
“… [the] deficiencies … revealed important shortcomings in the governance of the institutional framework for supervision itself and it sparked a period of unprecedented reforms in the EU, backed by an international consensus on the causes of the financial crisis and responses needed to address it.”22
He described the first phase of reforms which were implemented in 2009 and 2010 as an immediate response to the banking crisis. These reforms, which were mostly of a regulatory nature, prescribed a more intrusive regulatory approach. He said:
“… there has been … a pronounced shift to a more rule based approach, introducing a more detailed guidance in the regulatory framework for the supervisors to ensure that they step up their supervisory scrutiny….[including] liquidity management, large exposures, remuneration, management of securitisation, trading exposures and supervisory cooperation. For example, banks were required to develop robust strategies, policy, processes and systems for the identification, measurement, management and monitoring of liquidity risks and funding positions.”23
The second phase of regulatory reform:
“was adopted in 2013 and represented a more fundamental revision of the regulatory framework, responding in particular to the review of international prudential standards in the Basel III framework…. This includes new rules regarding the quality and quantity of banks’ regulatory capital, more detailed and harmonised rules dealing with liquidity, funding risks and excessive leverage, and measures improving banks’ corporate governance, including rules realigning incentives.”24
The role of supervisors was also further enhanced. Mario Nava said:
“Supervisors have obtained enhanced sanctioning powers and are required to carry out their duties in a more intrusive, intense and forward-looking manner. Particular attention was given to measures improving supervisors’ capacity to take appropriate remedial action at an early stage by putting more emphasis on macro prudential consideration.”25
The aforementioned prudential and regulatory reforms reflect only one part of the “period of unprecedented reforms”as described by Mario Nava.26 The wider process also included structural changes, along with reforms to assist the future resolution of banks in difficulty, as set out in the next two sections.
New EU institutions were created to better manage the supervision of financial stability and prudential risk. Ann Nolan said:
“The 2009 de Larosiére report recommended the establishment of a new European Systemic Risk Board and three new supervisory authorities, the European Banking Authority, the European Insurance and Occupational Pensions Authority, and the European Securities and Markets Authorities. These bodies set technical standards, resolve disputes between supervisors and assist in developing consistent interpretation of European law.”27
Two of these institutions are of particular importance: the European Systemic Risk Board and European Banking Authority.28
European Systemic Risk Board (ESRB): Chaired by the President of the ECB, this board was established in 2010 with the task of identifying and prioritising systemic risks, issuing appropriate warnings, and recommending measures to be taken in response to the risks identified. Its creation followed recognition that national regulators across the EU had paid insufficient attention to the build-up of macro systemic risks prior to the crisis.29
European Banking Authority (EBA): This was created “to promote convergency of supervisory practices in the EU and to improve communication and mutual trust among supervisors.”30
One of principal tasks set for the EBA at the outset was the creation and maintenance of the single European banking “rule book”- a unified set of banking regulations and supervisory practices effective throughout Europe. The importance of that in the context of the Single European Market was underscored by Mario Nava, who said:
“…a single rule book…respond[s] to the need for a more harmonised set of rules across the Single Market, to provide a true level playing field on which EU banks can compete. The degree of flexibility previously granted to member states and national supervisors … had led to divergent transposition of EU rules into national law. This created opportunities for regulatory arbitrage and hampered legal clarity. To achieve greater convergence, various options and discretions have been removed.”31
The lack of an EU-wide approach to banking recovery and resolution had been laid bare during the financial crisis, not least in the isolation felt by Ireland as described in the build up to the guarantee decision. Within the Euro area, the reforms went one stage further with the creation of a Banking Union.
Ann Nolan said:
“….the banking union proposal….centralised banking supervision and resolution for euro area countries, with a possible opt-in for non-euro countries. The Single Supervisory Mechanism, SSM, was set up as a new branch of the ECB with responsibility for supervising the top 130 banks in Europe. The bank restructuring and resolution directive, BRRD, was also agreed to provide for a single resolution mechanism to resolve financial institutions in difficulties.”32
Introduced into law in 2013 and fully operational from November 2014, the Single Supervisory Mechanism (SSM), a pillar of the European Banking Union, has placed responsibility for Eurozone banking supervision directly with the ECB. In this expanded capacity it now directly supervises around 120 of the largest “significant”banks in the Eurozone, while smaller, “non significant”banks continue to be regulated on a day-to-day basis by the relevant national authority.33
The Single Resolution Mechanism, through the establishment of the Single Resolution Board, has also created a framework for dealing with banks getting into financial difficulty.
Patrick Honohan gave his view of the Single Supervisory Mechanism (SSM):
“I am a great believer in taking banking regulation away from national pressures and perspectives. It is always risky changing regulatory structures. It is somewhat bureaucratic; it is somewhat slow in its decision-making, though when there were crucial decisions that we have needed to have taken, we have managed to accelerate them. I am cautiously optimistic.”34
Matthew Elderfield said:
“The Single Supervisory Mechanism (SSM) is a welcome innovation for Ireland and the Euro Zone. The SSM is valuable in that creating some distance between supervisors and the banks they regulate has helped to improve the capacity for challenge and ensure a broader, more detached, perspective on problems. Moreover, the SSM offers an opportunity to develop a best practice framework, broader skill set and more diversity of experience to strengthen supervision.”35
As stated in Mario Nava’s evidence, the cost of any such resolution procedures would in future be paid by the private sector rather the taxpayer.36 Thus a key objective is to ensure that any future banking crisis would result in minimum impact on taxpayers. Furthermore, he said that EU-level reforms in their totality provide a number of important safeguards to prevent a similar reoccurrence: “a more robust set of tools making a future crisis less likely and, if one were to happen, less costly”.37
These reforms are summarised as follows:
Structural and prudential reforms: The numerous such reforms are designed to ensure that banking and systemic risks are better identified and rigorously regulated on a consistent, European-wide basis. These may be described as the preventative reforms, aimed at avoiding any future excessive build-up of risk within the banking system.
Centralised risk management: In the event that one or more banks do get into difficulty, the existence of the Single Resolution Board should now provide an efficient, centralised structure and methodology for dealing with events, particularly on a cross border basis.
Enhanced capital requirements: Should losses occur, the enhanced capital requirements implemented under Basel III38 and subsequent EU Directives will ensure a much larger pool of shareholders’ equity to absorb these losses in the first instance.
Bond ‘bail in’ capacity: The Single Resolution Regime has also now placed into European law the ability to “bail in”bondholders in cases where shareholder equity is insufficient to fully absorb losses. This can include a write down in the value of bonds, or conversion of bonds into equity as part of a restructure.39
Single Resolution Fund: Should losses extend beyond that which can be covered by shareholders’ equity and bondholders, a final layer of protection within the Banking Union is the Single Resolution Fund. This fund is to be built up over a period of 8 years from fees levied on banks regulated within the Single Supervisory Mechanism. By 2024, when the scheme is fully funded, a reserve of approximately €55 billion, equivalent to 1% of deposits held, will be available if needed to assist any resolution scheme.40
Appendix 10 Footnotes
1. Marco Buti, Director General for Economic and Financial Affairs, European Commission, transcript, CTX00057-005 to 008.
2. The Stability and Growth Pact required countries to maintain a budget deficit of less than 3% and a maximum debt of 60%, both measured against national GDP.
3. Paul Gallagher, former Attorney General, transcript, INQ00110-004.
4. Donal Donovan, former International Monetary Fund Deputy Director, transcript, PUB00296-005.
5. Marco Buti, Director General for Economic and Financial Affairs, European Commission, transcript, CTX00057-031.
6. Marco Buti, Director General for Economic and Financial Affairs, European Commission, transcript, CTX00057-008.
7. Derek Moran, Secretary General and former Assistant Secretary Department of Finance, statement, DMO00001-012, transcript, INQ00114-004.
8. Brian Cowen, former Taoiseach and Minister for Finance, statement, BCO00002-032.
9. Fiscal Responsibility Act 2012 (No. 39 of 2012).
10. The application of Reverse Qualified Majority Voting means that a fine will be applied by the European Commission unless a qualified majority of 55% of countries representing at least 65% of total EU population vote against the fine being imposed. Article 7 of the Fiscal Compact Treaty.
11. Derek Moran, Secretary General and former Assistant Secretary, Department of Finance, statement, DMO00001-012.
12. Derek Moran, Secretary General and former Assistant Secretary, Department of Finance, transcript, INQ00114-019.
13. Philip Lane, Professor of International Macroeconomics and Director at the Institute of International Integration Studies, Trinity College Dublin, (Now Governor of the Central Bank of Ireland), transcript, CTX00059-029.
14. Brian Cowen, former Taoiseach and Minister for Finance, statement, BCO00002-032.
15. Philip Lane, Professor of International Macroeconomics and Director at the Institute of International Integration Studies, Trinity College Dublin, (Now Governor of the Central Bank of Ireland), statement, CTX00041-012.
16. Kevin Cardiff, former Secretary General and Second Secretary General, Department of Finance, statement, KCA00002-133.
17. NTMA Advisory Committee paper entitled European Debt Crisis: Resolution Mechanism, NTMA00353-003.
18. The European Financial Stabilisation Mechanism (EFSM) provides financial assistance to all EU Member States in financial difficulties. (Source: Europa.eu).
19. The European Financial Stability Facility (EFSF) was created as a temporary crisis resolution mechanism by the euro area Member States in June 2010. The EFSF has provided financial assistance to Ireland, Portugal and Greece. The assistance was financed by the EFSF through the issuance of bonds and other debt instruments on capital markets. (Source: Europa.eu).
20. Source: European Stability Mechanism http://www.esm.europa.eu/assistance/FCC/index.htm.
21. Alan Gray, Economist, former Non Executive Director, Central Bank, and Managing Director of Indecon Economic Consultants, AGR00025-009.
22. Mario Nava, European Commission Director of Regulation and Prudential Supervision, transcript, CTX00050-003.
23. Mario Nava, European Commission Director of Regulation and Prudential Supervision, transcript, CTX00050- 004.
24. Mario Nava, European Commission Director of Regulation and Prudential Supervision, transcript, CTX00050-004.
25. Mario Nava, European Commission Director of Regulation and Prudential Supervision, transcript, CTX00050-004.
26. Mario Nava, European Commission Director of Regulation and Prudential Supervision, transcript, CTX00050-003.
27. Ann Nolan, Second Secretary General, Department of Finance, transcript, INQ00076-005.
28. Mario Nava, European Commission Director of Regulation and Prudential Supervision, transcript, CTX00050-005.
29. This description of the ESRB was provided to the Inquiry by Klaus Regling, Managing Director, European Stability Mechanism, transcript, CTX00060-009/029.
30. Mario Nava, European Commission Director of Regulation and Prudential Supervision, transcript, CTX00050-005.
31. Mario Nava, European Commission Director of Regulation and Prudential Supervision, transcript, CTX00050-004.
32. Ann Nolan, Second Secretary General, Department of Finance, transcript, INQ00076-005.
33. Mario Nava, European Commission Director of Regulation and Prudential Supervision, transcript, CTX00050-005.
34. Patrick Honohan, former Governor, Central Bank, transcript, PUB00352-111.
35. Matthew Elderfield, former Deputy Governor, Central Bank, statement, MEL00001-006.
36. Mario Nava, European Commission Director of Regulation and Prudential Supervision, transcript, CTX00050-005.
37. Mario Nava, European Commission Director of Regulation and Prudential Supervision, transcript, CTX00050-005.
38. Basel III: A global regulatory framework for more resilient banks and banking systems December 2010 (rev June 2011) http://www.bis.org/publ/bcbs189.pdf.
39. Banking Resolution and Recovery Directive 2014/59/EU http://eur-lex.europa.eu/legal-content.
40. Council Implementing Regulation (EU) 2015/81 of 19 December 2014. http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32015R0081&from=EN.
Appendix 11: Structural and Cultural Changes in the Central Bank and the Department of Finance
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