23 June 2016

Andreas Dombret: Opt-in or opt-out? The future of the European Union in light of the UK referendum

Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank, at the Atlantik-Brücke, Hamburg

2. Standing firm in the face of uncertainty: the direct repercussions of a Brexit for the EU

[...] The terms of the EU Treaty would remain in force during the negotiation period. But businesses on both sides of the Channel would be unable to forge out any longer-term plans as long as these conditions haven't been clarified - so planning uncertainty is bound to be costly. And it's very much up in the air whether the spell of uncertainty will be over after two years or whether the negotiating parties will have agreed by mutual consent to extend the negotiating period.

Putting aside the tall order of gauging the economic fallout of a Brexit decision, there is naturally another question which arises from a European angle and for me personally as a central banker - given that a "leave" vote might spark a turbulent market response, how far will Europe's banking and financial system remain stable and continue to function properly?

Financial markets have already started to price in a Brexit scenario, and heightened volatility and climbing risk premiums are coming to the fore in the lead-up to the referendum. It's a safe bet that markets will remain in turmoil if the UK chooses to leave the EU.

For example, the pound is open to exchange rate risk, as it could devalue again strongly should there be a vote to leave the EU. Effects can also be expected on the stock markets. In particular, British bank shares could come under pressure if the markets expect a Brexit to push up banks' wholesale funding costs to the detriment of their profitability. Seeing as the financial sector accounts for a much greater share of the UK economy, at 6.7%, than it does in the rest of Europe, UK bank shares will be at the epicentre of market jitters. So it's not surprising that Mark Carney, governor of the Bank of England, has spoken out, as part of the BoE's monetary and financial stability mandate, on the repercussions of a Brexit and points to the likelihood of negative short-term effects.

That's why European supervisors wasted no time in urging euro-area credit institutions to precisely quantify and continuously review their forex, credit, equity and bond market risks, simulate scenarios and draw up "contingency plans". The vast majority of banks have treated the Brexit scenario with the seriousness it deserves and are rigorously prepared to face the aftermath - in some cases, their preparations have required a great deal of time and effort. The same goes for central banks, too, of course. They're ready to face up to the real risk of a "leave" vote. As things stand today, I think the risk that might emerge, say, from a theoretical UK rating downgrade or a possible revaluation of the UK property sector is manageable overall, but of course, no one really knows for sure.

As for the EU, a Brexit would also cause some fallout in the medium term. European banks based on the continent operate in the UK market and have branches in London. The UK capital is also home to a great number of non-European institutions which use the EU's passporting regime to conduct business in any other EU country - that makes London a hub for the entire European market.

If the UK voted to leave the EU, institutions in Germany and the other EU countries that operate branches in the UK would face the prospect of losing access to this passporting regime or seeing it be changed. This would force institutions to either convert their London branches into standalone subsidiaries and to apply for them to be licenced by the Bank of England or shift their operations out of the UK and into the euro area - two immensely costly options, might I add. But saying that, it is also true that if the UK opts to leave the EU, we will have to wait for the outcome of post-referendum negotiations before anything can really be said on the EU's passporting regime that will stand up in court.

But for financial centres elsewhere in the EU, the Brexit scenario opens up a number of opportunities over the medium term. Also, a larger number of foreign banks look set to switch from the UK to mainland Europe - and that's something that might even benefit the Frankfurt financial centre. London's pulling power as a venue for European bond and forex trading would shrivel. For even today, supervisors take a critical view of the fact that euro trading is based mostly in London, and therefore outside the euro area. This criticism would intensify if the UK chose to leave the EU, of course. The same can be said for clearing business and central securities depository services, at least for euro-denominated business - supervisory authorities will need to be a lot more tolerant if this business is to be allowed to be conducted not just outside the euro area but outside the EU as well. If truth be told, that's a level of tolerance I can barely imagine.

Looking at the medium-term horizon, the European Union also needs to consider how, given the close links between financial agents in the UK and continental Europe, it intends to safeguard financial stability in Europe if a more national brand of regulation and supervision is reintroduced on the other side of Channel. While UK banks aren't currently affected by the Single Supervisory and Resolution Mechanisms of the banking union, they do need to comply with the Single Rulebook.

Incidentally, the European Banking Authority plays an important role in this regard. Not only does the EBA ensure a harmonised interpretation of the rules, it also promotes interaction and dialogue on supervisory practices in the member states. And as I'm sure you all know, it is currently headquartered in London. So if the UK voted to leave the EU, the EBA wouldn't only have to find a new home; it would also have to rebuild the prudential cooperation with the UK from scratch. [...]

3. Strengthening crisis resistance: the long-term outlook for the EU

[...] The challenge of channelling diversity in the right directions has come up quite prominently in monetary union. In a large economic area, it is quite natural for individual regions to evolve in a variety of different ways; owing to the structures of their economies and societies, they will not respond to change in the same way. The underlying question is this: how can the system as a whole respond to such asymmetrical shocks? Put differently: how can the EU be made more crisis-resistant?

In a single monetary area such as the euro area, there are no more exchange rates to adjust; therefore, other channels are needed to cushion imbalances, such as adjustments to prices in the factor markets, sufficient labour force and capital mobility, or also, of course, a stability-oriented economic and fiscal policy.

Despite a variety of efforts at harmonisation, there are still 19 different sets of economic and fiscal policy in the euro area. Yet these states are not all necessarily addressing their respective structural problems in an appropriate manner because EU-level sanctioning mechanisms are either non-existent or, to put it mildly, being underused. It has also occurred in the past that, in dealing with their structural issues, governments have fobbed off part of the negative fallout of national policy measures on the rest of the euro area. Over the course of the euro crisis, this became clear in connection with sovereign debt. [...]

Let me frame the reform problem this way: Europe is facing the challenge of overcoming obstacles to reform along the route to a sustainable and coherent community order. There is certainly more than just one solution. The option of reforming the common economic and financial framework towards stronger European liability, however, is predicated upon transferring more national sovereignty to the European level. If we look at the discontent about "ever closer union," it appears as if this option is currently a political non-starter. However, another way for the European order to ensure synchronicity between actions and liability for their consequences is that these consequences are borne where the vast majority of scope for action is located: by national decision-makers. This means that they need to take responsibility for their actions and have convincing incentives to eliminate the structural problems. [...]

Let me once again reiterate the guiding theme of my foregoing remarks: there is an in-built conflict between short-term relief and the balance between actions and responsibility for their consequences, and thus also the basis for a rules-based order that can function in the long run. It is not only at the EU level but also, and in particular, member states where unpleasant structural reforms have to be undertaken in order to make the EU less vulnerable to crises. Time is of the essence and, given the challenges we are facing in the EU, should not be wasted.

Full speech

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