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10 September 2014

Note to Commissioners-Designate Dombrovskis,Katainen, Moscovici and Hill

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Welcome to the item at the top of your in-tray! You must all work closely together to create a financial system that is capable of supplying credit right across the euro zone economy. You must be bold – implement the President’s call for a Capital Market Union.

Dear Commissioners-Designate Dombrovskis, Katainen, Moscovici and Hill

Welcome to the item at the top of your in-tray!

You have been handed pivotal roles in easing Europe out of its long-running economic crisis. It is not over by a long way and there are no magic bullets – just a long slog to remove the boulders strewn along the road. But first you must have a collective vison of the destination for the European economy. Then you must all work closely together to create a financial system that is capable of supplying credit right across the eurozone economy – from the smallest to the largest companies and across the entire continent. That is the prerequisite for economic recovery and thus jobs – and onwards to re-build political legitimacy.

  • You must be bold – implement the President’s call for a Capital Market Union
  • Give power to the European people with an open union so the savers of Europe can make their own choice about where they put their money – a de-centralisation of power, both financial and political.
  • Avoid the vicious pro-cyclicality inherent in the strict rules on matching assets and liabilities that govern most EU financial intermediation via banks, insurers etc.
  • My Temporary Eurobill Fund (TEF) can be a foundation for this Capital Market Union.

This note suggests some next steps to deepen financial integration, and enhance financial stability – thereby bolstering economic confidence just as the euro area economy seems to be experiencing another round of `jitters’. I have sent a similar note to ECON as the Committee will be interviewing you shortly – giving an opportunity to influence and encourage you to commit to principles for bold action joining up both economic and financial regulatory policy.

As Commissioner with responsibility for financial regulation, Lord Hill, you will have the added responsibility for framing single-market regulatory policy for the European Union as a whole. Moreover, such policies should be sufficiently visionary to enable the ECB to adopt correspondingly bold technical measures - within its mandate and without risking accusations of usurping the democratic powers of elected politicians. The City of London – as the centre of the euro financial system – will be looking carefully at how you ensure that all the capabilities of the European Union can be deployed to assist the paramount need for swift flows of capital to all the parts of the Union where it can be profitably employed. The smoothness of those flows will have two benefits: rewarding savers and financing new jobs.

My principal `macro’ policy suggestion is a Capital Market Union (CMU) to complement Banking Union. Can `Capital Market Union’ develop beyond a handy catchphrase into a major contribution to the deepening of EMU? My recent paper on Capital Market Union sets out some of the possible principles for such a package of policies, and why it is particularly attractive at this juncture.

Banking Union has now been enacted and we `merely’ await the full implementation. But few observers recognise the massive pooling of sovereignty that is implicit in this. In contrast, a Capital Market Union that has been designed properly would deepen the single market in finance and simultaneously offset some of that pooling of sovereignty. It would be an open union enabling the savers of Europe to make their own choice about where they put their money – a de-centralisation of power, both financial and political.

Such de-centralisation is critical to avoid the vicious pro-cyclicality that is inherent in the fact that the great majority of EU financial intermediation is in the hands of financial institutions that are subject to strict rules on matching assets and liabilities. The requirement to maintain minimum capital buffers – even though they are large – forces sudden de-leveraging if there are major losses on assets. If the risk of a major loss due to currency shifts becomes apparent, then we have already seen how quickly the single market is forced to fracture as a natural consequence of these rules.

In contrast, if the bulk of financial intermediation is done via securities held by citizens, then citizens are not compelled by law to respond in such a leveraged manner.  However, if a risk becomes obvious, there should be no doubt that they will still respond in what I call a `rolling referendum’ on the economic policies of the state concerned. That would be a powerful force for corrective action.

My principal `micro’ policy proposal is for a Temporary Eurobill Fund (TEF). The last ECON Committee was instrumental in persuading the Commission to set up an Expert Group to examine the pros and cons of proposals for a Debt Redemption Fund and for Eurobills. I had the honour of serving on this Group and gave evidence to the Committee on 1st April, immediately after our Report was published (Press Release).  I attach a paper that summarises my arguments for a TEF and some key points are appended - with a longer summary here.


What is the TEF? It would follow a similar legal structure to that of the ESM with pro rata callable capital - but with a crucial difference:  only euro states in `good standing’ could join, thus excluding those in the ESM `sin bin’. The economic structure would be the plainest vanilla. The Fund would borrow from the markets - exactly matching quantities and maturities requested by borrower states – for maturities ranging up to two years. The key step is that participants would bind themselves to borrow all new funds in this maturity range only from the TEF. In short order, there would be a genuine, single European yield curve for this market sector – with a TEF size of €0.8 trillion (nearly 10% of GDP). Members would also have the right to re-finance maturing issues by borrowing from the TEF – thus removing roll-over risk and enhancing financial stability.

Political Governance: The decision-makers will be the Finance Ministers.

Can it be done? Yes – The Expert Group was clear that an ordinary Regulation of the European Union could set up the operational platform although a separate Inter-Governmental Agreement would be necessary to bind participants to decisions about the financial management of the fund: membership, size, maturity etc.  The key is that there would be no need to change the main European Treaty.

The Plan would be good for Europe because:

  • It binds the participating euro area states into closer financial solidarity – thus encouraging greater observance of the economic governance commitments.
  • Politically, the broadening of the `common interest’ of each EU member in the economic policies pursued by fellow members would be accelerated.
  • Monetary policy would also be simplified as the TEF would purchase more than half the securities of each state that the ECB would consider buying for OMT purposes. With current talk about QE, TEF bills would be a natural public asset to purchase as they would not represent monetary finance of governments and the state-by-state exposure would already have been agreed at the politically-accountable level of finance ministers.
  • Banking union would be re-enforced as short term TEF bills would be the most natural High Quality Liquid Asset (HQLA) for banks to hold. The `doom loop’ between banks and their sovereign would be cut by more than a third - at a stroke.
  • The concept of a Capital Market Union would be boosted as all financial institutions – insurance companies, pension funds, corporations and mutual funds – would have a `European’  asset to satisfy their legitimate economic needs for holding short-dated safe and liquid securities.
  • A minor practical benefit - but perhaps looming larger in restoring public trust in financial markets – is that a public authority would provide reference pricing based on massive activity for all financial contracts that need to specify an interest rate for any particular short maturity. That would include the variable interest rate on say longer term mortgages and bonds.
  • The existence of a yield curve for the safest and most liquid asset would naturally encourage the markets to innovate products with somewhat higher credit risk, and thus return.  This should provide a welcome boost to `good’ securitisation of say packages of loans to SMEs that would back commercial paper issued by banks and non-banks. The ECB’s easy money policy could then reach SMEs across the entire euro area.

© Graham Bishop

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