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dossier	SWD(2013)156 - European Financial Stability and Integration Report 2012.
document	SWD(2013)156
datum	25 april 2013

ANNEX I. EXAMPLES OF OTC DERIVATIVES CONTRACTS ...............................................................

CHAPTER 5: SME'S CREDIT ASSESSMENT INDUSTRY, CONTRIBUTION TO STABILITY AND GROWTH ............................................................................................................................... ...................

5.1 Introduction ...............................................................................................................................................

5.2 Business information and Credit Scoring Industry .........................................................................

5.3 Main sample features and scope of the study ....................................................................................

5.4. Diversity of business models .

5.5. Market entry and structure .

5.6. Contribution to SME growth ...............................................................................................................

5.7. Experience with the single market .....................................................................................................

5.8 Conclusion ..................................................................................................................................................

5.10 Annex ..........................................................................................................................................................

5.11 List of abbreviations ..............................................................................................................................

EXECUTIVE SUMMARY

This chapter presents how the crisis in financial markets in Europe has unfolded in its fifth year. Financial developments in 2012 have had a significant impact in holding back an economic rebound. In particular, they have born heavily on economic growth and employment performance, as visible in negative annual GDP growth and rising unemployment figures across the European Union (EU) and the Euro area. At the same time, lower growth has continued pressurizing agents’ balance sheets, general financing conditions and the capacity of agents to take new risks.

In this regard, Chapter 1 presents how the importance of deepening economic and financial integration across the EU unveiled in 2012. In particular, taken together, the cumulative impact of the policy initiatives proposed by the European Commission to build a Banking Union and the open commitment made by the European Central Bank (ECB) to do whatever necessary, within its mandate, to redress the risk of a euro breakup, seemed to have been a powerful deterrent to reduce stress across the board in EU financial markets.

Establishing a banking union is, however, one of a series of initiatives being developed by the EU institutions to reinforce financial stability and integration across the EU27. In this regard, chapter 2 presents the main policy initiatives that have been or are being implemented, adopted, presented, or developed in 2012. It covers both macro and micro-financial policies, including financial assistance and other support measures; economic governance reforms, in the context of reinforced surveillance of Member States economic policies; and the on-going Commission reform programme in the financial services sphere. The sheer magnitude of proposals and the advanced stage of their implementation evidence how far policymakers and, in particular, regulators have come since the Lehman Brothers bankruptcy.

The detailed summary of initiatives presented in chapter 2 does not preclude zooming in on a few fronts currently being analysed by the Commission, an aspect that is covered in chapters 3 to 5. Hence, chapter 3 takes stock of the important debate initiated by governments, international organizations, and, ultimately, the general public to analyse precisely the business models of the financial institutions. In particular, the chapter analyses the desirability of adopting structural reforms in the banking sector. Several EU Member States (UK, FR, DE, NL, etc.) and other G20 countries (US) have already embarked on structural reform agendas to address lingering problems in this sector. Having a pan-European approach in mind, the High-level expert group (HLEG) on structural reforms of the EU banking sector, chaired by Erkki Liikanen, recommended a package of reform measures in October 2012.

Structural reform initiatives may yield both ex-post benefits (improved resolution) and ex-ante benefits (improved risk management, monitoring, regulation and supervision). However, given the important and desirable diversity of financial systems and business models in the EU, and the relatively intrusive nature of structural reforms (coming on top of several other regulatory initiatives), any legislative proposals need to be grounded on broad public consultations and thorough evaluation, on the basis of a careful assessment of its effectiveness, efficiency, and coherence in the overall regulatory agenda. A pan-EU structural reform initiative could ensure that national structural reform efforts are not diverging, the underlying objectives are reached, and the functioning of the internal market is safeguarded. In any case, the ultimate overarching objective is to establish a stable banking system that serves the needs of citizens and the economy

of the entire European Union, which helps to foster economic growth by realigning incentives, reducing instability and improving resource allocation.

Banks are one of the main players in the financial system, but it is important not to lose sight if the financial instruments and activities performed by banks can be provided differently, including other trading venues or multilateral market platforms. In this regard chapter 4 describes progress to regulate the over-the-counter (OTC) derivatives markets. Derivatives play an indispensable role in modern finance, but the recent financial crisis has shown that they have the potential to exacerbate financial instability. In general, both the lessons of the financial crisis and recent academic research suggest that OTC derivatives markets have the potential to impose large social costs. Consequently, financial regulation has an important role to play in mitigate them, particularly given the light regulatory approach that characterized this field of finance prior to the crisis. To tackle these inherent vulnerabilities, the EU focused its attention on the lack of transparency, as well as on the excessive counterparty and operational risks in OTC derivatives markets.

The European Markets Infrastructure Regulation (EMIR) embodies the principal EU regulatory response in this field, entering into force in 2012 along with its associated principal technical standards. Stronger EU legal framework is expected to promote further integration of cross-border financial market infrastructures. At the same time, EMIR still has to be tested in practice and its effective implementation must, therefore, be carefully monitored. The EU regulatory agenda in the field of OTC derivatives includes also other legislative initiatives that are still negotiated. In particular, the observed move towards more secured funding along with the collateralisation requirements for OTC derivatives mandated by EMIR are expected to increase demand for high quality collateral at a time when its supply is constrained. This trend drives the development of new business models to improve market liquidity, which may introduce new risks into the financial system. Thus, further efforts are required to address the structural vulnerabilities linked to OTC derivatives in a holistic way.

Finally, it is imperative that the Commission, national regulators and, in general, policymakers do not to lose sight of the pivotal role the financial sector has in supporting the real economy and in providing jobs and growth for society. The analysis in chapter 5 underscores this point by examining the difficulties small and medium-sized enterprises (SMEs) experience in their access to funding. As is well known, SMEs present the bulk of EU businesses, providing jobs and contributing to wealth and economic growth. Nevertheless, historically they have always faced significant difficulties to access funding; one of the main reasons being the lack of credible public information about them. This has generated elevated costs and uncertainty for potential providers of funds to evaluate their credit worthiness. And it is one reason why they have traditionally strongly relied on bank financing: bank loans and other advances accounted for 85% of total non-financial corporate debt outstanding in the Euro area and in the UK in 2011, while non-financial corporate bonds accounted for only 15%. This is not the case across OECD economies: in the United States the proportion is 53% to 47%. As European banks are facing significant challenges, alternative finance sources, such as trade credit or market-based funding, are gaining importance.

The business information and credit scoring (BI & Scoring) industry can improve SMEs’ access to finance by providing information on their credit worthiness (scores). They can also establish risk awareness within the firm through progressive credit risk management systems and facilitate business decision-making. However, roughly 25% of European SMEs are not scored, because of insufficient or inappropriate data. Given the significant role SMEs have on growth and job creation, the Commission examined the landscape of the BI & Scoring industry in Europe. Results show that the business models of the firms are quite diverse, even if there is a high degree of firm concentration, ensuring stability and less pro-cyclicality in the EU-market. The BI & Scoring is not a regulated industry, which is one of the reasons for the variety in the quality of scores. It is therefore worth considering whether establishing “minimum requirements” or “technical standards” for this industry could help ensure a common ground for SMEs’ information in Europe. In particular, developing harmonised minimum quality standards on external credit scoring for SMEs might facilitate (cross-border) financing of their investments and deepen market integration. Such initiatives could help bridge the gap with the more diverse financing opportunities available for SMEs in the US relative to Europe.

CHAPTER 1: MARKET DEVELOPMENTS

1.1 Introduction

This chapter presents how the crisis in financial markets in Europe has unfolded in its fifth year. Financial developments in 2012 have had a significant impact in holding back an economic rebound. In particular, they have born heavily on economic growth and employment performance, as visible in negative annual GDP growth and rising unemployment figures across the European Union (EU) and the Euro area. At the same time, lower growth has continued pressurizing agents’ balance sheets, general financing conditions and the capacity of agents to take new risks.

In this regard, market developments have unveiled the importance of deepening economic and financial integration across the EU. Taken together, the cumulative impact of the policy initiatives proposed by the European Commission to build a Banking Union and the open commitment made by the European Central Bank (ECB) to do whatever necessary, within its mandate, to redress the risk of a euro breakup, seemed to have been a powerful deterrent to reduce stress across the board in EU financial markets.

Section 1.2 presents the macroeconomic and financial context faced at the beginning of 2012. Section 1.3 then examines how the situation evolved in sovereign debt markets. Sovereigns and their banking sectors have become interlaced in a feedback loop that negatively impacted and exacerbated risks to both the sovereign and its respective banking sector. In this regard, section 1.4 starts by presenting the Commission’s proposal for a banking union in Europe. It also highlights different elements that have affected banks’ funding conditions, an important driver of their lending activity throughout 2012, particularly given the increased financial fragmentation present in the EA. Section 1.5 focuses on the situation in wholesale financial markets faced by non-financial corporations. The insurance sector is the object of attention of section 1.6.

1.2 Macroeconomic and macro-financial context

The year 2011 ended with positive momentum, supported by strong policy decisions to address the adverse feed-back loops between sovereigns, the banking sector and economic growth, as was already analysed in depth in last year's EFSIR. Reinforced economic governance across the EU27 and initiatives aimed at further deepening the economic and monetary union, together with the measures adopted by the European System of Central Banks, including the Long Term Refinancing Operations (LTRO) announced by the ECB, brought some respite to financial markets at the end of the year.

Nevertheless, the unwinding of previously accumulated macroeconomic imbalances (subsection 1.2.1) continued to shape both macroeconomic developments and events on financial markets in 2012. This was not only visible in the programme countries (EL, IE, PT), where budgetary consolidation efforts and structural reforms were closely watched by investors. It became also evident in several other Member States, where external imbalances created considerable tensions in the funding of both public debt and banks, particularly with regards to foreign investors. Vulnerabilities became particularly manifest taking into account how external funding takes place across the Euro area (subsection 1.2.2), and financial markets become increasingly fragmented,

making several banks in vulnerable Member States largely reliant on ECB funding (subsection 1.2.3).

1.2.1 Imbalances in the Euro area

The detrimental role of macroeconomic imbalances for economic activity has been widely recognised. At the Union level, it led to the establishment of the EU’s Macroeconomic Imbalance Procedure (MIP). Since the reports prepared in the MIP framework¹ provide a detailed analysis of on-going trends and underlying factors, this section only sketches how divergences in fundamentals materialise in a monetary union. In particular, as they cannot find their way into changes of the nominal exchange rate, factor prices (interest rates and labour costs) have become an important mechanism through which persistent cross-country differences in economic performance surface.

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Chart 1.2.1: Long term interest rates.

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Chart 1.2.2: Unit labour costs in EMU (index 2000=100)

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Source: Organization for Economic Cooperation and Development Source: Eurostat

Chart 1.2.1 illustrates the impact generated by the establishment of the EA on funding conditions across Member States: in the 1990’s, interest rates converged to the point where differences became non-existent, once euro-area membership seemed close to certain. The across-the-board fall in the cost of funding increased the spread between the return on investments and funding costs in some EA Member States. This had a very significant impact in their economies, inter alia, with respect to their:

1. Competitiveness. The decrease in the cost of capital stimulated an expansion of investment activity and boosted aggregate demand. However, weaker competitive pressure in non-tradable sectors in interaction with market frictions, price and wage rigidities and labour´s bargaining power eventually found its way into higher labour costs in several Member States. Ultimately, the resulting labour cost divergences that arose between Member States were not fully justified by improvements in productivity. Consequently, unit labour costs (ULCs)² diverged, as chart 1.2.2 shows, leading to a pronounced loss of competitiveness in some Member States.

¹ For an overview of key documents related to the Macroeconomic Imbalance Procedure, see http://ec.europa.eu/economy_finance/economic_governance/macroeconomic_imbalance_procedure/index_en.htm.

² Unit labour costs are defined as total labour costs divided by real production (or total labour compensation per unit of labour divided by real production per unit of labour. The latter is equal to labour productivity.

2. Debt levels. The fall in the cost of funding mentioned above, in conjunction with rising aggregate demand incentivised firms and households to take on increasing levels of debt intermediated through financial institutions. Among other aspects, this resulted in rising real estate prices, particularly house prices, in a number of Euro area Member States, thereby creating a positive wealth effect, which, in turn, stimulated aggregate demand, but also diluted the notion of vulnerabilities induced by increased private indebtedness. The public sector also benefitted, as the low interest rate environment made the cost of servicing debt more bearable. Balance sheets of financial institutions expanded and capital inflows increased the overall pool of funds available to tap.

In the absence of qualitative improvements in goods and services, the price competitiveness loss witnessed in some Member States vis-à-vis the rest of the EA could, in principle, suggest bringing labour costs close to the levels observed prior to the EA. Retrenching wages to regain competitiveness is a demanding issue on its own. It represents an altogether greater policy challenge if indebtedness has already reached high levels, particularly if the non-tradable sector (usually, real estate) has accumulated financial debt in the production ramp-up prior to the crisis³.

In some Member States, real estate bubbles and oversized construction sectors have become a landmark of the financial crisis. Their correction implies a sizeable loss in financial wealth of households and firms spilling-over into the quality of bank assets. Indeed, as the share of non-performing loans rose, loan loss provisions increased and the value of real estate as collateral eroded. Consequently, a number of banks exposed to real estate booms have found their solvency questioned. The deleveraging pressure in the private sector - both financial and non-financial -reduced economic activity and therewith tax revenues. Funding costs for the public sector increased because, in addition to higher interest rates, the deficit to be financed also swelled. The fiscal burden of supporting banks added to the tensions experienced by the public sector (see below).

1.2.2 External capital flows

Chart 1.2.3: Gross issues by original maturity, euro-denominated debt securities. Euro area (% of GDP)

Chart 1.2.4: Gross issues by issuer sector, euro-denominated debt securities. Euro area (% of GDP)

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120% Financials

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rH(Nr\ir\|r\|r\|i*\|iNiNr\|(NMfN(NrN

Source: European Central Bank

Source: European Central Bank

In many episodes of financial crisis, vulnerability to large downward adjustment in relative prices of an oversized and over-indebted economic sector is a common characteristic. An important

If the sector's income falls, its debt servicing capacity becomes compromised.

additional element is the term structure of the liabilities incurred, as different types of capital flows have different associated benefits and costs.

Financial integration in the EA has been driven largely by portfolio flows, extending bank loans and negotiating securities across borders, compounded by another pattern: short term debt issuance4. In this regard, charts 1.2.3 and 1.2.4 present the pattern of debt security issuance that has taken place since the establishment of the EA, in terms of the maturity of the issued instruments and institutional sectors undertaking such issuance. First of all, both charts document declining (gross) debt issuance since 2009. Most issuance was in short term debt securities (chart 1.2.3) and financial institutions accounted for a dominant market share (chart 1.2.4).

Chart 1.2.5: Foreign investment in Spain. Gross flows (% of GDP).

Chart 1.2.6: German investment abroad. Gross flows (% of GDP).

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Source: Bundesbank. Balance of Payments

Note: a positive (+) sign is an asset for German residents.

Charts 1.2.5 and 1.2.6 zoom in on the composition of capital flows in two Euro area Member States, Spain and Germany. Since the relationship of capital flows between Member States with a current account surplus and those with a deficit are analysed extensively in European Commission (2012), this section is limited to an illustration of the importance of private non-FDI flows, which are largely cross-border credit flows among banks. Chart 1.2.5 presents gross foreign investment entering Spain, a country that has run systematic current account deficits with respect to the rest of the world, receiving net capital inflows that reached, at times, over 10% of its annual GDP during the period prior to the crisis (approximately EUR 100 billion per annum). Chart 1.2.6 presents gross investment abroad by Germany, a country that has run consistent current account surpluses, i.e. it has provided the rest of the world funds which reached, at times, over 7% of its annual GDP (approximately EUR 250 billion).

First of all, both charts illustrate the decline that has taken place in foreign investment since the outbreak of the crisis, both entering into Spain, to the point where investors have been liquidating previous investments (represented by negative flows), and exiting from Germany. Other qualitative features stand out:

(i) Gross capital flows are a multiple of net capital flows both for Spain and Germany (the ratio represents approximately 3 to 1 in both cases). That is, gross annual capital flows

In this regard, it is important to bear in mind that the economic literature suggests capital flows associated to the transfer of technology and to establishing a long term commitment with the receiving Member State seem to be more supportive of long term growth and financial stability. See Kose, Prasad, Rogoff and Wei (2009).

entering Spain have reached approximately EUR 270 billion euros and gross annual capital flows exiting Germany have reached approximately EUR 740 billion.

(ii) Private non-direct investment (non-FDI) flows entering Spain and exiting Germany increased substantively since the establishment of the EA, until the beginning of the crisis.

(iii) Direct investment (FDI) flows entering Spain and exiting Germany barely increased since the establishment of the EA.

(iv) Public flows were barely affected by establishing the EA, until the onset of the crisis.

1.2.3 External funding constraints

Financial crises can impair an economy’s access to international capital markets, as international investors tend to withdraw their engagement relatively quickly. In some instances, this behaviour can further determine a significant (and recurrent) fall in capital inflows⁵.

Since the sovereign debt crisis erupted, several such instances have been identified in the EA. They have had an impact on prices, contributing to rising interest rates on sovereign debt markets, and probably as importantly on quantities, restricting the ability of Sovereigns to obtain funding on markets at sustainable interest rates. This has led to the establishment of financial assistance and support mechanisms, further described in Chapter 2 of this report.

The withdrawal of foreign investors, both from abroad and other Euro area Member States, also contributed to several banks in vulnerable Member States encountering difficulties to obtain funding on markets. These banks became largely reliant on central bank funding. This change from private to central bank funding finds its reflection in the TARGET 2 system, which is the inter-bank payment system in the Euro area. Accordingly, changes in the credit or debit of national central banks' TARGET 2 claims have become a prominent indicator of fragmentation and tensions on wholesale funding markets⁶.

In this regard, Chart 1.2.7 presents the external position of the Bundesbank vis-à-vis the Eurosystem⁷. The chart illustrates, first of all, rising tensions in the Euro area during the first half of 2012: the peak of the position was reached in August 2012, amounting to EUR 751 billion. Moreover, the fall from the August peak highlights that once investors became more confident again that adverse scenarios will not materialise they were prepared to move capital across EA borders once again.

Chart 1.2.7: External Position of the Bundesbank. Claims with the Eurosystem (as % of German GDP).

Source: Bundesbank

⁵ There is an extensive economic literature on the phenomenon of sudden stops. See, for example, Calvo, Izquierdo and Mejia (2004), Merler and PisaniFerry (2012) and Couré (2013).

⁶ For a discussion of TARGET 2 balances, see Cecchetti et al. (2012).

⁷ That is, the claims of the Bundesbank on the Eurosystem through TARGET 2.

1.3 Market developments in sovereign bond markets

After a short chronological overview of market developments in 2012 (section 1.3.1), this sub-chapter explores factors that had an important impact on sovereign debt markets during the year. Among them are the long-term commitments from and towards those requiring financial assistance (section 1.3.2), the relative position of official and market funding (section 1.3.3), and the capacity of official lending (1.3.4).

The latter has become an important issue as another Member State was provided financial assistance in 2012 on novel terms to specifically address its financial sector weaknesses (Spain). The need to address the revealed sources of fragility, together with several others arising during the crisis -including cross-sector contagion-, determined the Commission to propose establishing a banking union (section 1.4).

1.3.1 Main market events

From the start of the year, it was expected Chart 1.3.1: Member States’ refinancing needs for 2012

that 2012 would be a year heavy in bond

redemptions (chart 1.3.1), with several

peak months of relatively high amounts of

maturing Euro area government debt.

Nevertheless, after the Autumn 2011

culmination in the sovereign debt crisis,

tensions in government bond markets

abated in the first months of 2012, and the

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Member States, including vulnerable ones, declined significantly.

Source: Member States’ National Treasuries.

Overall, EU sovereigns managed to generate sufficient funding and some Member States even started the year pre-funding their Treasury needs. For example, Italy overcame the big concentration of its redemptions between February and April. At the same time, Spain took advantage of the relatively benign financing conditions in early 2012 and frontloaded its issuance programme, funding more than 50% of its gross borrowing requirements for 2012 by April. New bond issuances from both countries met strong investors' demand.

The market improvement was largely driven by common factors, as reflected by the high correlation of sovereign spreads of, for instance, FR, AT, IT and ES. The liquidity injection by the ECB in the form of two longer-term refinancing operations (LTROs) in late 2011 and early 2012, benefitting banks, and via the strong banking-sovereign nexus the sovereigns, was the principal trigger for driving the spreads in more vulnerable Member States lower, in particular at the shorter end of the yield-curve. Besides, progress of Member States in implementing structural reforms and consolidating public finance, additional EU initiatives taken to enhance budgetary discipline (see Chapter 2.1 on economic governance), as well as survey-based signs that the economic slowdown in the EU was bottoming out contributed to a return of market confidence in the sovereign sector.

In the second quarter of 2012, negative market sentiment remounted and evolved into a fully-fledged sovereign bond crisis. Market participants' pessimism on the macroeconomic outlook and the perception of a loss of legitimacy among electorates of the reform strategies in the more vulnerable Member States fuelled worries on their ability to reach their fiscal targets for 2012 and, in the longer term, to preserve the sustainability of their public debt. The announced or envisaged downward revisions of targets by some Member States tended to anchor these expectations.

In this regard, at times of particular distress in sovereign primary bond markets, secondary markets activity decreased, with signs of dysfunction and lack of liquidity of vulnerable Member States' sovereign bonds. Liquidity turned to debt securities that were perceived as safe and in consequence yields in a number of sovereign debt markets fell to historical lows. The coincidence of declining sovereign bond yields and slightly widening sovereign CDS spreads in some countries gives a strong indication of portfolio reallocation flows towards safe havens. "Flight-to-quality" episodes spilled to beyond the EA's borders, affecting other sovereigns such as Norway, Sweden and Switzerland (Box 1.3.3).

In spite of the policy progress reached at the euro area Summit on 29 June, particularly the prospect of establishing a banking union and the possibility of direct ESM recapitalisation to break the negative feedback loop between sovereign and banking risk, market conditions remained turbulent over the summer. In this context, the ECB President on 26 July announced determined ECB support to bond markets and in September the ECB announced measures to conduct outright transactions in secondary markets to address unfounded fears on the part of investors about the break-up risk of the euro. The ECB made clear that strict and effective conditionality on a country attached to an appropriate EFSF/ESM programme is imperative to implement Outright Monetary Transactions (OMT). To ensure appropriate incentives for Member States if activated (even if under an EFSF/ESM programme), transactions in the OMT would be focused on the shorter part of the yield curve: in particular on sovereign bonds with a maturity between 1-3 years. No ex ante quantitative limits are set on its size and the ECB has stated publicly that the program can be used to buy or sell bonds.

Throughout 2012 Greece remained under intense market scrutiny regarding the development of its adjustment programme. Still, it succeeded in satisfying its financing needs over the summer and until end of the year via T-bill issuances. In December 2012, it was able to reduce its outstanding debt by repurchasing own bonds with a value of almost EUR 32 billion, whilst paying broadly a third of their face value to the bond holders. The debt buy-back operation was followed by the second disbursement under its second economic adjustment programme.

Ireland showed progress in its programme and was able to successfully issue long term government bonds (5 and 8 years maturity) in summer, as well as long-term amortising bonds, providing hope for a full return to the market at the end of the programme. Portugal's short and long-term government bond yields remained high in 2012, but decreased substantially over the year. T-bill auctions were generally successful over the year and presented decreasing yields.

Finally, within the more benign investment climate in the second half of 2012, auctions of sovereign bonds and T-bills in Italy and of T-bills in Spain registered strong demand and decreasing yields. In general, the funding available to sovereigns in markets has been affected by several special factors along the year, which are detailed in the following sections.

Box 1.3.3: Flight-home and flight-to-quality effects

Flight home. When banks perceive a significant deterioration of their balance sheet will take place, they tend to rebalance their loan portfolios away from foreign markets in favour of domestic borrowers.

Flight-to-quality. Discrete (upwards) jumps in the demand for low risk assets due to uncertainty about asset payoffs and/or about the macroeconomic outlook.

Within the EA. Because of the crisis, differences between Member States’ sovereign interest rates have increased sharply. The extent to which these spreads reflect increased individual riskiness of some Member States or are due to disappearing markets or flight-home or flight-to-quality phenomena is a source of debate. In this regard, chart 1.3.2 shows that the German Treasury is indeed funding itself at exceptionally low rates when issuing 10 year benchmark bonds. For shorter maturities of German government securities, investors were even accepting zero or negative yields. Also Belgium, France, the Netherlands, Austria, Finland and the EFSF were able to issue short-term debt securities at interest rates close to or even below zero.

Outside the EA: At times of very high stress in financial markets, investors have exited many asset classes denominated in euros. As substitutes to German treasuries, they have fled to currencies of countries with fiscal and monetary policies perceived as sound, such as Norway, Sweden and Switzerland (given the size of the latter’s banking sector, the impact can also be due to flight home effects). Chart 1.3.3 shows the 30% appreciation that took place by the Swiss franc between the beginning of the crisis and Summer 2011. At this point, the demand for Swiss francs was such that the Swiss National Bank (SNB) felt compelled to act to counter the negative aspects related to the appreciation of the Swiss franc versus the euro. Thus, on 6 September 2011, it announced that it would (i) no longer tolerate a EUR/CHF exchange rate below the minimum rate of 1.20; and (ii) enforce this minimum rate with the utmost determination, preparing to buy foreign currency in unlimited quantities.

1.3.2 Long term commitments between Member States

Throughout 2012 financial markets sought reassurance of the long-term commitments between EA Member States with respect to one another. In particular, signs of tensions on sovereign bond emerged around the times of programme reviews. Investors became concerned whether commitments would be renewed, particularly if funding was to be provided for very long periods.

A key instance was the (new) funding needs by the Greek sovereign, in a context where the initial estimates of financial assistance from May 2010 had to be reassessed. That is, doubts whether Greece’s funding needs –not financeable in markets- would be provided by the rest of the EA have been a key driver of market sentiment in 2012. The larger implication for market sentiment being none other than if Greece was not provided funds would other Member States (with larger funding needs) be, in case they needed assistance? In this regard, maintaining the long-term commitment required to continue to provide financial support to Greece in 2012 represented a significant challenge since the second quarter of the year.

The elections taking place on 6 May did little to appease sceptical market beliefs regarding Greece's capacity to honour its commitments. Moreover, the likelihood that political forces opposing Euro area membership could win the 17 June elections had an impact on other sovereigns, compromising their ability to continue funding themselves in markets without external assistance (chart 1.3.4). Fears that a large sovereign could lose market access brought stress in financial markets over the summer 2012 to levels not reached since 2008, with the fall of Lehman Brothers.

Chart 1.3.4: Sovereign bond spreads

Source: Bloomberg

1.3.3 Debt seniority

A second important topic of the year 2012 was the interaction between private and official sources of funding. The debt restructuring of Greek public debt by means of voluntary private sector involvement (PSI) in spring 2012 provided substantial relief to the Greek debt burden. Approximately EUR 197 billion or 95.7% of the bonds eligible for the exchange offer have been exchanged. Following this PSI, however, markets became concerned that the provision of funding from official lenders means that they benefit from a de-facto preferred creditor status.

In this regard, Spain's demand for financial assistance for a specific programme of banking sector reform on 9 June (see chapter 2, section 2.2.2) raised questions among private investors. In particular, it raised concerns regarding whether the provision of official funds was positive for current private debt holders, as Spain would obtain funds at low interest rates, or whether it was negative, as their claims would become junior to new funds. Thus, uncertainty about the seniority of official lending over private lending was brought forward as an explanation for why financial markets did not react positively to the announcement of a banking programme for Spain.

The 29 June Euro area Summit statement affirmed that financial assistance to Spain would first be provided by the EFSF on pari passu conditions with existing unsecured debt, until the ESM became available, and that it would later be transferred to the ESM, without gaining seniority status. The statement had a positive impact on the sentiment of financial market participants, also because these extrapolated its impact to other sovereigns with possible funding needs.

1.3.4 Large sovereigns

Chart 1.3.5: General government gross debt in 2012 (€bn). 0 2 000 4 000 6 000 8 000 10 000

10 804

USA Japan
Germany	^-^2 057
Italy	^^^1 842
France	^^■1594
China	^^1503
UK	^M12S2
Brazil	^1055
Canada	^■1014
India	_ 844
Spain	H 643
Source: International Monetary Fund, Bloomberg.

As long as countries experiencing difficulties in financial markets are small, the main difficulty raised for other Member States to fund them is to commit one another to "fund in exchange for reform”. In this regard, the Union has now established specific instruments to provide financial assistance to Member States in difficulty (see chapter 2 in this and last year's EFSIR). However, the opportunities available to use official lending as support for small Member States are not open to the same extent to large ones.

To remove a large Euro Area Member State (see chart 1.3.5) for a significant period of time from market funding would mean a very substantial quantitative commitment from other Member States and could quickly deplete the funds made available to the EFSF and ESM to provide official funding. Colloquially, the solution to this problem has been known as the need to establish a "firewall" to isolate large vulnerable Member States. For instance, to address the specific situation of a large country, probably requires that it continue to have market access. Thus, external assistance to a large Member State has, so far and as mentioned before, been limited to provide funds for a bank-specific programme of financial sector reform⁸.

Within this environment of further rising bond spreads in vulnerable Member States, which were considered as reflecting a premium for the risk of convertibility, EU Member States, institutions and policymakers established several measures to address the economic and financial situation in markets (see section 1.4).

1.3.5 Contagion from banks to sovereigns

The spill-over of banking weakness to the public sector across a large number of the vulnerable Member States evidenced that problems in the banking sector can quickly overburden the sovereign sector to cope with them. The need to avert banking system failure and economic disruption after the failure of Lehman Brothers in September 2008 has burdened taxpayers and significantly deteriorated public finances. In particular, the total amount of public funds approved to support the financial sector has risen to unprecedented levels: for example, between October 2008 and October 2012, they reached EUR 5.1 trillion (equivalent to 40% of EU GDP). In 2012 it also became evident, and will be detailed below in the banking section of this chapter, that the

For more information on the financial stability support package for Spain, http://ec.europa.eu/economy_finance/assistance_eu_ms/spain/index_en.htm.

8

see

feed-back loop between sovereign and banks became reinforced through the withdrawal of foreign investors and rising home bias of banks⁹.

Thus, the crisis has shown the necessity to reinforce the tools available to public authorities to deal with financial sector problems, but also the need to break the sovereign-bank nexus raised by the size of the banking sector in the EU (see section 1.4). To meet this challenge, in September 2012 the European Commission reasserted the importance of establishing a banking union¹⁰.

1.4 Towards a Banking Union

Boosted by the single currency and the Single Market, the EU banking sector grew and become much more integrated in the years preceding the crisis: banks’ cross-border activities blossomed, to the point of outgrowing their national markets (box 1.4.1). Moreover, the quality of the financial supervision achieved in the Euro area prior to the crisis was in need of being strengthened, among others, to reinforce the ability of sovereigns to isolate and contain risks emanating from the banking sector.

V

1,0

0,8 0,6 0,4 0,2 0,0 -0,2 -0,4 -0,6 -0,8

Chart 1.4.1: Net lending by the Eurosystem.

■ Deposit facility

■ MRO

LTRO

—Net lending: total

Chart 1.4.2: Three month difference between LIBOR & OIS.

#

*\ r\ r\ *\ *\ <\ r\ *\ f\ r\ *\ r\ *\ *\

Source: European Central Bank

Source: Bloomberg

In this regard, the funding challenge faced by EU banks in 2012 has been instructive. At the end of 2011, it was widely known that banks had to roll-over a large amount of expiring debt securities in the coming year and elevated indicators of funding costs suggested that many banks would need to close their funding gap under tight conditions. Accordingly, the ECB's two 3-year longer-term repurchase operations (LTROs) met a very high demand with banks asking for a total of EUR 1.1 trillion (gross). The net liquidity added to the euro-area banking system was some EUR 500 billion, as banks rolled over some of their previous shorter-term Eurosystem loans into the new 3-year LTROs. The 3-year LTROs had an impressive impact on short-term government bond yields and also fed through to longer maturities and other asset classes. Some covered and unsecured bank bond markets, which had been more or less closed in the third and fourth quarters of 2011, reopened.

The recovery experienced in interbank markets at the beginning of 2012 remained short lived. Neither the provision of ample liquidity through the ECB's operations (chart 1.4.1) nor the EBA

⁹ It was also agreed that the ESM will be empowered to finance direct recapitalisations of financial institutions through the ESM, once an effective single supervisory mechanism for euro area banks is established.

¹⁰ Available at http://europa.eu/rapid/press-release_MEMO-12-656_en.htm?locale=en.

efforts to improve transparency of banks' capital position or to foster the build-up of additional capital buffers yielded a durable return to normality on funding markets. It was also expected that the Greek PSI operation would remove an important piece of uncertainty about banks' exposure to sovereign debt from the market. However, money market spreads remained at an elevated level (chart 1.4.2) and issuance of debt securities by banks weakened again. Banks from vulnerable Member States remained heavily reliant on ECB funding and signs were emerging of declining deposit bases in some of them.

In this context, in the June 2012 European Council, the EA Heads of State or Government announced they would proceed to establish a single supervisory mechanism (SSM) for banks¹¹. In this regard, the European Commission reasserted the importance of establishing a Banking Union to support economic and monetary integration, restore credibility to the financial sector, break the link between Member States and their banks, and preserve tax payers’ money (next subsection).

Together, such initiatives set in motion forces to counter the marked deterioration in financial market conditions experienced in the first half of the year. In particular, they set the basis for the ECB to build a “bridge” while the rest of the institutions continued working to establish the foundations for a more stable European economy¹².

OMT and progress with banking union left a clear trace in bank funding markets in the second half of 2012 and early 2013. Most indicators of risk sentiment on EU financial markets improved, as the spiral of reinforcing upward trends in risk premia on sovereigns, banks and business cycle uncertainty encountered during the sovereign debt crisis was reversed. Mirroring developments on sovereign bond markets, funding costs of banks on debt security markets fell. Also banks’ CDS prices declined. Numerous EU banks returned to tapping debt market financing and, in autumn 2012, also banks from vulnerable Member States were able to issue substantial amounts of debt securities. At the same time, the retail deposit outflow from banks in several vulnerable Member States stabilised amid balance-of-payment data indicating a reversal towards private capital net inflows. Italian and Spanish Target 2 balances accordingly improved somewhat, which indicates a turnaround in their financing patterns towards wholesale funding, particularly via repo markets, and away from ECB funding.

This subchapter starts by explaining the concept of banking union and its motivation as it has been a key determinant of banking developments in 2012 and expected to shape the banking sector in the future. In addition to the focus on banking union (section 1.4.1), banks remained watchful to some special issues that evolved during 2012. These are discussed in the following sections, namely: market fragmentation, particularly on the funding side (1.4.2); the need to deleverage (1.4.3), eventually leading to reduced balance sheets and the tapping secured funds (1.4.4), in a context where asset encumbrance is rising. As a consequence, the capacity for banks to provide lending to the real economy has been muted (1.4.5).

¹¹ EA Summit Statement, available at http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/131359.pdf.

¹² Building a bridge to a stable European economy, Speech by the President of the ECB at the annual event “Day of the German Industries” organised by the Federation of German Industries, Berlin, 25 September 2012. Available at http://www.ecb.int/press/key/date/2012/html/sp120925.en.html.

Box 1.4.1: Size of the EU banking sector

There are approximately 8000 EU credit institutions. But a more important factor to determine the close relationship between developments in the financial sector and the fiscal condition of sovereigns in Europe is the significant size European banks have achieved in terms of their home country GDP.

According to the final report by the High-Level Expert Group chaired by E. Liikanen, the total assets of Deutsche Bank represented some 85% of national GDP at the end of 2011, Santander accounted for 118% of GDP, ING for 161% of GDP, whereas Nordea for 197% of GDP. The size of these banks is naturally much smaller, if measured against the EU GDP. Deutsche Bank would thus appear the biggest with 17.4% of EU GDP in total assets.

At the same time, the total assets of the entire EU banking system represented roughly 42tn euros, approximately 350% of EU GDP. This is a risk factor that cannot be ignored, although it also reflects the greater dependence of the European economy on bank financing than elsewhere. For example, the US banking sector accounted for only 78% of US GDP, whereas that of Japan for 174% of GDP in 2011¹³.

Another specific feature of the European banking landscape is the relative size of its top ten banks. At the end of 2011, they held assets worth EUR 15 trillion. Once again, there are differences in accounting standards (e.g. with respect to the netting of derivatives) that make EU banks appear relatively larger compared to their US counterparts than they actually are, but the magnitude is nevertheless telling. The top ten EU banks held assets worth 122% of EU GDP, as opposed to 44% in the case of the US.

Thus, absent corrective measures, EU governments potentially have to backstop very large financial institutions and markets take account of this fact. Banking sector restructuring since the beginning of the crisis has been slow, with few bank liquidations. The lack of any pan-EU resolution framework has also been a deterring factor. The Commission's 2012 State Aid Scoreboard revealed that the volume of national support to the financial sector used by banks between October 2008 and 31 December 2011 amounted to over EUR 1.6 trillion, which is equivalent to 13 % of EU GDP. Liquidity support accounted for EUR 1,274 billion (9.3 % of EU GDP) in the form of state guarantees on wholesale bank funding and other (short-term) liquidity support measures. Support to bank solvency amounted to EUR 442 billion (3.5 % of EU GDP) in recapitalisation measures and sorting out the impaired assets.

Three EU Member States accounted for nearly 60% of the total aid used: the United Kingdom (19%), Ireland (16%) and Germany (16%). Moreover, aid was concentrated on a few financial institutions: top three beneficiaries in the former two countries received more than 80% of all aid, whereas those in Germany received more than half.

¹³ One should also note, however, the special role played by the so-called Government-Sponsored Entities in the US (e.g. Freddie Mac), which are generally not included as part of its banking sector assets.

1.4.1 What banking union?

The events unfolding in 2012 witnessed the need to restore confidence in the financial sector through common and single supervision.

In the context of the challenges represented by financial fragmentation and its translation into uneven and asymmetric funding pressures, deleveraging needs, and signs of continued sovereign bank inter-linkages across the Euro area, further detailed below, the European Commission made a proposal to establish a fully-fledged Banking Union in a communication published in September 2012 accompanying the proposal for a Single Supervisory Mechanism (SSM). Such a Banking Union relies on four pillars: a single rule book (CRD4/CRR), single supervision, a harmonised system of deposit guarantee schemes and, ultimately, a Single Resolution Mechanism (SRM) –see chapter 2. In this regard, the Economic and Financial Affairs Council of the EU in December 2012 agreed, building on the Commission’s proposal, on the establishment of an SSM composed of the ECB and national competent authorities, with the ECB being responsible for its overall functioning.

Under the proposal, the ECB will have oversight of EA banks, although in a differentiated way and in close cooperation with national supervisory authorities. Non-EA Member States wishing to participate in the SSM will be able to do so by entering into close cooperation arrangements. National supervisors will remain in charge of tasks not conferred on the ECB, for instance in relation to consumer protection, money laundering, payment services, and branches of third country banks. The EBA will retain its competence for further developing the single rulebook and ensuring convergence and consistency in supervisory practice.

In principle, the ECB would assume its SSM supervisory tasks on 1 March 2014 or 12 months after the entry into force of the legislation, whichever is later, subject to operational arrangements. Importantly, the ECB has a very clear goal of price stability, expressed in a transparent and measurable way and its attachment to the primary objective of price stability is unquestionable. Thus, to achieve the SSM, its monetary tasks will need to be strictly separated from its supervisory role, to eliminate potential conflicts of interest between the objectives of monetary policy and prudential supervision. To this end, a supervisory board responsible for the preparation of supervisory tasks would be set up within the ECB.

Building a common pillar to integrate banking supervision in the Euro area is important to make sure it abides by the highest standards; establish trust between Member States in case financial backstops need to be used; and advance towards a more integrated approach with regard to deposit guarantee schemes and bank recovery and resolution.

In general, moving towards a banking union should help to:

• Undo financial fragmentation. Being more conscious of cross-country spill-overs than national supervisors, the SSM will correct the trend of financial institutions to increasingly focus on their national home markets in times of crisis. Such response could support an even provision of services by financial institutions across Member States. This would ensure, in particular, an efficient deployment and allocation of capital across the Euro area and the EU as a whole. Relatedly, since the increased home bias also impaired the

transmission of monetary policy impulses by the ECB into actual lending to the real economy, the SSM would contribute to make monetary policy more effective.

• Break the link between Member States and their banks. With integrated supervision, investors and Member States can have confidence in the quality and impartiality of banking supervision, addressing the notion of implicit mutual support between banks and sovereigns.

• Restore credibility of the financial sector. A Single Supervisory Mechanism for banks will enable a supervision of the highest quality unfettered by other non-prudential considerations, benchmarking and fostering good practices among European banks.

• Preserve tax payers’ money. Although the amount of approved funds for financial institutions between October 2008 and October 2011 has been significantly less than the amount of funds at their disposal mentioned previously (EUR 5.1 trillion), reaching EUR 1.6 trillion, the magnitude of public funding has nonetheless been unprecedented. EU rules for recovery and resolution (see chapter 2, section 2.4) envisage that problematic institutions will be isolated and resolved minimizing taxpayers’ money¹⁴.

The following sections present the drivers that coalesced in 2012 that determined the Commission’s proposal. Three issues have characterized the challenges faced by banks in 2012 to address their funding weaknesses, which remain present to this day (i) fragmentation, (ii) deleveraging and (iii) the shift towards secured forms of funding.

1.4.2 Funding fragmentation

Chart 1.4.3: Unsecured average daily turnover. Geographical counterparty breakdown (% of total)

20,0% ^^M -Euroarea

i National i other

Chart 1.4.4: Unsecured average daily turnover. Geographical counterparty breakdown (% of total)

■ Euro area

■ National

othor

33,1%

2012

Source: ECB.

Source: ECB

The difficulties faced by investors to identify precisely which financial institutions were most vulnerable to toxic assets, whether by sector (real estate bubbles) or geographic presence (EU sovereign debt crisis), have become a cause and a consequence of the crisis. Given that banks mainly lend to each other in unsecured markets, it is not surprising that they became much more hesitant to do so¹⁵.

In this regard, in the first half of 2012, financial conditions within the Euro area became more fragmented, as retrenching cross-border interbank capital flows, rising home bias in sovereign-

¹⁴ See http://ec.europa.eu/internal_market/bank/crisis_management/index_en.htm.

¹⁵ In particular, those excessively reliant in unsecured markets were the first to run out of cash as the loss in market confidence forfeited market access.

bond holdings, as well as growing divergence of funding costs for sovereigns and banks make evident.

Chart 1.4.5:Cross-country standard deviation of Euro area interbank rates (basis points)

Chart 1.4.6: Cross-border debt securities holdings of Euro area MFIs issued by other MFIs (in percentage)

50

Source: ECB.

Source: ECB

In particular, and as a second-round effect, the liquidity position of financial institutions has not only been affected by the increased fragmentation in bank funding markets across the EA; it has reinforced it. Healthy banks located in stigmatised areas have become squeezed out of funding, particularly in the unsecured segment (charts 1.4.3 and 1.4.4). Market fragmentation across Member States determined that healthy banks in some countries were only able to tap a much smaller pool of funds than in others, putting pressure on prices (chart 1.4.5). Fragmentation has led to divergent interest rates and restricted lending supply across Euro area Member States¹⁶. Evidence pointing to declining (or reversed) financial market integration was presented by the President of the ECB in August, upon discussing the OMT program¹⁷:

• Since 2006, cross-border use of collateral had fallen from 50% to 20%.

• Since 2008, non-domestic interbank deposits were at minima.

• Since mid-2011, the share of cross-border money market loans had fallen from 60% to 40%.

• Starting late 2011, a big divergence was observed in general collateral repo rates between Euro area periphery and core sovereigns.

Consequently, fragmentation and, eventually, redenomination risk in the Euro area has increased the pressure on banks to increase capital ratios, but also to retrench activity to national markets and to fund their activities within national boundaries. Moreover, some national regulators have made matters worse by ring-fencing capital and supporting liquidity at their national level, as well as by encouraging banks to invest in domestic debt (chart 1.4.6), in some cases exacerbating the vicious circle between sovereigns and their banking sectors¹⁸. Naturally, these instances run against the very idea of a single market for financial services in Europe.

¹⁶ Decomposing the total increase in divergence is not an easy task, as differences in risks have also widened. Battistini, Pagano and Simonelli (2013) decompose this divergence in interest rates into different components.

¹⁷ http://www.ecb.int/press/pressconf/2012/html/is120802.en.html.

¹⁸ The EBA Risk Assessment Questionnaire documents that many of the surveyed banks attribute a role to supervisors to cross-order retrenchment of activity and lending, see EBA (2013).

Box 1.4.2: The Vienna Initiative

Although the Vienna Initiative was established in 2009, market fragmentation has been an issue of lesser concern outside the EA. The Initiative brought together the major International Financial Institutions, as well as home and host country regulatory and fiscal authorities of the largest banking groups operating in Central and Eastern Europe (CEE), and the groups themselves. The aim was to avoid, precisely, episodes such as those that have taken place in the EA, and which are described in previous sections, to take place in CEE.

The reason why authorities believed they could be avoided was due to the concentration of cross border capital flows in CEE among a few foreign banks. If banks had retrenched behind national borders and replete their EA parent holding company at the expense of their CEE domestic banks, it could present a significant risk for financial stability. Moreover, addressing this risk one bank at a time was not possible: if an individual bank left, it made the temptation and incentive to flee greater for the remaining ones. Thus, coordination was of the essence (as in the EA), but coordination was possible.

Since 2009, the Initiative has evolved. In January 2012 Vienna 2.0 was launched to avoid disorderly deleveraging by banks. Deleveraging is a natural process to address imbalances, but it should be managed properly: decisions driven by geographic, not economic considerations are prejudicial to all.

Thus, geographic location has become an important variable to determine a bank’s health, whether from the asset side, given local asset price bubbles linked to real estate; or from the liability side (chart 1.4.7), given funding market fragmentation according to national boundaries, whether it results from rational decisions made by banks, market pressures that eventually stigmatize all institutions from one location irrespective of their underlying health (see box 1.4.2), or regulatory initiatives.

1.4.3 Deleveraging

Chart 1.4.7: Deposit interest rates on new business from

households, agreed maturity of up to 1 year (spread with

respect to German rates, basis points)

Source: ECB.

Though “disorderly” deleveraging could represent a serious threat to macroeconomic and financial stability, deleveraging is necessary, however, for banks to correct the imbalances built prior to the crisis and bring the economy back to a strong and sustainable growth path. During 2012, banks have continued to reinforce and strengthen their balance sheets and business models because of the damage inflicted by the crisis. Market pressures to reinforce balance sheets, regulatory measures to ensure banks’ resilience and restructuring obligations in compensation for state aid received during the crisis are behind such behaviour.

The means by which financial institutions deleverage can have quite different implications for the system, and the economy as a whole, as banks can deleverage by:

• Increasing their capital base (issuing shares or reducing dividends, executive compensation and share buybacks in favour of retained earnings).

• Reducing assets through organic (loan portfolio, including doubtful assets) or non-organic means (selling non-core lines of business or assets).

Faced by the funding pressures presented above, EU banks could have opted to shrink their balance sheet to minimize their funding costs in absolute terms. However, aside from some particular Member States, exemplified by the reduction of excess capacity in their banking sectors (see chart 1.4.8); so far banks have reduced their leverage ratios by mostly increasing their capital base, not deleveraging (chart 1.4.9). The deleveraging choice has determined that banks currently have very different capital ratios (chart 1.4.10).

Chart 1.4.8: Number of domestic credit institutions and Chart 1.4.9: Balance sheet of monetary and financial

branches of credit institutions. Spain

institutions in the Euro area, excluding the Eurosystem

Source: Banco de España

Source: ECB.

When looking at the period 2008 to 2012, banks' equity has risen close to €400bn., while the total banking system's balance sheet remained practically stable. This allowed that loans to non-financial firms did not decline but in fact slightly increased, albeit at a reduced rate, (see chart 1.4.13)¹⁹.

This first step was long overdue and one of the cornerstones of the regulatory reforms endorsed by the G20 Leaders. At a later stage, banks will eventually have to reduce their balance sheets, especially by addressing non-performing assets and de-risking in areas such as capital market activities and real estate lending, which grew too much in the run-up to the crisis. Finally, the last step will entail refocusing business models, especially towards more stable funding structures²⁰.

Current regulatory reforms are meant to address these fragilities that prevent banks from performing their fundamental functions (see chapter 3). The objective is none other than to significantly strengthen capital and selectively downsize asset levels, to continue to provide an orderly deleveraging process.

¹⁹ Including the 2011EBA recapitalization exercise, whereby banks were required to reach a Core Tier 1 ratio of 9 per cent, after a prudent valuation of their sovereign exposure. This was a temporary and exceptional buffer established to address the systemic risk arising from the EU sovereign debt crisis (see section 1.4.1).

²⁰ In this regard, see Van Rixtel and Gasperini (2013).

Chart 1.4.10: Tier 1 capital ratio in different EU countries, average in 2011.

Source: ECB.

Note: data for Greece refer to 2010.

1.4.4 Asset encumbrance

Turnover on unsecured money markets, which was the traditional main vehicle of short-term wholesale interbank lending, has fallen by 60% between 2007 and 2012. Upon very little liquidity in this and some other segments of funding markets, and given the difficulties faced by banks to shrink their balance sheets, secured lending has been on the rise. That is, debt has been tapped as was done previously, but providing greater guarantees to creditors by setting aside assets as payment in case of default. These assets set aside are said to be “encumbered”. Asset encumbrance is a practice mainly affecting funding obtained by issuing covered bonds or collateralised lending or when selling derivatives (for hedging or regulatory purposes).

The magnitude of assets currently encumbered in banks’ balance sheets is significant. Chart 1.4.11 represents a banks' stylized balance sheet²¹. The chart distinguishes a bank’s assets and liabilities, and exemplifies the level of asset encumbrance that secured funding determines on four major Swedish banks. In particular, as of December 2011, the average degree of asset encumbrance for this group of banks was about 33%. The majority of encumbrances in the balance sheet, 23.3%, were due to assets being pledged as collateral for covered bonds. Encumbrances for repo collateral represented 3.5% of the total, and derivatives and other funding 6%.

Pressure for further asset encumbrance will remain, as demand for secured funding is growing:

(i) Borrowing from central banks has increased (chart 1.4.2).

(ii) Unsecured issuance is being substituted by covered bond issuance (see chart 1.4.12).

(iii) Repo markets (i.e. repo transactions where payment means are exchanged for collateral) have become an important funding sources that filled the gap of declining volumes on unsecured money markets.

Taken from the Riksbank’s 2012 Financial Stability Report.

(iv) OTC derivative markets’ needs for collateral also keep on growing: the International Swaps and Derivatives Association (ISDA) estimated in 2012 that about 70% of the credit exposure to global OTC derivatives is collateralised, up from 67% in 2007. And this drive to further collateralise derivatives activities is bound to increase, among others reasons, because of regulatory demands (chapter 4).

Chart 1.4.11: Asset encumbrance in a panel of banks

Chart 1.4.12: Total amounts of CB outstanding (€bn)

Encumbered

assets, incl.

over-collateral

Secured creditors

F n cu m be red Ass. Assets

Source: Riksbank. Financial Stability Report 2012:2

Source: European Covered Bond Council. 2012 Fact Book

Increased strains to provide secured funding and demand collateral for derivatives’ activities is rational, understandable and required (among others, due to regulatory demands), particularly given the counterparty risks present in unsecured markets. However, it points to the need of a sufficiently large pool of high-quality assets to support it. And whilst the pool of assets that can be used for collateralized lending is endogenous, as eligibility criteria are determined by creditors, it is nevertheless true that the criteria are not open to absolute discretion. In this regard, the supply of safe assets as known prior to the crisis cannot be taken for granted. In particular, the International Monetary Fund has voiced concerns that the supply of safe assets could contract significantly since debt sustainability problems would question the ratings of several countries' sovereign bonds, which form a crucial building block in the universe of "safe assets"²².

Covered bond frameworks such as those present in Europe can help to contribute and cover part of the shortfall of safe assets (see box 1.4.3). Whilst higher recourse to secured funding during episodes of liquidity stress is understandable and may help avoid their transformation into credit squeezes, it can also make the return to unsecured funding more difficult, leaving banks reliant on liquidity support and central bank funds for longer than warranted.

See IMF (2012b).

Box 1.4.3: On covered bonds

Definition. Covered bonds (CBs) are debt obligations that give their holders recourse to the issuing entity (or an affiliated entity of the issuer). Upon default, covered bondholders also have recourse to a pool of collateral (known as the 'cover pool') separate from the issuer's other assets. This pool consists of high quality assets, usually made up of mortgages and public debt, although other assets can be part of it. The issuer is required to maintain (and replace non-performing) assets in the cover pool, at a value exceeding the par value of the bonds (what is known as 'over-collateralisation'). The pool generates a distinction between ‘encumbered’ from ‘unencumbered’ assets.

Advantages. The recourse to the issuer, the existence of the dynamic cover pool and over-collateralisation determine that CBs are generally considered relatively low-risk yield-bearing financial assets. However, it is not necessarily the case that their low risk is established at the expense of the issuing entity, i.e. by increasing its risk of failure. They may even reduce funding pressures, if financial institutions are unable to raise unsecured debt, thereby lowering their probability of failure.

From a policy perspective, CBs have advantages justifying a favourable regulatory treatment, as they provide incentives for prudent loan origination given that they remain fully accounted for in issuers' balance sheets, unlike 'originate-to-distribute' securitisations²³.

European financial market participants are fond of CBs, as chart 1.4.12 shows. If anything, the crisis has made them even more popular assets to obtain funding, given their general consideration as a relatively low-risk yield-bearing financial asset.

Disadvantages. The growing use of asset-backed securities and the related encumbrance of assets for the benefit of selected creditors may entail risks. Encumbered assets are prejudicial to the interests of other creditors both directly (because they stop being available -structural subordination- and the remaining assets are of poorer quality –have lower recovery rates- when implementing an ordinary wind-up of a financial institution) or indirectly (via pressure on the institution’s credit ratings and funding costs). Moreover, due to their 'dual recourse' nature (and in contrast to securitisations), other investors have to bear in mind that CB investors have also recourse to the issuer’s insolvency estate when their claims are not fully met by the proceeds of the cover pool (ranking equally with other creditors in this case). Finally, CBs are not always as homogeneous and universally a low risk asset class as they seem. Among other reasons, because national rules differ regarding CB issuance, and their quality tends to change over time (e.g. collateral type and quality –evolution of real estate markets in particular, varying credit enhancement levels, degrees of asset-liability mismatch, etc.).

See IMF (2009).

1.4.5 Bank lending

Chart 1.4.13: MFI loans in the Euro area (€tn)

Chart 1.4.14: MFI loans in the Euro area (% of total assets)

Source: ECB

Source: ECB

As long as vicious circles exist between banks and sovereigns, the support the financial system can provide to the rest of the real economy will remain under question, among other reasons because of crowding-out considerations. This section reviews developments in bank lending.

Chart 1.4.15: MFI loans to NFCs in the Euro area (€bn) Chart 1.4.16: MFI loans. Euro area. Quarterly flow (€bn)

Source: ECB

Source: ECB

The total stock of loans granted by Euro area MFIs has stagnated since the beginning of the crisis at a level of around €18tn (chart 1.4.13). Loans to non-financial corporations were particularly affected since the beginning of the crisis. Lending volumes for enterprises continued to display wide heterogeneity across Euro area with France and Germany maintaining their lending growth rates slightly above zero while Italy and particularly Spain recording significant declines in lending. Slight variations observed during the year 2012 reflect the loan instability in the context of economic crisis.

Supply and demand for bank credit

On the demand side, the slowdown in economic activity lowered profitability expectations and led to the deterioration of the quality of loan applications. According to the ECB Bank Lending Survey, the demand for loans from non-financial companies fell significantly during the year 2012. This decline seems to be mainly due to a sharp drop in financing needs for fixed investment. As for households, the declining demand for loans is also one of the causes behind the credit decrease. However, the survey reveals a deceleration of the decline of the household demand for loans at the end of the year 2012.

On the supply side, banks have had to deal with their need to deleverage and to adjust to new regulation concerning capital requirements. Nevertheless, the ECB survey shows a slight improvement in the conditions under which loans were given to enterprises and households in 2012. Indeed, as chart 1.4.17 shows, after a rise in 2011, the share of banks that tightened their credit standards for loans to non-financial companies fell significantly at the beginning of the year (from 35% to 9% in the first quarter). It then stabilized at a 13% level.

Chart 1.4.17: Credit standards in loans to non financial corporates (% of banks tightening credit standards)

70%

60% 50%

40%

30% 20% 10%

(j%



I..


linkui	HI

2D07 2008

Source: ECB

2009 2010 2011 2012

This improvement may be explained by the fact that companies have benefited from the easing of banks' costs of funds constraints. Currently, the factors behind the tightening of credit are mainly related to the general economic outlook and industry specific risks. To a lesser extent, they are also due to costs related to bank's capital position and access to market financing also contributed to the current situation. Yet, the Euro area averages tend to mask considerable heterogeneity across Member States.

The tightening of standard credit for households, whether for house purchase or consumer credit, has followed a similar trend to the one of corporations.

Small and medium sized enterprises

For small and medium sized enterprises (SMEs), bank financing remains the most important source of external financing. Indeed, bank loans accounted for 35% of total SMEs financing between April and September 2012. As SMEs comprise the overwhelming majority of European enterprises and generate more labour per unit of output than big companies, a restriction of credit for SMEs could threaten a potential economic recovery.

The ECB lending survey points out to a cautious lending policy by banks leading to lower willingness to provide loans to SMEs. Indeed, the tightening of credit standards increased for SMEs in the second half of 2012, while it remained stable for big enterprises. Moreover, according to the ECB survey on the access to finance for SMEs in the Euro area, their loan applications were more likely to be rejected when the company was small: from April to December 2012, the overall rejection rate of SMEs loans was of 15%, and reached 24% for micro firms (1 to 9 employees). In contrast, 5% of big companies' loan applications were rejected over the same period. To conclude, there is high concern that these developments will negatively affect the real economy in the near future.

1.5 Equity and corporate bond markets

The on-going sovereign debt crisis, the investors' re-assessment of sovereign and corporate risk, and the desire of non-financial corporates (NFCs) to diversify their funding sources, have been important to understand the dynamics in corporate debt and equity markets in 2012. Equity markets have been lifted by strong policy actions amid the sovereign debt crisis, despite lacklustre

macro-economic prospects. Corporate bond markets have benefited from a relative shift from bank lending to direct issuance of debt securities, and an increasingly favourable financing climate over the year. This section provides a short overview of developments in corporate capital markets.

1.5.1 Equity markets

Against the background of sluggish economic activity, European equity markets developed favourably over the course of 2012 (chart 1.5.1), with the Eurostoxx 50 registering a full year gain of 11%. In the first months of the year, equity markets rallied amid signs of stabilisation in the global economic environment. Another supportive factor for markets stemmed from the ECB's liquidity injection in the form of long-term refinancing operations (LTRO), in December 2011 and February 2012, aimed at securing bank funding. In Spring, however, indices dropped significantly from their previous peak, on re-intensification of the sovereign debt worries, and growing concerns about the economic growth (Eurostoxx 50: -21%). In early summer, the corporate market segment, including the equity market, seemed to decouple somewhat from tensions in the sovereign bond markets, and started a mild recovery process, supported by a weakening euro and a rebound of the US stock markets on account of some better-than-expected corporate earnings. The ECB's strong policy commitment over summer confirmed, very effectively, the mood reversal on equity markets. This resulted in an impressive rally in equity markets, holding on until the year-end (+27%).

The rally took place despite a weakening macro-economic outlook and narrowing corporate profit margins, suggesting the market recovery has been more closely tied to policy developments than to economic fundamentals, and been built partly on the expectation of continued strong policy support. At the end of the year, the implied volatility of stock prices, derived from option prices and regularly used as a measure of general market uncertainty, had declined to levels comparable to other troughs reached during the current 5-year crisis (chart 1.5.2).

Chart 1.5.1: EU stock market performance (index, Chart 1.5.2: Share prices. Forward-looking (implied)

Jan2010=100)

volatility indices

Source: Ecowin

Source: Ecowin

Among large Euro area Member States' stock markets the German DAX performed best with a full year progress of 29%, whereas the French CAC 40 displayed a positive evolution of about 15%. Member States heavily affected by the sovereign debt crisis underperformed significantly over the year (e.g. the Spanish IBEX 35 closed almost stable, while the Italian MIB realised a full

year return of 7%), and registered the strongest declines before the summer (IBEX 35: -33%; MIB: -25%).

In the US, the broad S&P 500 Index advanced 12% for the full year. In the last 3 months of the year it had to give back some earlier gains, amid worries about budgetary developments and signs of a slow-down in economic growth (chart 1.5.3). The STOXX Asia Pacific 600 posted a slightly lower return of 9%, as the economic activity lost steam.

The net issuance of quoted shares by Euro area non-financial corporations (NFCs) remained subdued (i.e. EUR 14 billion), marginally higher than in 2011 (chart 1.5.4). The net issuance reflects both a sharp reduction in redemptions (from EUR 16 billion in 2011 to EUR 11 billion) and a decline in gross issuance by close to the same amount (EUR 25 billion in 2012). Net equity issuance by NFCs remained in 2012 well below the boom years, while gross issuance was even at its lowest level in the last 12 years, despite much reduced price-earnings ratios (chart 1.5.4). The total amount of outstanding quoted shares is EUR 3.673 billion (end November), an increase of 0.4% year-on-year.

Chart 1.5.3: Global stock market performance (index, Chart 1.5.4: Net equity issuance (LHS, in €bn) and price

Jan2010=100)

ratios (RHS). Euro area NFCs

Source: Ecowin

Source: EFC

1.5.2 Corporate bond markets

The historically low interest rates on higher-grade sovereign bonds have pushed bond investors in corporate debt markets to accept increasingly narrowing spreads over the past year. This holds not only for the best-graded corporate bonds, but also for the lower graded, e.g. BBB-rated bonds (Chart 1.5.5). While, in the second quarter of the year, the spreads on these bonds were negatively affected by the deteriorating economic outlook, in the latter half of the year the spreads narrowed in parallel with the waning worries about the sovereign debt crisis, despite the absence of improving macro-economic fundamentals. The decline in spreads was mirrored by a fall of the indices of credit-default swaps which protect investors owning bonds against default and traders use to speculate on changes in credit quality. The fall in corporate spreads has occurred in all Member States, with the sharpest declines in distressed countries thereby reducing the heterogeneity in financing costs for NFCs across the EU.

Declining spreads and yields have prompted both investment-grade and "junk"-rated corporates to sell record high volumes of bonds. After a slow start in the first quarter of the year, primary

issuance gained traction and reached a 12.5% annualized growth rate at the end of the year. The increasing (incentive-based) momentum in issuance is highlighted in charts 1.5.5 and 1.5.6.

Over 2012, the gross issuance of debt securities amounted to EUR 178 billion, only surpassed by the record year of 2009. The total amount outstanding of debt securities issued by the NFCs reached thereby historical highs of EUR 978 billion at the end of the year. Issuing companies seem to have been keen to lock in low interest rates in particular for longer maturities, notably at fixed rates, as reflected by the high proportion of long-term debt securities issuance and the annual growth rate of 13.5%. Meanwhile, the issuance of short-term debt securities (growth of 1.4%) and of longer-term debt securities at floating rates (+1.3%) was subdued.

The increase in the issuance of debt securities is part of a gradual move that has been taking place in the EU financial markets towards more capital market based funding, and less bank-based funding by corporates. This trend has been reinforced by the crisis as bank lending has been more difficult to obtain.

Chart 1.5.5: Corporate bond spreads (basis points)

Chart 1.5.6: Itraxx default risk of NFCs, Euro area (basis points)

Source: Bloomberg

1.6 The insurance sector

Source: Markit-Itraxx

Note: Investment grade corresponds to the Itraxx Europe and High

yield to the Itraxx Crossover indexes.

This section looks at market developments in the insurance sector and the challenges that insurance undertakings will face in the near future.

1.6.1 Market developments

The weak macroeconomic environment led to a diminishing performance of the overall insurance sector in the year 2011: total gross written premiums decreased by 3.5% (chart 1.6.1). The new single premium business dropped remarkably, reflecting cautious consumer behaviour due to the crisis24, especially in life insurance (-7.6%). The countries most affected by this decline were Portugal, Luxemburg and, to a lesser extent, Italy and Belgium (Chart 1.6.2). In contrast, in the non-life sector, the situation was better: gross written premiums increased 2.7%.

Reinsurance undertakings faced considerable losses due to the occurrence of many catastrophes in 2011, especially the earthquake in Japan, which was the costliest natural catastrophe of all times. However, the sector has been able to cope with these difficulties thanks to its strong capital base.

See Insurance Europe, European insurance in figures, January 2013.

Therefore, business volumes of reinsurers at the end of 2011 were only 3% lower than in 2010²⁵. In the first half 2012, the declining trend in gross written premiums reversed.

However, growth rates remain subdued: gross written premiums in the second quarter 2012 were 2% higher than in the same period of the previous year²⁶. Despite continued competitive pressures, non-life segments recorded the highest increase, especially in fire and damage to property and general liability (+6%). Instead, competition in life insurance from similar banking products has decreased and lapse rates have improved, allowing the sector to stabilize. Most national supervisors expect premia to stabilise, in both the life and non-life segments over the next 6

to 12 months²⁷

Chart 1.6.1: Gross written premium (% annual growth rate)

08-09 EU27 09-10 EU27 10-11 EU27

I Life enterprises ■ Non-Life enterprises Tota Source: EIOPA statistics

In the first nine months of 2012, the reinsurance sector benefited from the absence of large-scale natural catastrophes and, thus, overall investment results improved. Hurricane Sandy (representing damages above 20 billion USD²⁸) will impact profits, but solvency margins will remain strong due to the buffers built in 2012.

Gross written premiums growth, 2010- 2011 (%)

Chart 1.6.2:

30%

20%

'0% 0% -10% -20% -30% -40% -50% -$0% -70%

Source: EIOPA Statistics, data available only until end 2011.

In terms of profitability, – measured as return on equity (RoE) – insurance undertakings proved resilient to the crisis by remaining broadly stable (RoE was around 7.5% in the 2nd quarter of

See EIOPA Financial Stability Report, June 2012.

See EIOPA Financial Stability Report, December 2012.

26

²⁷ See EIOPA Financial Stability Report, December 2012.

²⁸ See EIOPA Risk Dashboard, December 2012.

25

2012²⁹). According to ECB data, combined ratios³⁰ in the non-life sector have even improved in the 3rd quarter of 2012.

Solvency ratios have also improved in the first half of 2012, compared to the same period of the previous year, thanks to a decline in sovereign bond spreads and market volatility. They remained at comfortable levels in most European countries (the median solvency ratio was about 220% in the second quarter of 2012 compared to less than 200% for the same period in 2011³¹). Non-life solvency margins were particularly strong due to continued underwriting profitability. Moreover, policy responses at the European Union level (the Commission´s proposal to advance towards a Banking Union as mentioned in section 14.1 and the ECB measures, such as the OMT described in section 14.2) had a positive impact on market sentiment, leading to a rebound in equity prices in the second half of the year. This helped improve the capital position of insurance companies.

Asset allocation of insurance undertakings is dominated by fixed income assets (52% of total assets by the end of 2011), reflecting the industry's policy to try to ensure adequate and predictable cash flows over time. In this regard, EIOPA data show that insurance undertakings remain biased towards investing in government bonds, which represent 25% of total assets; followed by financials, by 18%; and non-financial corporate bonds, representing 13% of the total (chart 1.6.3). Changes are taking place over time, however, as in the last 12 months the relative share of non-financial corporate bonds has risen. And, despite home bias, insurers broadly adopted diversification policies to address the risk arising from the sovereign debt crisis.

Chart 1.6.3: Asset composition of European insurance companies

Assets of insurance groups (excluding unit linked assets)	1 Government bonds ■ Corporate bonds, financials, secured ■ Corporate bonds, financials, unsecured
18%
	^^^ 25%	■ Corporate bonds, nonEBinancials ■ Equity & participations
4% i		■ Property ■ Cash & deposits
4% fl
1% 1	■Investment funds
■ 7% 6% y V	■ Loans & Mortgages ■ Derivatives
3% ' ^W 9%	■ Structured products (ABS, CDO…)
4% ^^H
2%	■ Other investments
4% 13%	■ Other assets

Source: EIOPA risk dashboard, September 2012

Following the trend to limit risk taking, in the last years insurers´ asset allocation has gradually shifted towards holding lower levels of equity, which represented only 11% of total assets at the end of 2011³².

²⁹ See EIOPA financial stability report, June 2012: statistics consider median as more robust measure as the average.

³⁰ Combined ratio is measured as the ratio between (incurred loss and expenses) and gross written premiums.

³¹ Definition of solvency ratio: See EFSIR 2011; for statistics see EIOPA financial stability report, June 2012.

³² See EIOPA Financial Stability Report, December 2012.

1.6.2 Market integration and the role of insurers to finance real economy

Market integration increases opportunities for insurers and brings advantages to consumers, with respect to the quality and the variety of products offered. Most of insurers' business abroad is usually carried out through subsidiaries, and their physical presence (share of foreign branches) remains rather small. However, data from EIOPA show a clear trend towards market integration: the average share of gross written premium by foreign branches in 2011 increased to 7%, compared to 2% in the previous year. New Member States lead new branch openings and a large number of insurance undertakings have asked for authorisation to enter foreign markets. Still, the absolute number of foreign branches in Member States remains quite limited (chart 1.6.4)³³.

Insurance companies are among the biggest institutional investors in Europe and therefore play an important role in financing the real economy. Together with pension and mutual funds, they hold an estimated €13.8 trillion of assets, representing an amount larger than 100% of the region's GDP³⁴. As banks are currently more constrained to meet the long-term funding needs of borrowers (see section 1.4.6), this has created opportunities for insurers and pension funds to invest in non-financial corporations³⁵. This is because insurers tend to have long-dated liabilities, matching the demand for lending where banks are retrenching. This advantage arises from the funding capacity that characterizes them (together with pension funds): they can provide long term funding, such as annuities, as they are less dependent on maturity transformation.

Chart 1.6.4: Number of entities (2011)

Source: EIOPA

It is important to realize, however, that their investments tend to be concentrated on securities, rather than in providing direct loans. Against this background, channelling long-term resources via capital markets and reducing the dependence on bank funding would be a plus. Nevertheless, such a transformation in funding will, inevitably, take time.

Long-term projects, which often require a considerable amount of funds and know-how in their implementation, have intrinsic risks. Closer cooperation between investors and public authorities

See EIOPA December 2012.

33

³⁴ See Fitch (2011) and EFAMA (2012).

³⁵ See section 1.4.4 on deleverage pressures on the banking sector and ECB Financial Stability Review, December 2012.

may help to successfully carry through these projects. In this respect, the EU Commission has launched a green paper. The idea is to initiate a broad and meaningful debate on how to address the challenges represented by long term financing to the real economy. The idea is none other than to bring back the EU on a path towards smart, sustainable and inclusive growth.

1.6.3 Risks and challenges ahead

The insurance sector faces numerous challenges ahead, both in the short- and medium-term.

First of all, there is an uncertain overall economic outlook, constituting a major challenge to insurers, as recessionary pressures can negatively impact insurance demand. In the absence of growth, insurers encounter a challenging environment where to generate sufficient revenues to stand by their commitments. Moreover, they could be induced to search for higher yields, at the expense of undertaking greater risks. Obviously, the higher risk will come at a price, bringing other unwanted consequences.

The second biggest challenge faced by the sector is a prolonged period of low interest rates. This presents a high risk for the profitability and the capital position of insurance undertakings in the medium-term. Interest rates have a significant impact on business lines where investment income is a major source of earnings. Whereas long-term interest rates have been at historically low levels since 2010, both short- and long-term European benchmark rates have further declined since the beginning of 2012. Insurers, and particularly life insurers, are institutional savers that suffer from low investment yields, as the net present value of their long-run obligations to policyholders and pensioners increases when interest rates are low. Insurance undertakings that have offered guaranteed minimal rates of return to policyholders and those that have a significant duration gap between assets and liabilities will suffer more in such an environment.

Chart 1.6.5: Stoxx indices for insurers and banks £00------------------------

St apt x 6QD Insurance Europe

StOxx 600 Banks Europe

Chart 1.6.6: Sector CDS spreads for insurers and banks

600 500 400 300 200 100

en m co

Source: Bloomberg

Source: Bloomberg

According to an EIOPA stress test analysing prolonged low interest rates, published in its December 2012 Financial Stability Report, between 5% and 10% of the companies surveyed would face considerable problems (their Minimum Capital Requirement solvency ratio would fall below 100%). To address this issue, insurers are reducing or adjusting their guaranteed returns offered in new insurance policies. Nevertheless, life insurers will need to envisage strategies that go beyond these measures and design new products that enable them to effectively hedge interest rate risks. At the same time, life insurers will have to continue monitor closely and manage effectively the risk of low interest rates, to ensure they can meet their obligations. In this regard,

they will have to envisage a mix of strategies, such as cash-flow hedging, product changes (including the development of new products), as well as strengthening their capital base.

The third challenge faced by insurers is market volatility, particularly in (sovereign) bond prices, as it could affect the capital position of insurance undertakings in the near future. This is also one of the reasons why some insurance undertakings face negative rating outlooks³⁶. Many insurers are therefore paying increased attention to their earnings retention³⁷.

Finally, vulnerabilities in the banking sector remain a risk for insurance undertakings, as banks are a major counterparty for a significant part of insurers’ investments in debt securities (bank bonds accounted for 9% of insurers' and pension funds' total financial assets in the second quarter of 2012³⁸). As a result, the insurance and banking sectors are highly interlinked, as shown in the evolution of Stoxx indices and CDS spreads (charts 1.6.5 and 1.6.6, respectively). Therefore, drawbacks in or affecting the banking sector could spill over to insurance undertakings. Derivative contracts between banks and insurers increase interconnectedness and could also reduce resilience to shocks emerging from the banking sector. For example, liquidity swaps might expose insurance companies to additional liquidity risk³⁹. At the moment, liquidity swaps are traded by a small number of institutions and to a limited extent (3% of balance sheet assets in average⁴⁰). However, future developments should be carefully monitored.

³⁶ On a sample of 24 large insurance groups, 6 have negative rating outlooks and 17 stable outlooks (in contrast to respectively 4 and 18 for the year 2011). See EIOPA financial stability report, December 2012.

See also ECB Financial Stability review, December 2012. See ECB financial Stability review, December 2012.

38

³⁹ Banks might swap securities with insurers, in order to get the collateral that facilitates their access to liquidity.

⁴⁰ National variations go from 0% to 14% of the balance sheet assets. See EIOPA financial stability report, December 2012.

1.7 References

Battistini, N., M. Pagano and S. Simonelli (2013) “Systemic risk and home bias in the Euro Area”, European Economy –Economic Papers, forthcoming.

Böwer, U. and A. Turini (2009) “EU accession: a road to fast-track convergence?”, European Economy -Economic Papers 393, European Commission.

http://ec.europa.eu/economy_finance/publications/publication16470_en.pdf

Caballero, R.J. and A. Krishnamurthy (2008) “Collective risk management in a flight to quality episode”, Journal of Finance, 63(5): 2195-2230. Available at http://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.2008.01394.x/abstract.

Calvo, G.A., A. Izquierdo and L.-F. Mejia (2004) “On the empirics of sudden stops: the relevance of balance-sheet effects”, NBER Working Paper 10520. Available at http://www.nber.org/papers/w10520.

Cecchetti, S.G, R.N. McCauley and P.M. McGuire (2012), “Interpreting TARGET2 balances”, Bank for International Settlements Working Paper 393. http://www.bis.org/publ/work393.pdf

EBA (2013), Risk Assessment of the European Banking System, http://eba.europa.eu/cebs/media/Publications/report/EBA-BS-2012-273--Risk-Assessment-Report---January-2013-.pdf

ECB (2012), “Financial Stability Review”, December 2012. Available at http://www.ecb.europa.eu/pub/pdf/other/financialstabilityreview201212en.pdf

EFAMA (2012): “Asset Management in Europe: Facts and Figures”, May 2012. Available at http://www.efama.org/Publications/Statistics/Asset%20Management%20Report/Asset%20Mana gement%20Report%202012.pdf

EIOPA (2012), “Financial Stability Report 2012, First half-year report”, June 2012. Available at https://eiopa.europa.eu/fileadmin/tx_dam/files/publications/reports/EIOPA_First_Half-Year_Financial_Stability_Report_2012.pdf

EIOPA (2012), “Financial Stability Report 2012, Second half-year report”, December 2012. Available at

https://eiopa.europa.eu/fileadmin/tx_dam/files/publications/reports/EIOPA_Second_Half-Year_Financial_Stability_Report_2012.pdf

EIOPA (2012), “EIOPA Risk Dashboard”, September 2012. Available at https://eiopa.europa.eu/fileadmin/tx_dam/files/publications/reports/Risk_Dashboard_Sept2012.p df

EIOPA (2012), “EIOPA Risk Dashboard”, December 2012. Available at https://eiopa.europa.eu/fileadmin/tx_dam/files/publications/reports/EIOPA_Risk_Dashboard_-_December_2012.pdf

European Commission (2012), “Current accounts surpluses in the EU”, European Economy, 9. Available http://ec.europa.eu/economy_finance/publications/european_economy/2012/current-account-surpluses_en.htm

Fitch (2011), “European corporate funding disintermediation”.

Garber, P. (1999). “The TARGET mechanism: will it propagate or stifle a stage III crisis?” Carnegie-Rochester Conference Series on Public Policy, 51(1): 195-220. Available at http://www.sciencedirect.com/science/article/pii/S0167223100000105.

Gianetti, M. and L. Laeven (2012), “The flight home effect: evidence from the syndicated loan market during banking crises”, Journal of Financial Economics, 104(1): 23-43. Available at http://www.sciencedirect.com/science/article/pii/S0304405X11002820

High-level Expert Group on reforming the structure of the EU banking sector (2012). Available at http://ec.europa.eu/internal_market/bank/docs/high-level_expert_group/liikanen-report/final_report_en.pdf

IMF (2009), “Restarting securitization markets: policy proposals and pitfalls”, Ch. 2, October 2009 Global Financial Stability Report: 77-115. Washington, DC.

IMF (2012b), “Safe assets: financial system cornerstone?”, Chapter 3, Global Financial Stability Report. Available at http://www.imf.org/External/Pubs/FT/GFSR/2012/01/pdf/c3.pdf

Insurance Europe (2013), “European Insurance in Figures”, January 2013. Available at http://www.insuranceeurope.eu/uploads/Modules/Publications/eif-2013-final.pdf

Kose, M.A., E. Prasad, K.S. Rogoff and S-J. Wei (2000), “Financial globalization: a reappraisal”, IMF Staff Papers, 56(1): 8-62. Available at http://www.palgrave-journals.com/imfsp/journal/v56/n1/full/imfsp200836a.html

Merler, S. and J. Pisani-Ferry (2012) ‘Sudden stops in the Euro area’, Policy Contribution 2012/06, Bruegel. Available at http://www.bruegel.org/download/parent/718-sudden-stops-in-the-euro-area/file/1565-sudden-stops-in-the-euro-area/.

Reinhart, C.M. and M.B. Sbrancia (2011) “The liquidation of government debt”, NBER Working Paper 16893. Available at http://www.nber.org/papers/w16893.

Reinhart, C.M. and K.S. Rogoff (2009), This Time is Different: Eight Centuries of Financial Follies. Princeton, NJ: Princeton University Press.

Swiss Re (2012), “Facing the interest rate challenge”, Sigma 4/2012. Available at http://media.swissre.com/documents/sigma4_2012_en.pdf.

Van Rixtel, A. and G. Gasperini (2013), “Financial crises and bank funding: recent experience in the Euro area”, BIS Working Paper 406. Available at http://www.bis.org/publ/work406.pdf.

CHAPTER 2: POLICY DEVELOPMENTS

2.1 Introduction

This chapter provides an overview of the main policy measures introduced or continued in 2012. It covers both the macro-financial policies, including financial assistance and other support measures (section 2.2), economic governance reforms (section 2.3), and the on-going reform programme to achieve a better financial sector (section 2.4).

2.2 Financial assistance and support measures

2.2.1 Permanent financial backstop mechanisms

On the 27^th of September 2012 the Treaty establishing the European Stability Mechanism (ESM)⁴¹ entered in force, after having been ratified by all 17 Euro area Member States. The ESM is an important component of the comprehensive EU strategy designed to safeguard financial stability within the Euro area. Like its predecessor, the European Financial Stability Facility (EFSF), it provides stability to support Euro area Member States experiencing or threatened by financial difficulties. In accordance with the agreement reached among the Heads of State or Government of the Euro area, the ESM will operate alongside the EFSF for a limited period of time⁴².

The ESM is an international financial institution based in Luxembourg, established under public international law. The effective lending capacity of the ESM will be built up gradually, as the required paid-in capital is transferred to the ESM by its members. The Heads of State or Government of the EA agreed, in March 2012, that the first two tranches of capital (€16 billion each) should be paid in 2012, followed by two tranches in 2013 and a final tranche in the first half of 2014, to sum up to a total of €80 billion. To provide stability support, it is entitled to raise funds by issuing on the capital markets or by entering into financial or other agreements with ESM Members, financial institutions or other third parties. ESM assistance will be provided under economic policy conditionality, which encompasses a range of options intended to cater to the specific instrument being used.

The ESM offers a range of financial assistance instruments, which are mirrored under the EFSF structure: (i) granting loans to countries in financial difficulties; (ii) purchasing bonds of an ESM Member State in the primary or secondary debt markets; (iii) establishing precautionary financial assistance in the form of a credit line; and (iv) providing capital to an ESM Member for the specific purpose of assisting financial institutions (specifically to cater for non-programme countries facing problems stemming from the financial sector). Based on revised accords, maturities can extend up to 30 years.

According to an agreement reached among the Euro area Heads of State or Government in the course of 2012, the ESM will be empowered to directly recapitalise banks in the Euro area once an effective single supervisory mechanism for Euro area banks is established (see chapter 1, section 1.4). The ESM Treaty already allows for the possibility to create new instruments; thus the

⁴¹ http://www.european-council.europa.eu/media/582311/05-tesm2.en12.pdf

⁴² Already during the transitional period, until mid-2013, the ESM will be the main instrument for the financing of new programmes. While the EFSF will, as a rule, only remain active in financing programmes that were started before the ESM entered into force, it may engage in new programmes in order to ensure a full fresh lending capacity of €500 billion.

introduction of this additional instrument will not require a Treaty change. Work has already begun on designing the details and modalities of conducting direct recapitalisation. An agreement of the ESM Board of Governors will be required for its implementation into the ESM structure.

2.2.2 Financial assistance programme to Spain

As mentioned in chapter 1 (sections 1.3), on top of the existing financial assistance programmes to Greece, Ireland and Portugal, Spain requested financial assistance on June 9^th 2012 to recapitalize a number of its financial institutions by the EFSF. The total amount approved has been up to EUR 100 billion. This program has subsequently been taken over by the European Stability Mechanism (ESM).

The assistance is conditional on specific policy measures regarding the financial sector as foreseen by the Memorandum of Understanding⁴³. The financial-sector-specific policy conditions contain both bank-specific and horizontal conditionality that the country has to implement, to increase the long-term resilience of the banking sector, thus restoring its market access, and to deal effectively with the legacy stock of assets stemming from the burst of the real-estate bubble.

Horizontal conditionality applies to the entire banking sector, unlike bank-specific conditions, which only apply to banks unable to meet capital shortfalls identified by the bank-by-bank stress test without having recourse to State aid. The horizontal programme includes measures aimed, inter alia, at strengthening the regulatory, supervisory and bank resolution frameworks, enhancing the governance structure of savings banks and of commercial banks controlled by them, and improving consumer protection legislation as regards the sale by banks of subordinated debt instruments.

In addition, Spain needs to honour its commitments and follow the recommendations under the excessive deficit and macroeconomic imbalances procedures in the framework of the European semester.

The bank-specific conditionality, in particular based on and enforced through the full application of State aid rules for the financial sector⁴⁴, has three main components:

1. A comprehensive diagnostic as regards the capital needs of individual banks, based on an asset quality review and evaluation process, and bank-by-bank stress tests.

2. The segregation of impaired assets from the balance sheet of banks in need of public support and their transfer to an external Asset Management Company.

3. The recapitalisation and restructuring of viable banks and an orderly resolution of ultimately non-viable banks, with private sector burden-sharing as a prerequisite. Eight banks could not fill the capital shortfall revealed by the stress test without recourse to State aid, and subsequently had to be restructured in compliance with State aid rules.

The Spanish programme, which made the disbursement of ESM funds to Spain for the purpose of recapitalising banks contingent on the Commission's approval of restructuring or resolution plans,

⁴³ http://ec.europa.eu/economy finance/eu/countries/pdf/mou en.pdf

⁴⁴ http://ec.europa.eu/competition/state aid/legislation/temporary.html

has enhanced the role of State Aid control as a crisis resolution tool. It has contributed to reducing the cost of the Spanish programme for the ESM to approximately EUR 44 billion.

The terms and conditions of the financial sector assistance were negotiated between the Spanish authorities and the European Commission (EC), in liaison with the European Central Bank (ECB) and the European Banking Authority (EBA), with technical assistance of the International Monetary Fund (IMF).

The loans are provided to the Fondo de Restructuración Ordenada Bancaria (FROB), the bank recapitalization fund of the Spanish government, and then channelled to the financial institutions concerned.

2.3 REINFORCED ECONOMIC GOVERNANCE AT EU AND MS LEVEL

A major weakness of the pre-crisis surveillance arrangements was the lack of following macroeconomic imbalances and competitiveness developments in EU Member States, despite the proceeding economic and financial integration amongst them. As the crisis accelerated, the instability in one Member State risked spilling-over to others, thereby jeopardising the cohesion and stability of the entire EA and EU. The crisis made the need to deepen economic integration in the EA and the Union more broadly as obvious as urgent.

2.3.1 The Two-Pack

Recognising the need to further strengthen Euro area economic surveillance mechanisms and to go beyond the 'Six-Pack'⁴⁵, the Commission proposed, in November 2011, two supplementary Regulations - the so-called 'Two-Pack'⁴⁶. Both Regulations will apply to Euro area Member States. One of the Regulations aims to further strengthen surveillance mechanisms by, in particular, monitoring and assessing draft budgetary plans. The second will further align principles already being used in granting and implementing financial assistance with the Treaty framework. The latter sets out explicit rules for enhanced surveillance for those Euro area Member States experiencing or threatened with severe financial difficulties; it will also address measures for those currently under financial assistance as well as those in the process of exiting such assistance.

2.3.2 The Commission's Blueprint for a deep and genuine EMU

In June 2012 the President of the European Council, in cooperation with the Presidents of the Commission, the Eurogroup and the ECB presented a report to enable the EA to integrate quicker and deeper. The report, "Towards a Genuine Economic and Monetary Union", identified four essential 'building blocks' for further integration: (i) an integrated financial framework, (ii) an integrated budgetary framework, (iii) an integrated economic policy framework and (iv) democratic legitimacy and accountability.

⁴⁵ The legislative package known as 'Six-Pack' entered into force in December 2011. For a more detailed description, see EFSIR 2011.

⁴⁶ http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:DKEY=627835:EN:NOT and http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:DKEY=627834:EN:NOT

On 28 November 2012, the Commission published its 'Blueprint for a Deep and Genuine Economic and Monetary Union: Launching a European Debate', to move ahead and strengthen cooperation and integration in the financial, fiscal, economic and political field. The blueprint together with a second report by the four Presidents fed into discussion at the December European Council, which set a specific and time-bound roadmap for the achievement of a genuine banking, economic and political union, including legislative actions.

The main actions envisaged are the following:

• In the short term (within 6 to 18 months), implementing the governance reforms already agreed ('Six-Pack') or about to be agreed ('Two-Pack'). An effective banking union would not only require the setting up of a Single Supervisory Mechanism and the harmonization of deposit guarantee schemes. It also requires a Single Resolution Mechanism to deal with banks in difficulties. With the decision on the next Multi-annual Financial Framework (MFF) for the EU already taken, the economic governance framework has been be strengthened further by proposing the creation a "convergence and competitiveness instrument" within the EU budget – but separate from the MFF - to support the timely implementation of structural reforms, on the condition that "contractual arrangements" are concluded between Member States and the Commission. This would support the rebalancing, adjustment and therefore growth of the economies of the EMU and would serve as the initial phase in the establishment of a stronger fiscal capacity alongside more deeply integrated economic policies. Building on progress achieved in the economic governance of the Euro area, a strengthening and consolidation of its external representation should be pursued.

• In the medium term (18 months to 5 years), the Euro area would benefit from deeper coordination in the field of tax policy issues and labour markets, given the significance of labour mobility for adjustment capacity and growth within the Euro area. Building on the Convergence and Competitiveness Instrument, the fiscal capacity for the Euro area should be further enhanced. It should be autonomous and rely solely on its own resources. It should provide sufficient support to address important structural reforms in a large economy under distress. A clearly reinforced economic and fiscal governance framework could allow considering the reduction of public debt significantly exceeding the SGP criteria, by setting-up a redemption fund subject to strict conditionality. The common issuance by Euro area Member States of so-called Euro-bills - short-term government debt with a maturity of up to one or two years - could constitute a tool against the present fragmentation, reducing the negative feedback loop between sovereigns and banks, while limiting moral hazard. The monitoring and managing function for the fiscal capacity and other instruments should be provided by an EMU Treasury within the Commission. The further strengthening of policy coordination and enhancement of the fiscal capacity would initially start under secondary law, but would require Treaty changes at some point. The creation of a Debt Redemption Fund and the common issuance of short-term government debt would require Treaty changes.

• In the longer term (beyond 5 years), based on the progressive pooling of sovereignty, responsibility and solidarity at the European level, an autonomous Euro area budget

providing for a fiscal capacity for the Euro area to support Member States in the absorption of shocks should become possible. The central budget would provide for an EMU-level stabilisation tool to support adjustment to asymmetric shocks, facilitating stronger economic integration and convergence. Overall, a shared instrument could deliver net gains in stabilising power, as compared with current arrangements. How large this fiscal capacity would ultimately turn out to be will depend on the depth of integration desired and on the willingness to enact accompanying political changes. Also, a deeply integrated economic and fiscal governance framework could allow a common issuance of public debt, which would enhance the functioning of the markets and the conduct of monetary policy. This would be the final stage in EMU.

2.3.3 A Financial Transaction Tax

On 28 September 2011, the Commission adopted a proposal for a Council Directive on a common system of financial transaction tax (FTT) and amend Directive 2008/7/EC⁴⁷. The proposal required a unanimous vote in the Council, and it quickly became clear that some Member States had specific problems which made it impossible for them to accept the proposed directive.

Since then, eleven Member States have indicated their intention to establish enhanced cooperation between themselves in the area of the creation of a common system of FTT by addressing a request to the Commission in accordance with Article 329(1) TFEU. The Commission subsequently presented a proposal for a Council decision authorising enhanced cooperation. After the European Parliament's consent given in December 2012, the Council authorised enhanced cooperation in the FTT area in January 2013. Subsequently, in February 2013, the Commission adopted a proposal for a Council Directive implementing enhanced cooperation in the area of FTT⁴⁸.

The financial sector was a major cause of the crisis and received substantial government support. A common system of FTT introduced in a block of Member States representing around 2/3 of EU GDP will harmonise indirect tax legislation, generate significant revenues, safeguard a fair and substantial contribution from the financial sector and help ensure greater stability of financial markets, without posing undue risk to EU competitiveness.

In addition, it will constitute a milestone for EU tax policy, as it paves the way for more ambitious Member States to progress on tax files, following the direction of the blueprint⁴⁹.

2.3.4 The Compact for Growth and Jobs.

Economic growth is key to restore fiscal and macro-economic balances. Therefore, and in line with its Europe 2020 growth strategy, the European Council agreed in June 2012 on the Compact for Growth and Jobs, as an integral part of EU's response to the economic and financial crisis.

The Compact encompasses a wide range of growth-enhancing initiatives, instruments and policies based on the following pillars: boosting the implementation of the Europe 2020 Strategy;

⁴⁷http://europa.eu/legislation summaries/internal market/single market services/financial services general framework/mi0 087 en.htm

⁴⁸ http://ec.europa.eu/taxation customs/taxation/other taxes/financial sector/index en.htm

⁴⁹ http://ec.europa.eu/commission 2010-2014/president/news/archives/2012/11/pdf/blueprint en.pdf

deepening the Single Market; developing transport, energy and digital networks across the EU; completing the Digital Single Market and the Internal Energy Market; creating the right regulatory framework for growth, in particular for SMEs and micro-enterprises; promoting an industrial policy with an integrated vision on research and innovation to invest in the deployment of Key Enabling Technologies in order to enhance the competitiveness of the industry sector and favour growth; creating the right regulatory framework for growth; developing a tax policy for growth; boosting employment and social inclusion, especially adopting initiatives to tackle youth unemployment; and last, but not least, harnessing the potential of trade.

So far, significant progress has been made on several aspects of the Compact, for example the increase in capital of the EIB, the launch of the first EU project bonds and the adoption by the Commission in June 2012 of a Communication on “A European strategy for Key Enabling Technologies –A bridge to growth and jobs”.⁵⁰

2.3.5 Enhanced governance in practice: the 2012 European Semester

In 2012, the EU completed its second European semester. The European semester is integrating all revised and new surveillance processes into a comprehensive macro-economic, fiscal and structural policy framework. On the basis of a Commission proposal, the Council provides ex ante policy guidance to each Member State and to the Euro area as a whole. These recommendations cover Member States' budgetary, financial, structural and employment challenges. Member States have to incorporate the policy advice in their budgetary and structural reform agendas and implement the country-specific recommendations (CSR) within the following 12 months.

In 2012, the Commission's Annual Growth Survey, which provides general guidance to the Member States on the coming year's key policy priorities, called for national and EU efforts to be concentrated on five priorities, with a clear focus on measures that enhance growth and labour-market participation:

• Pursuing differentiated growth-friendly fiscal consolidation.

• Restoring normal lending to the economy.

• Promoting growth and competitiveness for today and tomorrow.

• Tackling unemployment and the social consequences of the crisis.

• Modernising public administrations.

In 2012, the Commission’s proposal for country-specific recommendations (CSR) on public finances called, inter alia, for respecting obligations under the Excessive Deficit Procedure (EDP), making progress towards the Medium Term Objectives, adjusting fiscal frameworks, and improving long-term sustainability of public finances, e.g. by linking statutory retirement age to life expectancy. All Member States were also recommended to undertake action in the area of the labour market, particularly regarding labour market participation, including improving education systems. In the area of structural reforms, the CSR proposal called, inter alia, for adjusting wage setting mechanisms, shifting taxes from labour to e.g. environmental taxes, strengthening

COM (2012) 341 final.

competition in network industries and for further liberalising professional services. For some Member States, the CSR proposal called for further restructuring banks and improving supervisory cooperation, supporting access to finance for SMEs, and reviewing financial regulation and property taxation with a view of preventing excessive volatility in the housing market⁵¹.

The 2012 European semester incorporated the new elements implied by the entry into the force of the six-pack legislation. Firstly, the public finances assessment and the CSR proposals made reference to compliance with the new expenditure benchmark and debt reduction benchmark under the SGP. Secondly, the preventive arm of the new Macro-economic Imbalances Procedure (MIP) was fully integrated in the European semester.

The 2013 European semester was kicked off by publication of the Commission's Annual Growth Survey, in end-November 2012. The 2013 key policy priorities were kept the same as in 2012 (listed above). The annual Alert Mechanism Report (AMR) of the Macro-economic Imbalances Procedure was published at the same time as the Annual Growth Survey. The AMR identified 14 countries which were considered to be at risk of a macro-economic imbalance and for which an in-depth review will be drafted to assess the situation. The in-depth reviews are being published at the time this publication was printed (April 2013) and will provide the basis for in depth discussions with Member States before the Commission comes out with the country-specific recommendations in May.

2.4 Reforms of the financial sector

Following the outbreak of the financial crisis in 2008, the stabilisation of financial markets became a priority and financial sector reform a crucial instrument to achieve it. Filling in the gaps in financial sector regulation and strengthening the supervision of the financial sector in Europe have been the two main strands of work undertaken by EU institutions. In particular, and in line with the commitments taken by the G20, the Commission has targeted the following structural sources of vulnerability in its reform agenda:

• The observed low levels of high quality capital and liquidity in the banking sector, partly reflecting inadequate and pro-cyclical prudential requirements and failures in risk assessment and management;

• Supervisory shortcomings with regard to institutions operating in a cross-border context and in the unregulated part of the financial sector, including the OTC derivatives market;

• Corporate governance failures which contributed to excessive risk taking practices in financial institutions and insurance undertakings;

• Insufficient market transparency and inadequate disclosure of information to authorities, particularly with reference to complex structured financial products;

• Lack of adequate regulation and supervision of Credit Rating Agencies;

51

The European semester includes the assessment of policy commitments that Member States take in the context of the Euro Plus Pact. This Pact, created in 2011 by the Heads of State or Government of the EA and joined by Bulgaria, Denmark, Latvia, Lithuania, Poland and Romania, aims at strengthening economic policy coordination and improving competiveness.

• Insufficient macro prudential surveillance of the financial sector as a whole, to prevent macro-systemic risks of contagion;

• The absence of a harmonised framework to facilitate the orderly wind-down of banks and financial institutions, which has contributed to put pressure on Member States to inject public money into banks to prevent a general collapse.

2.4.1 The Banking Union

Section 1.4 of chapter 1 presented the Commission’s proposed Single Supervisory Mechanism. In this subsection we analyze in detail the June 2012 proposal on recovery and resolution tools for banks in crisis, and the other two components necessary for an integrated "banking union":

A single recovery and resolution framework: The Commission's proposal on recovery and resolution tools for banks in crisis, presented in June 2012⁵² implements the European Union’s commitment, as part of the G20, to review our bank resolution regimes and bankruptcy laws in light of the crisis, to allow for an orderly wind-down of large complex cross-border institutions. The proposal fully implements the Key Attributes developed by the Financial Stability Board endorsed by the G20.

To that end, the proposal would equip national authorities with tools to force the orderly restructuring of a bank that is failing or likely to fail with a view to preserving components that are considered systemic from a financial stability point of view. This typically includes deposits and payment systems. The financial burden is put first and foremost on shareholders and creditors, not taxpayers (known as “bailing-in”, instead of “bailing-out” banks). The proposal also aims at ensuring coordination between national authorities in resolving cross-border groups, with a view to preserving the internal market and avoiding contagion across the whole EU.

The single rulebook in the form of Capital Requirements: In July 2011, the Capital Requirements Directive (CRD) was replaced with a Directive and a Regulation in order to implement the Basel III agreement, which significantly increases the levels of capital which banks and investment firms must hold to cover their risks. The CRD IV⁵³ follows the Basel Accord very closely and is accompanied by a thorough impact assessment, in line with Commission practice.

The Regulation, in being directly applicable without national transposition, eliminates the danger of divergent national rules. It contains detailed prudential requirements for credit institutions and investment firms. In particular, it covers: a) capital, addressing the amount and quality of own funds; b) liquidity, introducing a Liquidity Coverage Ratio; c) leverage, introducing a ratio to limit excessive leverage; and d) counter party credit risk, encouraging institutions to clear OTC derivatives in central counterparties.

The Directive, which needs transposition, covers: a) enhanced governance, b) sanctions, c) capital buffers (on top of the minimum capital requirements, a capital conservation buffer and a countercyclical buffer), d) enhanced supervision and, e) reduction on the reliance on external credit ratings.

⁵² http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:52012PC0280:EN:NOT

⁵³ http://ec.europa.eu/internal market/bank/regcapital/new proposals en.htm

Harmonized deposit protection schemes: Thanks to EU legislation⁵⁴, bank deposits in any Member State are already guaranteed up to EUR 100,000 per depositor if a bank fails. In July 2010, the Commission proposed to go further⁵⁵, with a harmonisation and simplification of protected deposits, faster pay-outs and improved financing of schemes, notably through ex-ante funding of deposit guarantee schemes and a mandatory mutual borrowing facility between national schemes.

2.4.2 Progress of the financial reform agenda

The Commission has continued its regulatory agenda in 2012. Its aim is none other than to improve financial supervision and financial institutions’ governance; ensure the efficiency, integrity and liquidity of markets; safeguard adequate protection and inclusion of consumers and investors; and stimulate investment in the real economy, with a clear focus on SME financing.

2.4.2.1 Approval of key reforms

2012 saw approval of three important files enhancing the transparency, efficiency and integrity of markets: EMIR⁵⁶ (European Markets Infrastructure Regulation on Over-The-Counter derivatives markets) was proposed in autumn 2010 to implement the G-20 commitment to clear standardised OTC derivative transactions via central counterparties (CCPs). EMIR’s technical standards have equally been approved in February 2013. The new rules will reduce the risks related to derivative transactions, by increasing transparency in OTC derivatives markets, and making them safer, by reducing counterparty credit risk and operational risk (see chapter 4 for further discussion).

The Regulation on short-selling and credit default swaps⁵⁷ entered into force in November 2012. It equally seeks to increase transparency via a requirement for notification or disclosure of significant short positions relating to shares and sovereign debt; it imposes restrictions on short sales through a location requirement; it prohibits naked CDSs on EU sovereign debt instruments; and it enhances competent authorities and ESMA’s intervention powers, in order to reduce the risks from short selling and CDSs and ensure a common regulatory approach across the EU.

In January 2013 an agreement was found on Credit Rating Agencies⁵⁸. The proposals for a directive and a regulation amend existing legislation on credit rating agencies (CRAs) in order to reduce investors' over-reliance on external credit ratings, mitigate the risk of conflicts of interest in credit rating activities and increase transparency and competition in the sector. Specifically, the draft directive amends current directives on undertakings of collective investment in transferable securities (UCITS) and on alternative investment funds managers (AIFM) in order to reduce these funds' reliance on external credit ratings when assessing the creditworthiness of their assets.

Other reforms approved during 2012 increase the protection and inclusions of consumers and investors, stimulating in turn investment in the real economy: the SEPA (Single European Payments Area) Regulation⁵⁹ entered into force in March 2012. It will speed up the process for

⁵⁴ http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:068:0003:0007:EN:PDF

⁵⁵ http://ec.europa.eu/internal market/bank/docs/guarantee/20100712 proposal en.pdf

⁵⁶ http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32012R0648:EN:NOT

⁵⁷ http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2012:086:0001:0024:en:PDF

⁵⁸ http://ec.europa.eu/internal market/securities/agencies/index en.htm

⁵⁹ http://eur-lex.europa.eu/Result.do?T1=V2&T2=2012&T3=260&RechType=RECH naturel&Submit=Search

direct debits and credit transfers and will make payments all over the Euro area as easy and quick as domestic payments. The migration deadline is set for February 2014.

Agreement was found in March 2013 on Venture Capital Funds⁶⁰ and Social Entrepreneurship funds⁶¹, two closely linked initiatives. The two new regulations introduce a label for funds investing in SMEs and social enterprises in order to make them more easily identifiable for investors.

The proposal for a Regulation on European Venture Capital Funds will make it easier for venture capitalists to raise funds across Europe for the benefit of start-ups. The approach is the following: once a set of requirements is met, all qualifying fund managers can raise capital under the designation "European Venture Capital Fund" across the EU. By introducing a single rulebook, venture capital funds will have the potential to attract more capital commitments and become bigger.

The proposal for a Regulation on European Social Entrepreneurship Funds lays the foundations for a European market for social investment funds. It introduces a new "European Social Entrepreneurship Funds" label so investors can easily identify funds that focus on investing in European social businesses. To get the label the funds must invest for the most part in SMEs or social businesses (70% of the capital received from investors). The approach is similar to the Venture Capital proposal: once the requirements defined in the proposal are met, managers of social investment funds will be able to market their funds across the whole of Europe. Uniform rules on disclosure will ensure that investors get clear and effective information on these investments.

2.4.2.2 Further progress on other dossiers

In order to further increase the integrity, transparency, liquidity and efficiency of markets, the Commission adopted in October 2011 a proposal for a Regulation on Market Abuse⁶² and a proposal for a Directive on Criminal Sanctions for Market Abuse⁶³ as part of a package with the review of the Markets in Financial Instruments Directive (MiFID)⁶⁴.

The latter seeks to improve the transparency, efficiency and integrity of securities markets in several ways. In particular, the scope of MiFID will be extended to new types of trading platforms and financial instruments, thus removing some opaque areas of securities markets and ensuring a level playing field. Transparency requirements will be extended to all kinds of securities (not just shares), with derogations only applicable in well justified cases. The review also seeks to improve other key areas, such as better investor protection; more competitive and efficient market infrastructures; more transparent commodity derivatives markets; and addresses new issues emanating from market developments such as high frequency and algorithmic trading.

⁶⁰ http://ec.europa.eu/internal_market/investment/venture_capital/index_en.htm

⁶¹ http://ec.europa.eu/internal_market/investment/social_investment_funds/index_en.htm

⁶² See European Commission (2011), 'Proposal for a Regulation of the European Parliament and of the Council on insider dealing and market manipulation (market abuse)', October 2011.

⁶³ See European Commission (2011), 'Proposal for a Directive of the European Parliament and of the Council on criminal sanctions for insider dealing and market manipulation', October 2011.

⁶⁴ Directive 2004/39/EC.

With respect to legislation on market abuse, this has been revised to increase investor confidence and market integrity. In particular, to keep pace with market developments; reinforce the regulators' investigative and sanctioning powers; reduce administrative burdens on SME issuers; and define criminal offences at the EU level.

With the same aim of improving markets, and bring more safety and efficiency to securities settlement in the EU, the Central Securities Depositories (CSD) Regulation was proposed in March 2012⁶⁵. The proposal defends shortening the time of securities settlement and ensuring that market participants comply with strict measures to minimise settlement fails. It also proposes that CSDs should comply with a set of rules, in line with international standards, to ensure their safety and soundness, and that a true internal market for the services provided by national CSDs is introduced.

Following the launch of the three new European Supervisory Authorities on 1 January 2011 the Commission proposed targeted changes to legislation in the area of insurance and securities regulation to ensure that the new Authorities can work effectively (Omnibus II/Solvency II)⁶⁶.

The amendments are necessary for: a) the definition of the appropriate areas in which the Authorities will be able to propose technical standards for supervisory convergence and with a view to developing a single rule book to ensure strengthened stability, equal treatment, lower compliance costs and to prevent regulatory arbitrage; b) the Authorities to be able to settle disagreements between national supervisors in a balanced way; and c) the existing Directives to operate in the context of new authorities.

Thus, the proposed text for Omnibus II/Solvency II seeks to improve the stability and governance of financial institutions. The 2008 financial crisis highlighted, moreover, considerable shortcomings in the European audit system. Audits of some large financial institutions resulted in 'clean' audit reports despite the serious intrinsic weaknesses in the financial health of the institutions concerned. To tackle these issues the Commission adopted in November 2011 a comprehensive legislative proposal⁶⁷, including a proposal for a review of the Statutory Audit Directive as well as a proposal for a new regulation for public interest entities, which include financial institutions. These proposals resulted from an extensive consultation process (e.g. the Green Paper on Audit Policy) and aim to improve audit quality by clarifying the role of the auditors, strengthening their independence as well as ensuring greater diversity into the current highly-concentrated audit market.

The remaining initiatives presented by the Commission are seeking consumer and investor protection and stimulating investment in the real economy:

In July 2012 the Commission presented three key initiatives in order to ensure consumer protection and one initiative to protect investors. These were: a proposal on packaged retail investment products (PRIPs)⁶⁸ in order to ensure that all consumers in Europe will in the future be able to get short, focused, and plainly-worded information about investments in a common

⁶⁵ http://ec.europa.eu/internal market/financial-markets/central securities depositories en.htm

⁶⁶ http://ec.europa.eu/internal market/insurance/solvency/future/index en.htm

⁶⁷ http://ec.europa.eu/internal market/auditing/reform/index en.htm

⁶⁸ http://ec.europa.eu/internal market/finservices-retail/investment products en.htm

format, with risks and costs made much clearer and easier to understand, aiding comparisons; a proposal for the revision of the Directive on Insurance Mediation⁶⁹, seeking to ensure a level playing field between all participants involved in the selling of insurance products and at strengthening consumer protection and market integration, and, the revision of the UCITS Directive⁷⁰ based on the experience from the financial crisis, so as to continue to ensure the safety of investors and the integrity of the market. In particular, this proposal will ensure that the UCITS brand remains trustworthy by ensuring that the depositary's (the asset-keeping entity) duties and liability are clear and uniform across the EU.

A proposal for a Directive on credit agreements relating to residential property⁷¹ was presented by the Commission in March 2011. It aims at creating a single market for mortgage credit and to ensure at a pre-contractual stage a high level of consumer protection while at the same time promoting financial stability by ensuring responsible lending to consumers. The proposal sets out: a) conduct of business rules for the provision of mortgage credit; b) a legal framework to ensure that all actors involved in the origination and distribution of mortgage credit are appropriately regulated (e.g. credit intermediaries, non-banks) and c) introduces a passport for credit intermediaries.

The Commission equally put forward the Transparency and Accounting Directives which simplifies the regulatory environment for small and medium-sized issuers by alleviating the unnecessary administrative burden and improves their access to capital, which are high political priorities for the Commission and would also close the existing gaps in the regime for notification of major holdings of voting rights by requiring disclosure of cash-settled derivative financial instruments.

The initiatives described above represent the fulfilment of all G-20 commitments made by the EU.

2.4.2.3 New initiatives

At the Cannes Summit in November 2011, the G20 Leaders agreed to strengthen the oversight and regulation of the shadow banking system, and endorsed the Financial Stability Board (FSB)’s initial recommendations with a work plan to further develop them in the course of 2012.

Non-bank credit activity, or shadow banking performs important functions in the financial system: it creates additional sources of funding and offers investors alternatives to bank deposits. But it can also pose potential threats to financial stability, especially when it performs bank-like functions and when there is a clear interconnection with the traditional banking system. There is also a risk of regulatory arbitrage, since the rules for banks have been tightened.

In this context, the Commission presented a Green Paper⁷² with the objective of consulting stakeholders on definition, risks and benefits, the need for stricter monitoring and regulation, outstanding issues and next steps for shadow banking. During 2013 the Commission services are working on initiatives concerning a follow up to the Green Paper, together with Money Market Funds.

⁶⁹ http://ec.europa.eu/internal market/insurance/consumer/mediation/index en.htm

⁷⁰ http://ec.europa.eu/internal market/investment/ucits-directive/index en.htm

⁷¹ http://ec.europa.eu/internal market/finservices-retail/credit/mortgage en.htm

⁷² http://ec.europa.eu/internal market/bank/docs/shadow/green-paper en.pdf

In November 2011, a High-level Expert Group was set up in order to examine possible reforms to the structure of the EU's banking sector, under the chairmanship of Erkki Liikanen. Its mandate was to determine whether, in addition to ongoing regulatory reforms, structural reforms of EU banks would strengthen financial stability and improve efficiency and consumer protection, and if that is the case to make proposals as appropriate. The Group presented its final report to the Commission on 2 October 2012⁷³ (see chapter 3 for further discussion of such reforms).

In 2013 the Commission services are working on a Bank Account Package which will tackle the concerns of the 2007 Commission retail banking inquiry and will build on further research undertaken by the Commission more recently, which pointed to the existence of obstacles to customer choice and mobility. These included the lack of transparency and comparability of bank fees and complexity of the switching process for consumers when they intend to change their bank account providers. A third problem concerns the difficulties faced by a significant number of EU citizens in accessing basic banking services.

Finally, following the recent manipulation of LIBOR, the Commission launched in September 2012, on top of the Regulation on market abuse and the Directive for criminal sanctions for market abuse, a consultation inviting stakeholders to comment on possible new rules for the production and use of indices serving as benchmarks in financial and other contracts. It is analyzed in the next subsection.

2.4.3 Ensuring a level playing field across sectors, the example of financial benchmarks

Benchmarks are a statistical measure, calculated from a representative set of underlying data, typically used as a reference price for financial or other contracts. A wide variety of them are currently produced for different purposes. They differ in the underlying data analysed, the methods employed to collect it, how the indexes are calculated and their ultimate use.

Financial benchmarks are not currently supervised or regulated. They are, nevertheless, widely used as an indicator of liquidity in the financial system and to price contracts globally. In this regard, the alleged manipulation of interest rate benchmarks (such as LIBOR, EURIBOR and TIBOR) that has been taking place even prior to the crisis has highlighted both their importance and vulnerabilities.

Manipulation of benchmarks can cause significant losses to consumers and investors and distort the real economy. Even the risk of manipulation or doubts about their integrity can undermine market confidence and cause significant disruptions in the proper functioning, stability and confidence of financial markets. Because of this, regulators across the world have taken steps to restore market confidence and address possible criminal behaviour:

• In March, the U.S. Securities and Exchange Commission, Commodity Futures Trading Commission and Department of Justice, together with the U.K.’s FSA and the Japanese Financial Supervisory Agency first announced their on-going investigation to determine whether some banks had submitted inaccurate data to LIBOR for their own benefit. In parallel, the Commission is also investigating possible cartel abuses in relation to EURIBOR and LIBOR.

³ http://ec.europa.eu/internal market/bank/docs/high-level expert group/report en.pdf

• In June, the IOSCO Board Level Task Force on Financial Market Benchmarks published a report and will issue recommendations in 2013, following a request by the FSB.

• In July, the European Commission proposed to amend its existing proposals for market abuse Regulation (MAR)⁷⁴ and criminal sanctions for market abuse Directive (CSMAD)⁷⁵ to clarify that benchmark manipulations are clearly and unequivocally illegal and can be subject to administrative or criminal sanctions.

• Also in July, the Chancellor of the Exchequer of the UK commissioned a review of the structure and governance of LIBOR and the corresponding criminal sanctions regime to Martin Wheatley, which was published in September 2012. It includes a 10-point plan for comprehensive reform of LIBOR which is now part of the upcoming Financial Services Bill.

• In September, the European Commission launched a public consultation on a possible framework to regulate the production and use of indices serving as benchmarks in financial and other contracts. Changing the sanctioning regime, as proposed in July, was not considered sufficient to improve how benchmarks are produced and used. For this reason, the consultation addressed key issues and shortcomings in the production and use of benchmarks to assess and ensure their future integrity.

• Finally, also in September the Economic Consultative Committee of central banks governors set up a senior officials group to study benchmark issues and consult the market in order to provide input for further discussions at FSB and G20 level.

In this, as in several other instances, there is a need to reinforce regulatory practice to address instances when financial stability and competition policy are both at stake.

2.5 Concluding remarks

A lot was achieved during 2012: the launching of the banking union project and substantive progress on the financial reform agenda fully in line with G20 commitments. Nonetheless, the effects of the financial crisis are still having a very considerable impact on the European economy. In this regard, the first priority of the Commission has been to reinstall confidence: taking the necessary steps towards financial stability and to avoid a similar crisis in the future. Confidence is therefore necessary to put Europe back on the path of a smart, sustainable, inclusive growth, improving its competitiveness vis-à-vis the rest of the world.

At the same time, the banking sector is changing and opportunities are arising for institutional investors (insurers and pension funds) as well as for financial market intermediation to fill the gaps left by banks in what concerns the financing of the real economy and in particular long term finance, with a particular focus on SMEs, which account for more than 98% of Europe’s business and provide more than 67% of its jobs.

⁷⁴ Amended proposal for a Regulation on insider dealing and market manipulation, COM(2012) 2011/0295 (COD)

⁷⁵ Amended proposal for a Directive on criminal sanctions for insider dealing and market manipulation, COM(2012)

2011/0297 (COD)

Additionally, the capacity of the economy to finance productive investments depends on its capability to generate and mobilise savings and attract foreign investments, as well as to channel the funds effectively and efficiently to the right users and uses.

In December 2011, the Commission adopted an action plan to improve access to finance for SMEs, which showed the breadth of the proposed legislation, financial instruments and policy measures. As explained in the previous section, and to give some examples, the Commission has drafted proposals for the creation of a EU regime for Venture capital and Social Entrepreneurship Funds; MiFID II will create an SME market regime; the Transparency and Prospectus Directives will reduce the burden and costs for SMEs; and the Market Abuse Directive will reinforce regulators’ investigative and sanctioning powers. The focus now is, therefore, on ensuring that financial reform stimulates lending to the real economy; to long term financing and SMEs (see chapter 5, for a related discussion).

It is in this context that the Commission published at the end of March a Green Paper on the Long Term Finance of the European Economy⁷⁶, to ensure that Europe continues advancing towards growth.

6 http://ec.europa.eu/internal market/consultations/2013/long-term-financing/docs/green-paper en.pdf