The 2007-9 financial crisis and the subsequent Eurozone debt crisis posed an existential threat to the single currency and even the European project as a whole. Financial imbalances that had built up in the decade were at the heart of both crises. Policy-makers identified major flaws in financial regulations: they were mainly focused on risks for individual institutions, the micro level, without looking at systemic risks, the macro level. They hailed ‘macro-prudential policy’ as the solution to financial markets’ boom-bust patterns, enabling supervisors to tighten requirements during booms, to loosen them when risks recede, and to impose tougher rules on systemically important institutions.
Post-crisis reforms in the EU thus saw the birth of a macro-prudential policy framework. This framework is now generally considered the ‘first line of defence in addressing potential financial stability risks‘, with ECB President Draghi concluding in 2019 that it has made Europe ‘better placed to prevent or mitigate risks to financial stability than it was in the run-up to the global financial crisis’.
If the EU’s macro-prudential policy framework is indeed our best hope against financial stability risks, we would expect it to be both very strong and, given cross-border spill-overs, thoroughly harmonized. Yet this is not the case. Although policy-makers included several macro-prudential instruments in EU’s post crisis bank capital requirements (2013), their activation is constrained by complicated procedural requirements. There are also limits to their stringency and scope. The framework’s degree of supranationalisation is also limited: national authorities have much discretion in how they measure and mitigate systemic risks, while the ECB and the European Systemic Risk Board (ESRB) mostly have coordinating roles.
The financial trilemma meets macro-prudential reform
My JCMS article shows that this half-hearted macro-prudential framework is the result of fundamental disagreements between key EU actors during its birth (2009-2013) and subsequent refinement (2014-2019). To illuminate these disagreements I build on the well-known financial trilemma thesis. This holds that there are inherent tensions between pursuing financial stability, financial market integration, and national policy discretion. As the financial crisis demonstrated, a single EU financial market with national policy discretion may lead to financial instability. Financial stability and national discretion only work if policy-makers limit banks’ international activities. Finally, stability and integration can be married only if policy-makers surrender national financial policies.
I argue that these trade-offs obstructed the development of a strong, supranational EU macro-prudential policy framework. A framework facilitating the activation of tough requirements on financial institutions and activities that create systemic risk would be conducive to stability. Yet it could constrain banks’ cross-border activities, with host supervisors imposing extra tough requirements on foreign banks for their local exposures. A supranational strategy could resolve this tension between stability and integration, as transnational flows would unlikely be inhibited if EU authorities applied systemic risk norms. Yet this implied that national authorities would have to cede control, and this proved to be a fundamental problem.
Obstacles to harmonisation
Why was harmonisation difficult? A key reason is that macro-prudential policy has potentially significant distributional and macro-economic consequences, as it imposes system-wide constraints on financial institutions and borrowers. Member states balked at the idea of EU control over their credit policies, leading to the exclusion of the politically sensitive borrower-based tools (loan-to-value and loan-to-income limits) from the EU framework, even though these are arguably the most effective tools to constrain housing market booms. But problems were not only political but also practical. Systemic risks are elusive and dynamic, and they have an important national dimension, which hampered the design of a one-size-fits-all approach to identify them.
As a result, member states were hesitant to delegate extensive macro-prudential competences to EU-level bodies. They made sure that the ESRB, set up in 2010, could not impose binding decisions on national authorities, but only issue warnings and recommendations on a comply-or-explain basis. Similarly, member states blocked the Commission’s proposal (2012) during Banking Union negotiations to give the ECB strong macro-prudential powers. The ECB instead only obtained powers to top-up measures that member states had already introduced, leaving the main decision-making powers at the national level.
Financial stability versus the single market
The financial trilemma thesis holds that these obstacles to harmonisation implied a tension between integration and stability. Fearing that national macro-prudential actions would fragment the single market, the Commission proposed a very narrow macro-prudential toolset in 2011. A coalition of member states led by France and Germany supported this, as they feared that other member states’ actions would harm their internationally active banks.
However, the Commission was vehemently opposed by the UK and several Scandinavian and Eastern European countries. Many of them were very exposed to foreign banking activities and preferred sufficient discretion to safeguard national financial stability. This group was supported by the ECB and the ESRB, which argued that the framework ‘should be expanded to allow national authorities to impose stricter prudential requirements for macro-prudential purposes at national level’. Subsequent Council negotiations led to the addition of several extra tools in the macro-prudential policy framework.
The Commission disliked this push for flexibility, which Commissioner Barnier feared would ‘lead to markets putting one member state after another under constant pressure to meet ever-higher capital demands, to the detriment of growth and employment’. To limit flexibility, the Commission added lengthy consultation procedures before the tools could be used and introduced limits on their stringency that authorities could only exceed with explicit EU-level approval, if at all. The framework agreed in 2013 thus contained a lot of red tape. ‘It is Europe at its maximum complexity’, according to one of my interviewees.
Limited policy progress
The EU macro-prudential framework has been reviewed in the period 2014-9, leading to minor changes in the role and competences of the ESRB and incremental reforms of the macro-prudential toolset. Policy-makers nevertheless acknowledge that key issues remain unresolved, particularly the fact that housing markets and the non-banking sector escape the confines of the EU macro-prudential framework. And although the framework does not prevent authorities from taking action, it is doubtful whether it facilitates a swift response when necessary. At the same time, EU bodies have limited power to force reluctant member states into action. If macro-prudential policy is the first line of defence against the EU’s financial imbalances, this is a worrying outcome.
It therefore seems crucial that policy-makers try to correct these shortcomings in the Commission’s current review of the macro-prudential framework. As an incremental reform policy-makers could consider replacing the current ex ante restrictions with ex post scrutiny of authorities’ macro-prudential actions, allowing for a quicker response to systemic risks. Additionally, the ESRB has recently put forward interesting suggestions to expand the policy’s scope, notably by including borrower-based measures (albeit that policy competences would remain at the national level), systemic liquidity risks, and non-bank financial intermediation. Finally, the framework’s complexity and the limited powers for supranational authorities need to be addressed: although a thorough harmonisation is off-limits, steps in this direction are needed if macro-prudential policy is to achieve its potential.
Bart Stellinga is a Senior Research Fellow at the Netherlands Scientific Council for Government Policy (WRR). He is also a lecturer at the Institute for Interdisciplinary
Studies of the University of Amsterdam. He has published on the politics of financial
regulation, money and banking, the privatization of public sector activities, and food policy.
Link to academic profile: https://www.researchgate.net/profile/Bart-Stellinga