Europe’s Slow Financial Reforms

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Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

To many Americans, financial reform in Europe may seem like a faraway issue about which they care little, but any such perception would be a mistake. The ability of the European Union â€" and particularly the euro area â€" to make its financial system safer is of fundamental importance not just for its economic prospects but also for what happens next around the world.

Europe accounts for more than a quarter of the world’s gross domestic product and its banks are big, with more than $25 trillion in total assets. (The G.D.P. of the United States is around $16 trillion, and the E.U. is slightly bigger, depending on which exchange rate you use.)

There are two perspectives on what is happening.

The first is that of the European Commission and others who spend time in continental conference rooms: “We have done a lot” and “we are making progress.”

The second view is more widely held among skeptical outsiders: there is a great more deal to do; Europe is at risk of falling behind even the United States, where reforms have hardly been carried out with alacrity; and, most worrying, Europe may be on course to settle for lower equity capital in its banks than the United States ultimately will. Without question, the European Commission and its allies have guided through a great deal of change. The question is not the diligence or hard work of the people involved but rather the obstacles they face, particularly at the national level, including some in France and Germany.

The European Commission has an extensive set of materials on its Web site, with this colorful chart that shows reforms in progress and on the planning board (the font is small but it is highly informative). And there are helpful lists of initiatives and reforms with regular updates (e.g., on financial supervision).

Perhaps understandably, most of the constructive euro area official attention has been focused on repairing crucial defects of its currency union, which created one monetary system without integrating fiscal policy or creating a unified approach to bank regulation, supervision and resolution.

Without doubt, it makes complete sense to set up a Single Supervisory Mechanism for the euro zone, as is now under way. And in July the European Commission proposed a Single Resolution Mechanism for the Banking Union. Resolution in this case means how the failure of banks is handled, to ensure losses are fairly allocated while the system as a whole is not disrupted.

The commission, working with national authorities, should press further in this direction, as recommended by André Sapir, Martin Hellwig and Marco Pagano (leading European academics, respectively chairman and vice chairmen of the Advisory Scientific Committee of the European Systemic Risk Board â€" see their October 2012 contribution and the longer July 2012 report by their full group.)

Unfortunately, however, once we turn to more universal weaknesses that cause potential dangers in any financial system, three serious issues seem likely to remain insufficiently addressed in Europe for the foreseeable future.

First, any analysis of a financial system should start with the facts on bank capital (the equity funding of banks, which serves as a buffer against losses). But the facts are hard to come by today for Europe today. You can complain about how bank stress tests have been handled in the United States to date (and I have complained, including in this space), but they are a paragon of transparency compared with what happened in Europe.

In principle, such stress tests are intended to reveal what losses may occur and the extent to which banks have sufficient equity to withstand pressure without collapsing or becoming some sort of dysfunctional zombie (a quasi-technical term in banking circles, if you can believe that).

I recommend “Behind Smoke and Mirrors: On the Alleged Recapitalization of Europe’s Banks,” by Jakob Vestergaard and María Retana of the Danish Institute for International Studies, a searing indictment of European stress tests and the broader European approach to ensuring their banks have enough capital.

As with any cross-borders discussion of banking, I strongly advise consulting the numbers put together by Thomas M. Hoenig (current vice chairman of the Federal Deposit Insurance Corporation and former president of the Kansas City Fed). Mr. Hoenig has done a great service by converting the generally accepted accounting principles accounts used in the United States (the standard for financial reports from American banks) to I.F.R.S. (the accounting standard used by European and other international banks); see Table 1 in this speech.

(The crucial assumption in this conversion is how to treat derivatives. In the United States, under GAAP, derivatives positions can be netted in a way that is relatively generous, i.e., reducing the total balance sheet size of the bank in question. The I.F.R.S. procedure is more cautious about how much netting to allow and, I contend, better suited to regulatory purposes â€" when you want to see what kind of shadow a bank casts and how far the shock waves would reach if there is some kind of problem.)

The bottom line is that while United States banks do not have as much equity funding relative to total assets as is commonly supposed, some of the largest European banks are in significantly worse shape. Deutsche Bank has loss-absorbing equity that is less than 1.5 percent of its total assets (known as its leverage ratio), Société Générale and Crédit Agricole are under 2 percent and Barclays is not much better.

These banks are under pressure to raise more capital, and Deutsche Bank and Barclays have announced plans that move in the right direction. But the amounts involved do not change the broader assessment.

And, more worryingly, European officials seem content to settle at or around a 3 percent leverage ratio. There is also a serious proposal to set a cap on this ratio (i.e., limiting how much equity a bank is “allowed” to have relative to its assets) for European banks, supposedly to help maintain a common market in financial services. From the F.A.Q. for the relevant new rules:

Higher levels of capital requirements in one member state would also distort competition and encourage regulatory arbitrage. For example, institutions could be encouraged to concentrate risky activities in member states that only implement the minimum requirements. Therefore, capital requirements need to be set at a level that is appropriate for the E.U. as a whole.

The F.A.Q. adds that capital requirements cannot be increased by national authorities “unless a specific add-on is justified following an individual supervisory review or based on systemic risk or macro-prudential concerns.”

Such a policy of capping equity is folly. Countries should be competing to strengthen their financial systems, not being held back by some lowest common denominator.

Second, there needs to be much more progress with handling the resolution of banks with cross-border operations. This remains an Achilles heel in the current European situation, as was demonstrated recently and most painfully by what happened in Cyprus.

The irony is that on bank capital, it is Germany (and France) that hold down equity requirements, in part because their banks are so undercapitalized. Yet on resolution it is also the German government that drags its feet, saying it fears the cost of bailing out weaker banking systems. As Professors Vestergaard and Retana lay out in convincing detail, “The core of the problem is in the core of the Euro zone: German and French banks” (Page 42).

Given the weight of those countries (and their financial interests) in European decision-making circles, it is hard to expect a rapid acceleration of reform.

Third, the organization of banking remains problematic. There were many sensible ideas in the European Commission’s recent Liikanen Report, which recommended a form of firewall between relatively risky trading activities and those relatively boring but essential features of banking, like running the payments system:

The group has concluded that it is necessary to require legal separation of certain particularly risky financial activities from deposit-taking banks within the banking group. The activities to be separated would include proprietary trading of securities and derivatives, and certain other activities closely linked with securities and derivatives markets (see Page iv).

Again, I recognize that discussions continue (e.g., see this commission Web page), but little real progress is evident or â€" in my assessment â€" likely. (In contrast, Britain seems on course to carry out at least the spirit of similar recommendations from the British government’s Vickers Report.)

The French and German governments, with others, like having universal banks that do a bit of everything. The Vickers and Liikanen reports made a convincing case for moving away from this model.

Unfortunately, politics will trump economics in the euro area, and financial sector reform will remain slow or even glacial on this dimension.