Crisis management in the EU

Sylvester Eijffinger

04 December 2008

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The ECB is doing crisis prevention in many ways, in particularly through promoting co-ordination and co-operation between national supervisors, mainly through the ESCB Banking Supervision Committee, and providing liquidity management on the inter-bank markets. A non-binding Memorandum of Understanding (MoU) on Cross-Border Financial Stability was also signed last summer between the Financial Supervision Authorities, Central Banks and the Finance Ministries of the European Union. Stress test and crises management simulations have also taken place. However, in practice it looks like Member States have taken very different approaches in face of banking problems and crisis management, for example in the Benelux countries, in Ireland, in Germany, in Denmark and in the UK to mention some.

In CEPR Policy Insight No. 27 , we discuss the crisis management in the EU. It describes the development of the crisis with the denial phase, the discovery phase and the disposal phase of the crisis. We also analyze the nationalization of banks and the three conditions that need to be fulfilled to make a bailout as unattractive as possible.

Bail-outs or nationalizations by the government need to satisfy three criteria. First, the nationalization needs to be temporary to keep intact the level playing field on the financial markets. This holds for both banks and insurers. Second, the government and thus the taxpayers need to face an upward risk, which arises when the bank is privatized after the nationalization period. Although it is not the intention for the government and taxpayers to make a profit of the bail-out or nationalization, they are entitled to this upward risk because they are providing risk-bearing (tier 1) core capital. Third, there should be a downward risk for the financial institution involved and its executives and shareholders. They have caused the problems that the bank or insurer is faced with, so they also have to ‘feel the pain’ by respectively giving up bonuses and options and lower stock prices.

This credit crisis has provided us with four important lessons:

  • Top management reward and remuneration structure has been excessive;
  • Risk management models based on Basel II have proven to be inadequate;
  • Financial supervisors in the US and Europe have not been involved thoroughly enough, and;
  • The US framework of financial supervision has proven to be too much fragmented and totally ineffective.

The essay ends with an analysis of benchmarks for the new financial system: sustainability, integrity and transparency. Financial engineering and innovation has a price, which is that financial crises do occur every now and then. Regulators and supervisors have to let markets develop in order to achieve economic growth. They should learn the lessons of the past crises, but they can never prevent the next financial crisis, which will show itself in a different shape.

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Topics:  EU policies Financial markets

Tags:  monetary policy, EU, financial crisis, crisis management

Professor of Financial Economics at Tilburg University, President of the Tilburg University Society and CEPR Research Fellow

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