The European response to the crisis: Not quite there yet

Marco Pagano

17 October 2008



At last, European countries appear to have realised that the solvency problem at the heart of the current crisis goes well beyond their national borders and requires cooperation. After a week of collapsing stock markets and rising fear of widespread bank defaults, the leaders of the 15 euro-zone countries have reached an agreement on a plan that follows the broad outline of the British bail-out plan – governments will buy equity stakes in banks and will guarantee new borrowing to unblock the interbank market. Together with the announcement that the ECB will create an unsecured lending facility to purchase commercial paper by banks, this plan has finally managed to instil some confidence into the markets, as witnessed by the immediate jump of stock prices.

Devil in the details

Of course, while the broad lines of these interventions are clear, much is still unknown about their detailed design and implementation – and this is a case where the devil is in the details. How will each government determine the equity stakes to be bought in distressed banks? Clearly, governments should not bail out all banks irrespective of their degree of solvency. The same issue arises for the provision of loan guarantees and the purchase of commercial paper from banks. Presumably equity injections and loan guarantees should be implemented in close cooperation with the relevant banks’ main supervisors, as already argued by Javier Suarez.1

But other “details” are no less important for the long-term outcome of the bail-out. What will ensure that these equity injections and the implied partial or total nationalisations of European banks will not take us back to the era of widespread state control over banks? In the UK, Germany, France and Italy (as well as in the US), governments are pledging that they will take equity stakes in the form of preferred shares and that they regard this as a temporary investment, to be eventually sold back to the market once the crisis is over. But are such pledges common to all of the Euro-area governments? And in the countries where governments made them, what guarantees that they will be upheld, and over which time horizon?

Governments as passive investors

A related question is whether governments will behave as passive investors or wield some control over the key decisions of the banks that they bail out. Historical experience from past crises shows that governments tend to take an active role in controlling the institutions that they bailed out. This applies, for instance, to the Reconstruction Finance Corporation created by President Herbert Hoover in 1932 and to the Institute for Industrial Reconstruction (IRI) created in Italy during the Great Depression. It also applies to the more recent experience of Sweden’s financial crisis in the early 1990s, when the government bailed out the country’s banks, replaced their executives, and forced mergers among them to strengthen the survivors. But if governments are going to have such sweeping control rights, it would be important to indicate clearly how they will use them. For instance, will they be entrusted to bank surveillance authorities or will they rather stay directly with the governments?

Put bluntly, what will prevent reverting to a regime where politicians extract huge rents from the control of banks or mismanage them, as used to happen in much of Continental Europe before the privatisations of the 1980s and 1990s? Clearly, this question is closely tied to the credibility of government’s exit as a shareholder. If we go back to a regime where politicians can extract control rents from banks, governments will find it hard to surrender such control once the crisis is over, as witnessed, for instance, by the fact that IRI kept controlling stakes in the largest Italian banks for over half a century after the Great Depression.

The answers to these questions will shape the structure and working of European financial markets for a long time.

Bailing out big, cross-border banks: Create a supra-national authority

There is also the all-important issue that unfortunately European leaders have completely disregarded so far – how to deal with the bail out of large banks with extensive cross-border activities and subsidiaries. European governments have decided to implement the bailout plan at the national level rather than create a common authority to attack the problem at a supra-national level. This is probably an efficient solution for most Euro-area distressed banks, which are small or medium institutions with little or no cross-border operations. But it is totally inadequate for those few large banks with extensive cross-border operations and subsidiaries, whose solvency is crucial for the systemic stability of the European credit market. If any of these banks were to experience solvency problems, we would need a fast and commonly agreed procedure to determine how the governments of the various countries involved should intervene and share the burden of the bail-out.

The best way to face this formidable challenge would probably be to create a supra-national authority to coordinate the bailout. Of course, designing the rules to determine when such an authority should bail out a cross-border bank and how the implied costs are to be shared across EU member states is no easy task. One can think of alternative sharing rules. For instance, the burden to be paid by each government might be set on the basis of the balance sheets, the share of risk-weighted assets, or the share of regulatory capital of the various subsidiaries. The design of these rules will have important implications for the incentives of the managers of these banks and, most importantly, for European taxpayers. But, for all their technical difficulty and political sensitivity, these issues can no longer be dodged. If one or more of euro area’s largest cross-border banks turned out to be insolvent, this limitation of Europe’s policy response would become tragically apparent.

Set up an embryonic Euro-area bank supervisory authority

Taking up this challenge would be a golden opportunity to create the embryo of a future Euro-area bank supervisory authority, capable of monitoring the risks being taken by the few large European banks with large cross-border operations, while leaving the many purely national banks of the Euro area under the surveillance of the corresponding national supervisors – an idea that has already been repeatedly proposed by Tommaso Padoa-Schioppa.2 Hopefully the crisis will induce governments to recognise that, in its current incompleteness, European monetary and financial integration is in a potentially unstable situation. We have created a single, integrated financial market where the operations of the main players naturally transcend national boundaries. Yet, we have so far failed to complement this construction with its natural counterpart – a supra-national surveillance authority for Europe’s supra-national banks. This half-way stop is a very dangerous one. Precisely because the current situation poses substantial risks for the European banking system, it can also become a unique opportunity to secure European financial integration on much firmer grounds than it currently is.


1 See Javier Suarez, “The Need for an Emergency Bank Debt Insurance Mechanism,” CEPR Policy Insight No. 19, March 2008.

2 See Tommaso Padoa-Schioppa, “Europe Needs a Single Financial Rulebook,” Financial Times, 11 December 2007, p. 13.



Topics:  EU policies Financial markets

Tags:  EU, financial regulation, bail-out

Professor of Economics, University of Naples Federico II and CEPR Research Fellow