Tuesday, June 14, 2011

The European Systemic Risk Board and Default in Greece

Greece will default on its debt this year, whether Europe helps it or not. The only questions now are: how big will the default be; will the default take Europe down with Greece?

The answer to those questions will look far more positive in relative terms if the European Systemic Risk Board is used to figure out and manage the impact of a Greek default. The ESRB was designed for a different purpose: for preventing financial collapse when a private bank collapses. Now, if its members have any sense at all, it must start making contingency plans for a Greek default. It will have to run through a number of scenarios, from total and unregulated default, with uncontrolled consequences, to a negotiated, managed and partial default. Each will bring its own set of consequences for the rest of Europe, particularly for banks.

For that is the ESRB's job. It exists to plan what will happen when one or more banks collapses. It was not really designed for a country collapsing, but the job is the same, and it is of vital importance that they step up to the plate and do something.

There are reasons, however, due to the ESRB's institutional design, to believe that the ESRB will be a political cripple and not fulfil the role it needs to if it waits for a green light before forging ahead. First, the head of the Board is the European Central Bank, which is refusing to cooperate with anyone on the issue of a managed default. It may have a contingency plan for when Greece can't pay, but if it does, it isn't admitting it. Second, the Board lacks the political clout to make the deals that are required to make a rescue plan work. Its members are the ECB, the central banks of the EU member states and representatives of three European Authorities that regulate or advise the Commission on regulating banks, securities and insurance companies respectively. Unlike the Financial Stability Board in Basel or the Financial Stability Oversight Council in the United States, there are no representatives of national governments at the table.

These are the reasons why we are hearing so much from the European Commission, the European Central Bank and the European Council of Economics and Finance Ministers, but so little from the one institution that was created to ensure the stability of Europe's financial system, at the moment of its greatest peril.

The European Systemic Risk Board needs an explicit mandate to intervene and give much-needed advice on the implications for financial stability of full and partial defaults. It also needs to provide advice on how to manage a Greek exit from the euro. And it needs to start making contingency plans for propping up the European financial system when the Greek default comes. That means it will have to have specific information about bond holdings by banks, and model through who will need what, when and how, once Greek bonds implode and Greek private banks cease to exist. It may also have to consider how great the knock-on effects will be for pension and insurance companies who invest in such bonds, as well as capital requirements for banks. Banks need not set aside reserves for loans to governments, a policy that surely must end.

The Board has this mandate already, even if it is implicit. If it does not get it explicitly from the Commission, the Bank and the Finance Ministers, it should claim it directly for itself without asking permission. That is how the European Court of Justice established its position and the position of EU law in Europe. It claimed it. Right now, national governments are bickering, putting partisan plans forward and kicking the can down the road rather than facing the threat in the eye and dealing with it. That is catastrophic and will become Europe's demise if allowed to continue. If Europe is to be saved, the European Systemic Risk Board will have to assert itself, and others will have to accept a new, larger role for the Board than they originally envisaged. There are two advisory boards within the ESRB that can push for these developments where the key members may not: the Technical Advisory Board (which does the work of modelling the causes and impacts of defaults); and the Academic Advisory Board, which collects experts on a variety of issues related to financial system stability. These are the groups who must start doing some persuading and drawing contingency plans.

Europe's existence is hanging on a thread. Regardless of how long national governments take to agree on strategy, there is both a moral and existential imperative that the ESRB start acting like what it needs to be: Europe's best hope for averting catastrophe once the defaults start rolling. When the politicians look at the tsunami that starts rolling toward them, they will hopefully look at the Board and its plans, and say Yes.

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