Two SSE Professors at the Heart of European Macro-prudential Regulation
On March 11, the World Health Organization (WHO) declared Covid-19 a pandemic. As countries around the world implemented policies to contain the virus, and as global populations observed social distancing measures, many businesses faced unprecedented losses of revenue, stock markets dropped, and credit markets seized up in late March. Colossal policy interventions from governments and central banks to support struggling companies have been associated with rebounding stock markets and improving credit market conditions, but severe challenges remain for the EU financial system. Bankruptcies are rising, some banks remain affected by the sovereign debt crisis a few years ago, and market integration is still under way. As members of the Advisory Scientific Committee (ASC) at the European Systemic Risk Board (ESRB), we reached out to SSE faculty members Lars E.O Svensson, Affiliated Professor, and Bo Becker, Cevian Capital Professor of Finance, to discuss current efforts to protect European financial stability.
The ESRB: Ongoing Efforts to Ensure Financial Stability in the EU
The European Union’s system of financial supervision consists of two legs – a macro-prudential and a micro-prudential. Micro-prudential regulation is the supervision of individual banks and financial institutes, and the traditional form of financial policy. This is undertaken by the European Securities and Markets Authority (ESMA), the European Insurance and Occupational and Pensions Authority (EIOPA), and the European Banking Authority (EBA). The European Systemic Risk Board (ESRB) was founded in 2010 to complement this with a system-wide perspective on the functioning of the financial system. This is macro-prudential supervision. The ESRB is hosted by the European Central Bank (ECB) in Frankfurt, and is chaired by its president, Christine Lagarde. The ESRB helps the ECB understand financial conditions inside the union and outside, and issues recommendations and research. “There are few institutions in Europe that make more important decisions than the ECB. The ECB gets one key input from the ESRB about financial stability; that piece alone makes it very significant”, Becker points out.
The ESRB’s Advisory Scientific Committee (ASC) helps conduct and direct research, and connect ESRB’s work to academic research. It has fifteen members. Svensson and Becker were appointed members in 2019 and 2020, respectively. Currently, members are from the University of Michigan, Bocconi University, and London Business School, among others. Apart from SSE, no other university or school has more than one faculty member currently on the ASC. “It is a little bit like academia which is incredibly global and integrated and real work on the same issues... and the ASC consists of academics basically so the culture reflects that as well. No one is there to represent some particular interest or geography”, Svensson underscores.
The ESRB has issued several recommendations to address stability concerns due to the epidemic. “The Spring has been completely dominated by the coronavirus crisis work. ASC was very much involved in that, giving advice and comments”, Svensson says. “The issues we have covered include safeguarding market liquidity, preparing for the effects of adverse developments in credit markets, and recommending restraints on dividend payments, share buybacks and other pay-outs. The purpose of the limits on payouts were motivated by preserving bank equity”.
The Unusual Features of the COVID-19 Recession and the EU Financial System
Svensson and Becker point out how many recessions start with a financial dislocation. For example, the global financial crisis in 2008 was triggered by losses on mortgage-backed securities held by financial institutions, which set off a world-wide recession. “This time, however, the source of the economic downturn is not due to any inherent weakness with the financial system,” Svensson underscores, “but reflects an exogenous disturbance - the pandemic”. Becker points to the disconnect between the real economy and financial markets: “While stock markets are back to all-time highs, and credit spreads have narrowed again, the real economy remains under severe pressures: unemployment is rising, bankruptcies are accelerating”.
Svensson takes notice of the fact that the European financial system “is more resilient and robust now than it was at the onset of the global financial crisis, but there is still considerable work and policy needed to maintain and improve its resilience and make sure that it can help in the economic recovery”. Becker points to one remaining challenge: “The European financial system is only partially integrated across national boundaries, which reduces resilience”.
Worrying Scenarios Looming Ahead
If “we see flare-ups of the Covid-19”, Svensson warns, “it could trigger additional pressures. Government support to injured firms may be insufficient and business failures may accelerate”. Becker points to concerns when many firms fail at the same time: “The current business cycle drop is unprecedented in its speed. Many firms struggle at the same time. If the number of bankruptcies and in-court restructurings rises beyond some point, court systems get overwhelmed. If you cannot resolve cases, the firms are stuck in limbo, and the ability to protect and restructure may disappear. This would generate additional, unnecessary, losses for employees, investors and suppliers. Resources remain stuck in unproductive firms. Viable business may expire waiting for a legal process”.
Another threat that Becker pays particular attention to are credit losses imposed on bank’s creating serious issues in the banking system if the economy is closed for another year. “Once you let a recession roll for a little bit, banks will face credit losses from either households or businesses, or both, and this may impact access to credit negatively.” A danger that the ESRB will no doubt monitor as the coronavirus recession continues through the summer, along with the many other potential threats looming ahead.