Breaking the common fate of banks and governments by Daniel Gros and Cinzia Alcidi

/DANIEL GROS * / CINZIA ALCIDI**/

Breaking the common fate of banks
and governments

1. Introducción; 2. Recent eurozone history: From bad to worse; 2.1. Recalling
the building blocks of the EMU construction; 3. A false solution to the crisis: the
fiscal compact; 4. Fiscal indiscipline versus financial regulation inconsistency;
5. A proposal for a new regulatory treatment of sovereign debt securities in the
euro area; 6. Conclusions; Bibliography

* Dr. Daniel Gros is the Director of the Centre for European Policy Studies (CEPS) since
2000. Among other current activities, he serves as adviser to the European Parliament
and is a member of the Advisory Scientific Committee of the European Systemic Risk
Board (ESRB), the Bank Stakeholder Group (BSG) of the European Banking Authority
(EBA) and the Euro 50 Group of eminent economists. He also acts as editor of Economie
Internationale and International Finance. In the past, Daniel Gros worked at the IMF
(1984-86), at the European Commission (1989-91), has been a member of high-level
advisory bodies and provided strategic advice to numerous governments and central
banks. Gros holds a PhD. in economics from the University of Chicago, has taught at
prestigious universities throughout Europe and is the author of several books and nume-
rous contributions to scientific journals and newspapers. Since 2005, he has been Vice-
President of Eurizon Capital Asset Management.
** Dr. Cinzia Alcidi holds a Ph.D. degree in International Economics from the Graduate
Institute of International and Development Studies, Geneva (Switzerland). She is

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Breaking the common fate of banks and governments

1. Introduction

Since 2010 the news about Europe has gone from bad to worse.
In early 2012, it still cannot be claimed that the eurozone crisis is
solved, thought markets within the euro area seems to return
(maybe only temporarily) to more normal conditions.

Interestingly enough, the average of the fundamentals of the
euro area looks actually relatively good: compared to the US, the
eurozone as whole has a much lower fiscal deficit (4% of GDP in
2011 against almost 10% for the US) and unlike the US, it has no
external deficit. Its current account is close to balance, which
means that enough savings exist within the monetary union to
finance the public deficits of all its member states. This implies, in
turn, that potentially enough, domestic, euro zone’s resources exist
to solve the debt problem, without recurring to external lenders.
Whether these resources will be invested to finance eurozone
governments is a different question.

currently LUISS Research Fellow at Centre for European Policy Studies (CEPS) in
Brussels where she is part of the Economic Policy Unit dealing mainly with issues rela-
ted to monetary and fiscal policy in the European Union. Before joining CEPS in early
2009, she taught undergraduate courses at University of Perugia (Italy) and worked at
International Labour Office in Geneva. Her research interest focuses on international
economics and economic policy. Since her arrival at CEPS, she has worked extensively
with Daniel Gros on the macroeconomic and financial aspects of crisis in Europe and
at global level, as well on the policy response to it. She has published several articles on
the topic and participates regularly in international conferences.

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The Future of the Euro

In spite of this relative strength, eurozone policy-makers seem
incapable to solve the debt crisis. Meeting after meeting, heads of
state and Government or finance ministers have failed to convince
markets of the validity of their strategy, which has focused almost
exclusively on fiscal discipline and has repeatedly advocated the
need of financial help from outside investors, e.g. IMF and Asian
investors, regardless of whether resources exist within the eurozo-
ne. This approach has been both misguided and unconvincing.

Against this background, the paper emphasizes that while the
political agenda is almost obsessively focused on fiscal issues, the
euro zone crisis does not have a mere fiscal nature neither a simple
fiscal solution. It involves different dimensions running from
current account and external debt problems to the weak state of the
banking sector, which is still largely undercapitalized. This paper
will focus on the last element, the state of the banking system and
attempts at highlighting how features of the existing financial mar-
ket regulation framework which are inconsistent with main buil-
ding blocks of the monetary union have affected the course of the
crisis. We will argue that this inconsistency has crucially contribu-
ted to eurozone crisis and still remains unaddressed. The paper also
expresses concern about the misleading, prevailing view that the
just signed fiscal compact will work as crucial ingredient in the reci-
pe to overcome the eurozone crisis, while the banking sector
remains highly leveraged and exposed to the fortune and misfortu-
ne of sovereign governments. On this ground, the paper puts for-
ward some ideas about how to break the tight linkage between

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governments and banks. This is at the root of their common fate
and represents a decisive obstacle to overcome the eurozone crisis.

2. Recent eurozone history: From bad to worse

To understand why the euro crisis has gone from bad to worse,
one needs to develop a better understanding of the inconsistencies
in the setup of European Monetary Union (EMU) that caused the
problem in the first place. The official reading is that this is not a
crisis of the euro, but of the public debt of some profligate euro
area member countries. Therefore, tackling the causes of this crisis
and averting future ones requires only a new, tighter framework for
fiscal policy – which will be delivered by the new ‘fiscal compact’.

Yet, financial markets do not seem much impressed by a further
strengthening of fiscal rules: Portugal and other countries still have
to pay high risk premia while Greece has defaulted on its debt and
still teeters on the brink of a total collapse. This suggests that the
official approach captures only part of the problem and still misses
the full picture.

It is not only fiscal indiscipline in the periphery which turned
the public debt problems of a small country like Greece into a cri-
sis of the entire euro area banking system. The euro zone crisis is
the result of a constellation of vulnerabilities within the eurozone.
They include balance of payments problems, foreign debt, sudden-

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stops of crosser-border financing running from North to South
combined with a generalized undercapitalization of the banking
system.

This financial fragility has been the result of inconsistencies in
the setup of the EMU as well as a fundamental inconsistency in
financial market regulation that has yet to be addressed.

2.1. Recalling the building blocks of the EMU construction

The original design of EMU, as established by the Maastricht
Treaty in 1992, contained three key elements:

i) An independent central bank, the ECB, devoted only to price
stability.
ii) Limits on fiscal deficits enforced via the excessive deficit pro-
cedure (Treaty based) and the Stability and Growth Pact (SGP,
essentially an intergovernmental agreement, although still
within the EU’s legal framework).
iii) The ‘no bail-out’, or rather ‘no co-responsibility’ clause (art.
125 of the TFEU).

The treaty also contained other elements of economic gover-
nance,1 but this remained mostly declamatory as in reality

1 For instance, Article 121 of the TFEU contains the provision that member states
should regard economic policies as a matter of common concern and shall coordinate
them within the Council.

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Member States did not see any need to coordinate economic poli-
cies; at least, not before the crisis.

The first key element of the Maastricht Treaty, i.e. the very
strong independence of the ECB, was based on a large consensus
among both economists and policy makers that the task of a cen-
tral bank should mainly be to maintain price stability. The con-
sensus was based on a common reading of the experience of the
previous decades that higher inflation did not buy more growth
and independent central banks (with the Bundesbank as the most
prominent example) are best placed to achieve and maintain price
stability.2

Some academic economists and some observers at international
financial institutions worried already in the 1990s about financial
instability and advocate a clear role of the EBC in safeguarding
financial stability.3 Some also emphasized that a common currency
area also requires a common system of supervision of financial
markets.4 But the issue of financial stability did not attract the
attention of policy makers mainly for two main reasons. The first
one is theoretical: most prominent economic models before 2007
suggested that price stability delivers financial stability as by-pro-

2 A prominent paper of the period when plans for EMU were taking shape encapsula-
ted this insight in the title ‘The advantage of tying one’s hands’ (see Giavazzi and
Pagano (1988).
3 See for instance Garber (1992).
4 Among others Tommaso Padoa Schioppa (1994).

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duct, with no need to add another tool to achieve it. The second
one is much less sophisticated and relates to the fact that the two
key member states driving EMU, France and Germany, had not
experienced a systemic financial crisis for decades.

The second element of the Maastricht Treaty, namely the limits
on fiscal policy, did not enjoy the same consensus in the academic
profession (nor among policy makers) as central bank indepen-
dence. During the 1990s a wide ranging debate took place about
the sense or non-sense of the Maastricht ‘reference’ values of 3% of
GDP for the deficit and 60% for the debt level. Apparently the
advantage of tying one’s hands was much less recognized in the field
of fiscal policy. However, this debate did not need to be resolved as
long as benign financial market conditions prevailed and even the
core countries conspired to weaken the limits on deficits set by the
SGP in 2003.

The third element was only in the background and remained
untested until recently. Contrary to a widespread misconception,
Article 125 of the TFEU does not prohibit bail outs. It merely
asserts that the EU does not guarantee the debt of its member sta-
tes and that member states do not guarantee each other’s obliga-
tions. Germany had insisted on the no bail-out clause when the
Maastricht Treaty was negotiated about 20 years ago. Today, it is
clear that this clause does not provide the kind of protection that
was sought and widespread financial market turbulences threaten
to engulf Germany to agree to huge bail-out packages which would

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have been unthinkable only recently. However, instead of working
on averting the repeat of this situation in the future, German
policy makers are focusing exclusively on the need to ensure lower
fiscal deficits. This is the purpose of the Treaty on Stability, Coordination
and Governance in the Economic and Monetary Union also called the
‘fiscal compact’ under which euro area member countries agree to
adopt strict rules, ‘at the constitutional or equivalent level’, limi-
ting the cyclically adjusted deficit of the government to less than
0.5% of GDP. Will this fiscal compact work where the Stability Pact
failed?

The ‘original’ SGP already contained the engagement by mem-
ber states to balance their budget over the cycle. If implemented
since the onset of the monetary union, the rule would have led to
a continuous reduction of the debt-to-GDP ratio towards the 60%
target. But this did not happen. The promise or rather exhortation
contained in the SGP to balance budgets over the cycle was widely
ignored, given that the rule was not binding and financial markets
remained in a ‘permissive’ mood. All of the larger euro area mem-
bers ran budget deficits in excess of 3% of GDP threshold for the
first 4-5 years of the euro’s existence. Even Germany ran deficits
above 3% of GDP from 2001 to 2005. In 2003 a proposal put for-
ward by the Commission to ratchet up the excessive deficit proce-
dure to the point where fines might have been imposed on France
and Germany was defeated in the Council (of finance ministers,
ECOFIN). In the crucial vote the large countries (most of which
had excessive deficits, except Spain) colluded to water down the

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proposal and won the opposition of the smaller countries. The
’band of three large sinners’ (Germany, France and Italy) even
managed to put together a qualified majority to ‘hold the proce-
dure in abeyance’.5

This narrative is interesting in the light of the new ‘fiscal com-
pact’ which is supposed to radically strengthen the enforcement of
the fiscal rules by the application of the ‘reverse qualified majo-
rity’. Under this principle, an excessive deficit procedure launched
by the Commission is taken to be approved unless it is opposed by
a qualified majority. As past experience shows, despite the new sys-
tem makes the opposition harder, it does not ensure enforcement.

In 2005, following the 2003 episode, the SGP was changed. The
official justification was the need to improve its economic rational
and thus ownership,6 but it clear that it was necessary to avoid the
repeat of the embarrassing situation in which a literal application
of the rules would have led to sanctions for Germany and France
among others. The reaction in academia and among policy makers
was mixed: the SGP was ‘softened’ according to some, but ‘impro-
ved’ according to others. The very fact that professional opinion
on the merits of ’binding rules for fiscal policy’ was divided from
the start certainly facilitated the change in the SGP when it beca-
me politically opportune.

5 See Gros et al. (2004). 3 See for instance Garber (1992).
6 Annex to the 2005 Council conclusions
(http://register.consilium.europa.eu/pdf/en/05/st07/st07619-re01.en05.pdf).

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As matter of facts, shortly after the SGP was made less stringent,
the upturn of the business cycle allowed most governments to
reduce their deficits to below 3% seemingly vindicating the official
position that the ‘improved’ Stability Pact had led to a more res-
ponsible fiscal policy. But structural deficits (i.e. adjusted for the
cycle) actually improved very little even at time the boom reached
the peak in 2006-7 and, when the crisis hit, any remaining caution
was thrown overboard as deficits were allowed to increase again.

The euro area countries thus never lived up to the rules they gave
themselves. But even so, on average they remained relatively con-
servative in fiscal terms. In 2009, the average deficit peaked at 6.5%
of GDP, its highest level, whereas both the UK and the US went
above 11% during that year. Moreover, while the eurozone deficit
has brought back to 4% of GDP in 2011, it has remained at double
digits levels in both the UK and the US. In this limited sense, one
could argue that the Maastricht provisions against ‘excessive’ defi-
cits did have some influence after all, at least on average.

While the average deficits for the euro area appear today
‘modest’ by the standard of other large developed countries, one
euro area country, Greece, clearly violated all rules for years. But
mounting evidence that the Greek fiscal numbers did not add up
was never acted upon until it was too late. As long as financial mar-
kets provided financing at favorable rates any action was politically
inconvenient and was avoided.

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When the euro debt crisis started in early 2010 following the
discovery that Greece was running a deficit of 15% of GDP (and
that previous deficits had been misreported), some policymakers,
German in particular, started to call for tighter fiscal rules as essen-
tial to the survival of the euro.Despite Greece was an extreme case,
the case of Italy is widely seen as providing another justification
for tighter fiscal rules. However, the country seems to stand for
complacency rather than fiscal profligacy. Over the last ten years
the deficits of Italy have on average been lower than those for
France and even today its deficit is below the euro area average
(and declining rapidly).Yet, the incapacity of the country to redu-
ce its very high debt-to-GDP ratio has made it vulnerable to a loss
of investor’s confidence.

3. A false solution to the crisis: the fiscal compact

The new Treaty that was agreed upon in March 2012 has a long
title, Treaty on Stability, Coordination and Governance in the Economic
and Monetary Union, but upon closer examination it is long on
good intentions and rather short on substance in terms of binding
provisions.

The core of the new ‘fiscal compact’ is an obligation to enshrine in
national constitutions the commitment not to allow cyclically adjus-
ted deficits to exceed about ½ of 1% of GDP, which is roughly equi-
valent to balancing the budget over the cycle as in the original SGP.

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This should be done ‘preferable at the constitutional level’. The
European Court of Justice (of the EU) can be asked to pass a judg-
ment on these national rules, but the maximum fine that could be
assessed is capped at 0.1% of GDP – hardly a strong deterrent by
itself. This Treaty concerns only the framework for fiscal policy, i.e.
the rules setting up national ‘debt brakes’, not their implementa-
tion. This Treaty thus does not give any new powers to the Court
of Justice (neither to the Commission) to interfere with the actual
conduct of national fiscal policy. None of the provisions on eco-
nomic policy coordination are binding. Essentially they reiterate
the already often repeated statements of good intentions on struc-
tural reforms.

Among the provisions, the specification on governance institu-
tes regular meetings, at least twice a year, of the heads of state and
government of the euro area. However, since these meetings will
remain informal, in truth, there was no need for an international
treaty to establish them.

As far as the non-euro EU member states who signed the Treaty
are concerned, there is no obligation for them to do anything, but
the signature constitutes a political statement which gives them a
partial ‘seat at the table’ of the eurozone meetings, allowing them
to participate in most of the euro area summits.

From a purely legal point of view, this Treaty contains an inhe-
rent contradiction: it implies that its signatory countries agree on

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binding constraints for their constitutional order via an ordinary
international treaty. In most countries the national constitution is
of a higher in legal hierarchy than international treaties. This
means that even the provisions on the ‘fiscal compact’ constitute
essentially a political statement, unless the treaty is ratified with a
constitutional majority, as will be done in Germany.

The main value of this political statement coming from all euro
area member states is of course that it provides political cover for
the German government in its efforts to sell the euro rescue ope-
rations to a sceptical domestic audience. However, it is doubtful
that the ‘fiscal compact’ was really needed for this purpose. Data
on German support of the euro show that public opinion remains
much more constructive on the euro than widely assumed (see
Gros and Roth, 2011). Moreover even before the fiscal compact
existed, all votes in the Bundestag have resulted in very large majo-
rities in favour of the euro area rescue operations, even when they
contained large fiscal risks for Germany.

In judging the value of this Treaty one should also keep in mind
that, of the four large euro area countries, three have already natio-
nal debt brakes at the constitutional level: in Germany it is already
operational, in Spain has been adopted recently and in Italy is in
course of adoption. In the fourth country, France, it is already clear
that the Treaty will be implemented, if at all given the negative
attitude of the current opposition, via a so-called ‘loi organique’ and
that the French constitution will not be changed.

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All in all, the fiscal compact is probably useful in the long run
and may contribute to avert a future crisis. It forces Member States
to adopt stronger national fiscal frameworks at home. Some, per-
haps most, would have done so anyway under the pressure of the
markets, but it is unlikely that the new Treaty will make a signifi-
cant difference. The main danger is that that it has been oversold.

It is likely that the ratification process (e.g. the referendum in
Ireland) and then the implementation process in some difficult
countries (e.g. France) will receive a lot of attention and create a
distorted impression of the importance of the Fiscal Compact.

However, the initial excitement will be over once the national
fiscal rules have been put into place and this Treaty will quietly be
forgotten. Its only remaining impact will consist in the meetings of
the euro area heads of state which are likely to produce the regular
conclusions that ‘Member States commit’ to everything desirable
(structural reforms, etc.). Conclusions which become irrelevant
once the heads of state return to their capitals and their domestic
political realities.

The experience with the SGP suggests that how this new ‘fiscal
compact’ will be applied in future will depend on the degree of con-
sensus on the need to balance the budget over the cycle. If anything,
political will to follow this balanced budget rule will be even more
important for the new ‘fiscal compact’ since it will take the form of
an intergovernmental Treaty outside the legal framework of the EU.

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Today the consensus that only balancing budgets can solve this
crisis and allow the euro to survive seems strong and the position
of the German government seems particularly tough. This is cer-
tainly desirable to prevent future public debt problems but it
neglects the crucial role financial market fragility has played in this
crisis. The case of Greece is emblematic in this sense: despite
Greece accounts for less than 3% of the euro area’s GDP, the pros-
pect of the Greek government becoming bankrupt caused Europe’s
financial markets to go into a tailspin. The reason behind it was
the fragility of banks due to their undercapitalization and their
large holdings of government debt.

In this perspective, while for a creditor country like Germany it
might be important that other member states are forced to copy its
balanced budget rules, it should be even more important to ensu-
re that financial regulation helps to provide additional incentives
for good fiscal policy and that financial markets become more
robust and able to withstand a sovereign insolvency. This is what
would reduce the need for future bail outs by the German govern-
ment. German savers have over the last decade of current account
surpluses accumulated about one trillion euro worth of claims on
other euro area countries. Safeguarding the value of these claims
(which amount to about 50% of GDP) and ensuring the future
German savings surpluses are invested with minimal risk should
thus be a key policy goal for German policy makers.

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4. Fiscal indiscipline versus financial regulation inconsistency

The key insight that has been overlooked in the official circles
dominating EU policy making today is that today’s crisis is largely
due to an inconsistency in the original design of EMU, not in the
area of fiscal policy, but in the area of financial market regulation.
Even after the start of the EMU, financial regulation in general, and
banking regulation in particular, continued to be based on the
assumption that in the euro area all government debt is riskless.
This was from the start logically incompatible with the no-bail out
clause in the Maastricht Treaty, which implies that a euro area
member country can become insolvent, and the institution of an
independent central bank which cannot monetize government
debt. But it was adopted anyway, maybe because of the perception,
expressed recently in a spectacularly mis-timed paper from the IMF,
which proclaimed: “Default in Today's Advanced Economies:
Unnecessary, Undesirable, and Unlikely”.7

In the much more forgiving environment of the turn of the cen-
tury, it was quite natural for policy makers to ignore the logical
inconsistency between the no bail-out clause and maintaining the
assumption that government was really risk less. Yet this contra-
diction had two important consequences. First, banks did not (and
still do not) have to hold any capital against their sovereign expo-

7 Cottarelli, C., L. Forni, J. Gottschalk, and P. Mauro (2010) Staff Position Note No.
2010/12.

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sure. Second, it was also deemed unnecessary to impose any con-
centration limit on the claims any bank can hold on any one sove-
reign. This lack of a concentration limit for sovereign debt is in
clear contrast to the general rule that banks must keep their expo-
sure to any single name below 25% of their capital. This exception
would make sense only if government debt is really totally riskless.

The main result of this special treatment reserved to govern-
ment debt securities on banks’ balance sheets has been that about
one third of all public debt of the eurozone is held by eurozone
financial institutions, which also tend to privilege the financing of
their own government. The fate of governments and banks is thus
tightly linked.

To the inconsistency of financial market regulation it must be
added that the ECB failed to apply differentiated haircuts to
government debt it accepted as collateral. Debt securities issued by
euro area governments ware accepted in indiscriminate fashion
provided that the country was rated at investment grade. This was
the case for all euro area member countries, of Greece as Germany.
When the Stability Pact was weakened by Germany and France in
2005, the ECB took member countries to court, but it did not
change its collateral policy. By doing so it would have given a con-
crete signal that it was worried about the long run sustainability of
fiscal policy and its consequences for the future of the single
currency. Alas, it did not do so, not even during the crisis, after it
was clear that it was changing its policy stance. Only now, the ECB

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applies a sliding scale of graduated haircuts which makes it less
attractive for banks to hold lower rated government debt.

The idea that governments provide the only safe assets even in
a monetary union where a no bail-out clause exists was also the
main reason for another omission: a common euro area (or EU)
deposit insurance scheme was never seriously considered. At EU
level, deposit insurance is regulated by the 1994 Directive on depo-
sit guarantee schemes, but the minimum harmonization approach
adopted at that time has proven largely insufficient and the ulti-
mate back up for all national schemes remains the national govern-
ment. A common European deposit insurance modeled on the US
approach of a fund financed ex-ante by risk based contributions
from banks like the Federal Deposit Insurance Company – FDIC-
would have had obvious advantages in terms of risk diversification.
But the preference for national solutions (based on the fear that a
European equivalent to the FDIC would lead to large transfers
across countries) and the bureaucratic interests of the existing
national deposit guarantee schemes ensured that such ideas do not
get a hearing even today.

The experience with Greece should have served to rest the idea
that government debt in the euro area is riskless. But so far no cri-
sis summit has drawn the conclusion from this experience for ban-
king regulation. Of course, it is true that once the crisis has hit it is
no longer possible to tighten the rules on government debt becau-
se this is pro-cyclical as the mayhem which followed the only

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attempt to shore up the banking system in the context of the
recent EBA stress tests on government debt has shown.

However in order to illustrate the importance of thinking about
the larger benefits from a different kind of banking regulation it is
still worthwhile speculating what would have been different if
banking regulation had been ‘Maastricht’ conform, i.e. if it had
recognized that belonging to the European Monetary Union
implies that national government debt is no longer riskless.

One could thus consider how the crisis would have played out
if the following rules had applied since 1999:
i) Forcing banks to have capital against their holdings of euro area
government debt.
ii) Applying the normal concentration limits also to government
exposure.
iii) A different collateral policy of the ECB, for example with a sli-
ding scale of increasing haircuts on government debt in func-
tion of the country’s deficit and debt and its position in the
excessive deficit procedure.

One can only speculate what would have been different if this
kind of regulation had been in place during the boom years. But a
few conclusions seem certain.

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Greece would certainly have encountered much more difficul-
ties selling its bonds to banks which would have had to hold capi-
tal against it would be less able to use them to access ECB funds.
The same applies to Italy, whose rating went already in 2006 below
the threshold at which under normal banking rules higher capital
requirements kick in. Both these countries would thus have seen
gradually increasing market signals, which would have most pro-
bably led to a more prudent fiscal policy.

Moreover, their problems would today have been much easier
to deal with because banks would have more capital and the con-
centration limit would have prevented Greek banks to accumulate
Greek government debt worth several times their capital. The
resources necessary to prevent the collapse of the Greek banking
system has increased considerably (by about 40 to 50 billion euro)
the size of the financial support Greece needed so far.

The negative feedback loop between the drop in the value of
banks and in the yields on government bonds which destabilized the
entire European banking system so much during the summer and fall
of 2011 would also have been very much mitigated if the concentra-
tion limit had been observed. Italian banks would have accumulated
less Italian debt and would have been able to offset some of the mark
to market losses on the Italian debt with their gains on German debt
holdings which they would have had to hold as well.

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Common euro area wide deposit insurance would have contri-
buted in several ways to deal with the financial crisis from the
beginning. First of all, in 2008 it would have obviated the percei-
ved need for the competitive rush to provide national guarantees
for bank deposits. The Irish government would thus probably not
have had felt the need to provide the blanket guarantee for all lia-
bilities of its local banks which proved fatal once the extent of the
losses was revealed.

Ireland would still have suffered from a massive real estate bust
with all the consequences in terms of unemployment, but the Irish
government would not have been bankrupted by its own banks.
Paul Krugman has drawn attention to the parallels in terms of eco-
nomic fundamentals between Nevada and Ireland8 arguing that
explicit fiscal transfers and higher labour mobility within the US
constitute the main differences. However, Ireland has actually
experienced a degree of labour mobility which is quite similar to
that among US states like Nevada. During the boom it had immi-
gration running at over 1% of its population, which after the bust
turned into emigration of a similar order of magnitude. The wides-
pread held opinion that the euro could never work because there is
not enough labour mobility in Europe is not entirely correct.

In the case of Ireland the key issue was not one of a lack of labor
mobility, but of the absence of a common safety net for banks. A

8 See http://krugman.blogs.nytimes.com/2010/12/29/ireland-nevada/.

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European deposit insurance would have provided stability to the
deposit base. It is also likely that the European Deposit insurance
would have been less complacent and less beholden to the inte-
rests of Irish banks and would thus have started to increase its risk
premium when the signs of a local real estate bubble were clear to
almost everybody outside the country.

Greece, where the national deposit guarantee scheme is now
practically worthless because it is backed up only by the Greek
government, which has just defaulted on its debt, provides anot-
her example of the potential importance of stabilizing the banking
system. With a European deposit guarantee scheme there would
have been no deposit flight, which has amounted so far to about
50 billion, or over 25% of GDP. There would have thus been much
less need for the ECB to refinance the Greek banking system, lowe-
ring again the cost of the Greek bail out.

The next crisis will be different from the current crisis, but it is
clear that different rules for the banking system could bring two
advantages: they would provide graduated market based signals
against excessive deficits and debts. Moreover, a better capitalized
banking system with less concentrated risks would be much better
able to absorb a sovereign insolvency, thus reducing the need for
future bail outs. Acting on this front seems a much more promi-
sing route to reduce the likelihood for future crises and minimize
the cost should they occur anyway.

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Perceptions matter. Europe’s policy makers seem to be driven by
the perception that this crisis was caused by excessively lax fiscal
policy in some countries. In reality, however, the public debt pro-
blems of some countries have become a systemic, area wide, finan-
cial crisis because of the fragility of the European banking system.
The ‘euro’ crisis is likely to fester until this fundamental problem
has been tackled decisively.

5. A proposal for a new regulatory treatment of sovereign
debt securities in the euro area

The purpose of this section is to sketch a simple proposal for a
new regulatory treatment of sovereign debt securities in the euro
area which follows the arguments illustrated in the previous sec-
tions.
1. Any risk weights to be introduced after the crisis might better be
based on ‘objective’ criteria, rather than ratings.
2. Diversification of banks’ exposure; this is even more important
than risk weighting for sovereign exposure.

A simple way to attach a risk weight on government debt secu-
rities of a given country would be to make the weight function of
objective factors like the debt and deficit of the country. For exam-
ple, one could imagine that the risk weight could remain at zero if
both government debt and fiscal deficit relative to GDP remain
below 60% and 3% respectively. If the deficit and/or the debt ratio

219


exceed the ‘reference’ values of the Treaty, the risk weight would
increase by certain percentage points in a proportional or progres-
sive fashion. In addition the risk weights should be linked to the
stages of the excessive deficit procedure (EDP). When the procedu-
re is launched, the risk weight is increased and at each additional
stage of the EDP the risk weighting would be increased further. This
would provide the EDP with real incentives even without the need
to impose fines.

Introducing positive risk weights for government debt will not
be enough to prevent crisis because of the ‘lumpiness’ of sovereign
risk. Experience has shown that sovereign defaults are rare events;
but the losses are typically very large (above 50%) when default
does materialize. Even with a risk weight of 100% banks would
have capital only to cover losses of 8%. Risk weights would thus
have to become extremely high before they could protect banks
against realistic loss given default scenarios. This suggests that the
more important aspect is diversification.

All regulated investors, i.e. banks, insurance companies, invest-
ment funds, pension funds, have rules which limit their exposure
vis-à-vis a given counterpart to a fraction of their total investment
or capital (for banks). However, this limit does not apply to sove-
reign debt, especially within the eurozone for banks. The result of
this lack of exposure limits has been that, in the periphery, banks
have too much debt of their own government on their balance
sheet which has led to the deadly feedback loop between sovereign

220


and banks. In Northern Europe, investors, such as investment
funds and life insurance companies, which typically cannot avoid
government debt have also concentrated their holdings nationally.
This has led to a significant fall and in some cases even to negati-
ve value of government bond yields, not only in Germany but
throughout Northern Europe. From the point of view of core
Europe investors, today this might appear as being a prudent stra-
tegy, but this concentration increases the vulnerability of the sys-
tem to any reversal of fortunes. Moreover, if Northern investors
were required to diversify their holdings there would be a natural
demand for Southern European bonds, which would bring some
oxygen to those governments which have experienced a dramatic
surge in their borrowing cost.

Introducing exposure limits during a crisis period would be
much less pro-cyclical than introducing capital requirements. In
practical terms, the simplest approach would be to grandfather the
existing stocks, but apply exposure limits to new investments.

6. Conclusions

This paper has emphasized that while the political agenda has
been obsessively focusing on fiscal issues since the early onset of
the euro zone crisis; this crisis has neither a mere fiscal nature nor
an exclusively fiscal solution. Despite the Greek episode seemed to
point only to fiscal indiscipline, the reasons why the crisis did not

221


confined itself to Greece but spread out to the entire euro area assu-
ming a systemic nature should be sought in the state of the euro
area banking sector. European banks were, and still are, largely
undercapitalized and too tightly linked to the fortune and the mis-
fortune of governments.

The paper spots three contradictory building blocks of the EMU
construction: the no bail-out rule in the Stability and Growth Pact,
the independence of the European central bank and the provision
in the financial market regulation framework that government
bonds are considered as risk free assets. The combination of the no-
bail clause with the institution of an independent central bank
implies that fiscally undisciplined countries may have to face
default as no other country, nor the EU can take on its debt and the
central bank cannot monetize it. This definitely collides with the
principle that banks are not required to hold any capital against
government debt securities as it assumed that they do not carry
any default risk. In fact, Greece has proved this assumption wrong.

This contradiction was completely overlooked during the good
years in the turn of the new century and the politically more con-
venient approach suggested by financial regulation became the
dominant. The ‘risk free treatment’ of public debt securities has clearly
worked as incentive for banks to finance profitable government
spending and accumulate large amounts of government bonds.

222


This is at the root of the common fate of euro area banks and
governments. Alas, the crisis has made that fate an evil one.

Though these contradictory elements have now emerged clearly,
the issue has not been addressed and the regulator treatment of the
government bonds has not changed yet.

On this ground, the paper puts forward some concrete ideas
about how to break the tight linkage between governments and
banks, which represents a decisive obstacle to overcome of the
euro zone crisis.

We argue that positive risk weights for government debt securi-
ties must be introduced in the banks’ balance sheet, but alone this
measure will not be enough to prevent a new crisis. A clear pres-
cription to reduce concentration of the risk and impose diversifi-
cation is at least equally important and complementary to the risk
weighting.

While developing the arguments for the regulatory changes, the
paper expresses skepticism about the official, widespread view that
the just signed fiscal compact will have a crucial role in overco-
ming the eurozone crisis. As far as the banking sector remains weak
and highly exposed to governments, and the common fate of
government and banks is not broken, the crisis will be hard to die.

223


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