Central Bank Independence and the Future of the Euro 9781788212861

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Central Bank Independence and the Future of the Euro

Comparative Political Economy Series Editor: Erik Jones A major new series exploring contemporary issues in comparative political economy. Pluralistic in approach, the books offer original, theoretically informed analyses of the interaction between politics and economics, and explore the implications for policy at the regional, national and supranational levels. Published Central Bank Independence and the Future of the Euro Panicos Demetriades Europe and Northern Ireland’s Future Mary C. Murphy The New Politics of Trade Alasdair R. Young The Political Economy of Housing Financialization Gregory W. Fuller Populocracy Catherine Fieschi Whatever It Takes George Papaconstantinou

Central Bank Independence and the Future of the Euro Panicos Demetriades

To Sofia, Emma and Polis, with unconditional love

© Panicos Demetriades 2020 This book is copyright under the Berne Convention. No reproduction without permission. All rights reserved. First published in 2020 by Agenda Publishing Agenda Publishing Limited The Core Bath Lane Newcastle Helix Newcastle upon Tyne NE4 5TF www.agendapub.com ISBN 978-​1-​78821-​153-​6 (hardcover) ISBN 978-​1-​78821-​154-​3 (paperback) British Library Cataloguing-​in-​Publication Data A catalogue record for this book is available from the British Library Typeset by Newgen Publishing UK Printed and bound in the UK by CPI Group (UK) Ltd, Croydon, CR0 4YY

“The only good central bank is one that can say no to politicians” The Economist, 10 February 1990

Contents

Preface Acknowledgements Foreword by Erik Jones

ix xv xvii

1

Central bank roles: historical context

1

2

Central bank independence in Europe: origins, scope and limits

15

3

Crisis management and legitimacy

39

4

The European Central Bank’s policies during the crisis

49

5

Whatever it takes

67

6

Banking union

79

7

Small countries and why they matter

99

8

Political money-​laundering

111

9

Can the erosion of central bank independence be reversed?

121

References Index

129 135

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Preface

Within hours of the announcement of my decision to step down from the governor’s post at the Central Bank of Cyprus (CBC) on 10 March 2014, The Economist published an article entitled “A blow against [central bank] independence” (The Economist 2014). The article argued that my resignation set “a worrying precedent in the euro zone”, but went on to qualify this by suggesting that Cyprus might be a special case. Specifically, it referred to the “disastrous events of March 2013” and “Cyprus’s continuing plight”, with Bank of Cyprus, the country’s biggest bank, being in a “dire state”. It also indicated that my resignation had something to do with the blame game after the crisis and the Cypriot central bank’s poor job in supervising the banks, failing to mention that I was appointed only in May 2012 and the crisis was already simmering before I took office. The article correctly stated that my relations with President Nicos Anastasiades, who came to power ten months after I had been appointed by the previous government, “were not just poor but non-​existent”. It failed to explain, however, that Anastasiades was surprisingly close to the bankers who caused the crisis. Nonetheless, and notwithstanding the qualification about Cyprus being perhaps a special case, the article concluded that “similar pressures may be exerted elsewhere” that could “undermine the capacity of the ECB [European Central Bank] to act in the interests of the euro zone as a whole”. It was important to set the record straight. That is largely why I felt compelled to write my first book, soon after I returned to my academic post in the United Kingdom; A Diary of the Euro Crisis in Cyprus: Lessons for Bank Recovery and Resolution (2017) tells the story of the Cyprus crisis from my first day in office (3 May 2012) to the last (10 April 2014). It explains the root causes of the Cypriot crisis, and explains how the country’s banking system doubled in size between 2005 and 2011 to

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Preface

reach 9.5 times the size of the country’s gross domestic product (GDP). It explains how the two biggest banks became too big to save and too big to regulate, with a combined balance sheet of four times GDP. It sheds light on Cyprus’s “special relationship” with Russia, the murky financial flows between the two countries and the shady links between politics and banking. It provides the details of what actually happened in March 2013: why deposits were raided, who introduced capital controls and the events that led to my resignation. In a nutshell, it was the Cypriot government’s unrelenting determination to exercise greater control over the central bank that led to my resignation. Central bank independence (CBI) and its erosion played a considerable role in the Cypriot crisis, but that book only touches on this and the risks to the euro that could undermine the Eurosystem’s1 capacity to act in the interests of the euro area as a whole. At the time, another book did not seem warranted. Cyprus could indeed have been a special case. Even before I had finished writing my Diary, however, attacks on central bank governors in the euro area were growing. Bostjan Jazbec (Slovenia), Yiannis Stournaras (Greece), Carlos Costa (Portugal) and even my own successor in Cyprus, Chrystalla Georghadji, all appeared to be facing vicious political campaigns against them, if not also against their families. Since 2017 Jazbec has resigned from his post while Ilmārs Rimšēvičs, Latvia’s central bank governor, has effectively been removed from office without due process. Even in Germany, the ECB itself has faced fierce public criticism and threats from politicians over its non-​standard policies. So much so that Yves Mersch, a member of the ECB’s executive board, had to issue a public warning to Germany over attempts to constrain or limit how it exercises monetary policy. In March 2019 Jozef Makuch, Slovakia’s central bank governor, stepped down nearly two years before the end of his term in order to allow the government to appoint a successor ahead of the general elections in 2020. This is not how central bank independence in the euro area was meant to be.2

1. The Eurosystem comprises the European Central Bank (ECB) and the national central banks (NCBs) of the countries that have adopted the euro. 2. Bostjan Jazbec, the Slovenian central bank governor, faced a lengthy campaign of harassment, following the imposition of losses on bondholders of a failed bank, which included death threats and police raids. Within a year of x

Preface

The erosion of central bank independence is not unique to the euro area. The rise of populist governments in several countries suggests that CBI anywhere in the world can no longer be taken for granted.3 Even in the United Kingdom and the United States it is no longer considered taboo for politicians to attack central banks and their governors. In July 2018 the US president, Donald Trump, described the tightening of monetary policy by the Federal Reserve as “crazy”. In the United Kingdom Governor Mark Carney was attacked by pro-​Brexit politicians for stating the obvious risks that Brexit entails for the economy and the financial system. In India the governor of the Reserve Bank of India (RBI), Urjit Patel, resigned in December 2018 following government moves to exert more control over the bank’s distribution of its dividends and regulatory powers; in June 2019 he was followed by the deputy governor, Viral Acharya, in a move described by international media as a further blow to the RBI’s independence. There is little doubt that these worrying trends are the result of central banks taking on new and expanded roles in an attempt to manage the global financial crisis and its aftermath. Legal scholars and political scientists have suggested that central banks should return to their narrow monetary policy mandates, in order to safeguard their democratic legitimacy and independence. But is that the right way forward? her appointment, my successor, Chrystalla Georghadji, was facing proceedings initiated by the Cypriot government to dismiss her for a conflict of interest that she allegedly had not declared when she was appointed. Yiannis Stournaras, Greece’s central bank governor, faced attacks from the SYRIZA government in Greece, as well as allegations of corruption, with media reports suggesting that the Greek government was following the example of Cyprus. Carlos Costa faced a political storm when the socialist government attacked him over alleged “irresponsible” delays in making decisions over investor compensation relating to the collapse in 2014 of Banco Espírito Santo. Ilmārs Rimšēvičs was detained by anti-​corruption authorities over corruption allegations, and a Latvian judge released him on condition that he could not resume his duties at the central bank or attend Governing Council meetings at the ECB until the court case was concluded. 3. See the lead article published on 13 April 2019 in The Economist entitled “The independence of central banks is under threat from politics –​that is bad news for the world” (implicitly confirming that Cyprus was not a “special case”). See also the excellent speech by the governor of the Reserve Bank of South Africa at the Peterson Institute for International Economics in April 2019 (Kganyago 2019). xi

Preface

Should central bankers withdraw and choose to interpret their independence in ways that placate populist politicians? The incomplete architecture of the euro makes such challenges even more serious in the case of the Eurosystem, not least because central bank independence is one of the key pillars of the monetary union. It is, therefore, vital to understand and analyse these challenges, as well as their implications for CBI. And what might happen if the ECB remains relatively passive while the euro’s foundations are being eroded? This seems to have been the case  –​inadvertently  –​under Mario Draghi’s presidency, from 2011 to 2019. Will the euro survive the next crisis, if the erosion of its foundations is not remedied in the years to come? I try to answer these questions in this book, drawing on my own personal insights from my role as a euro area central bank governor from 2012 to 2014, a period that coincided with the Cypriot crisis but also the peak of the Greek and euro crises. My main conclusion is that central bank independence in the euro area is, to a large degree, an illusion, at least in the way in which it has been interpreted or defended. At this juncture it can easily be breached or circumvented by any government that is determined and imaginative enough, without significant consequences, perhaps even without appearing to violate the letter of the Treaty on the Functioning of the European Union (TFEU: see European Commission 2012b).4 This is, of course, highly problematic for the future of the euro, and is compounded by the reluctance of the European Commission (EC) to take legal action against governments that so obviously violate the treaty. Combined with the rise of populist and authoritarian politics and other geopolitical risks emanating from political money-​laundering, this poses an even greater risk to the integrity of the euro area that has hardly been registered, let alone discussed. Although I do not particularly want to paint a doomsday scenario for 4. The Treaty on the Functioning of the European Union came into force on 1 December 2009, following the ratification of the Treaty of Lisbon, which made amendments to the Treaty on European Union (TEU) and the Treaty establishing the European Community (TEC). Reference here is to Article 130, which articulates the independence of the ECB and national central banks from “Union institutions, bodies, offices or agencies, from any government of a Member State or from any other body” (European Commission 2012b: 104).

xii

Preface

the euro, I do argue that, unless central bank independence is restored, the ECB’s policy of doing “whatever it takes” can no longer be taken for granted, even if Christine Lagarde, the new president of the ECB, is fully committed to it. To this end, I put forward six practical policy recommendations, which, if implemented, will help to strengthen the Eurosystem’s governance, its legitimacy and, ultimately, its foundations.

xiii

Acknowledgements

I am grateful to George Georgiou, Alison Howson, Radosveta Vassileva and an anonymous reader for many helpful comments and ideas during the writing of the manuscript. Naturally, any remaining errors are my own. I  would also like to thank Matthew Gaisford St Lawrence for assistance with the graphs.

xv

Foreword Erik Jones

Central banks are never independent from politics. The bankers who run those organizations may have the institutional power to define their own objectives, the technical capability to adjust the settings on their monetary instruments, and strong legal protections around the terms and conditions for their employment. But none of that is enough to insulate them from politics. Determined politicians will find a way to exercise influence, no matter what the obstacles. More often than not, such politicians will do so without even implicating the legislative process. They do not have to rewrite the laws to violate central bank independence. Politicians only need to take advantage of the fact that central bankers come from society, they (and their families) have to live somewhere, and eventually they will also retire. This is the harsh reality that former Cypriot central bank governor Panicos Demetriades reveals in his analysis of central bank independence. His point is not to deny the very strong theoretical reasons for trying to create a division between politics, on the one hand, and monetary policy, on the other. Rather it is that any such arrangement is only as sound as the commitment among politicians to respect the divide. Once that commitment wavers or the respect is lost, then central bankers are no more independent from political influence than anyone else. They can be pressured, scapegoated, outnumbered, intimidated. Moreover, the smaller and more tightly knit the society, the easier it is for politics to predominate. Demetriades makes this argument by using his own experience as a case study. He is careful to note, however, that his experience is not unique. Central bankers in other countries have found themselves in similar situations  –​right down to the level of intimidation. And the more that experience has been repeated, the easier it has become for

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Foreword

politicians to copy. If there was a consensus on the virtues of central bank independence, that consensus is now broken. Demetriades’ argument has important implications for the euro area and the European system of central banks. Because Europe’s economic and monetary union includes a large number of very small countries, the European community of central bankers has many points of vulnerability. Cyprus is one example, but Hungary, Lithuania, Malta, Slovakia, and Slovenia are challenging conventional norms about central bank independence as well. Moreover, the problems do not only come from politicians. Central bankers are prone to overreach, particularly in moments of crisis. The last decade has left the central banking community exposed both in terms of responsibility and in terms of scrutiny. Now politicians are taking advantage of the vulnerability that exposure has created. The solution, Demetriades argues, is to return to first principles. That means getting central banks out of activities that are inexorably political, like banking resolution. It also means ensuring that at least some central bank board members should come from other countries, which makes them less vulnerable to political influence. Demetriades has a number of other recommendations for insulating central banks from the politicians who seek to violate their independence. He is careful to note, however, that the goal is not to reinforce the privileged position of the central banking community. Rather it is to reinforce the ability of central bankers to deliver the policy outcomes for which they were appointed. Central bank independence is an instrument to achieve the policy objective of stable macroeconomic performance. Such independence is no guarantee that the economy as a whole will prosper or that the financial system will avoid any crisis. But it is better than the alternative of giving politicians direct control over monetary policy instruments even if the political independence of central banks does not really exist. Demetriades’ argument is essential reading both for those who seek greater accountability within the central banking community and for those who worry how macroeconomic policymakers are likely to respond to the next crisis.

xviii

1

Central bank roles: historical context

From financing wars to inflation targeting: a brief history of central banks Central banks are institutions that issue currency, provide banking services to governments and commercial banks and have responsibility over monetary policy, including setting short-​term policy rates (at which they provide short-​term liquidity to commercial banks through monetary operations). Often central banks have responsibilities relating to financial stability, which sometimes include regulating and supervising commercial banks and, more recently, resolving banks that are failing. Central bank legal frameworks vary considerably from country to country, largely reflecting differences in attitudes shaped by diverse historical experiences. A key feature of the European Central Bank (ECB), unlike the United Kingdom’s Bank of England (BoE) and the United States’ Federal Reserve (the Fed), is that it is explicitly prohibited by the Treaty on the Functioning of the European Union (Article 123 –​ known as the monetary financing prohibition) from financing government deficits. Moreover, although all three central banks have mandates in which price stability is central, price stability is the ECB’s overarching objective: it can support other goals, including financial stability, growth and employment, only to the extent that they do not interfere with price stability. By contrast, the Fed has a dual mandate set in law: it aims to maximize employment and stabilize prices (as well as moderate long-​term interest rates). The Bank of England’s objectives are set annually by the government, however. Ever since the bank was granted operational independence, in 1997, the main aim of monetary policy has been the achievement of low and stable inflation; other

1

Central Bank Independence and the Future of the Euro

government objectives, including employment and growth, have been subordinated to price stability –​very much like the ECB. Nevertheless, although, in the BoE case, the mandate can be changed by the government in any given year, the ECB’s mandate cannot change without a revision in the TFEU; such a change requires unanimous agreement by all EU member states. The Swedish Riksbank was the first institution recognized as a central bank. It was established in 1668 as a joint-​stock bank, and chartered to lend funds to the government and to act as a clearing house for commerce. It was followed by the Bank of England, which was established by royal charter in 1694 to raise money to fund a war with France. The Bank of England was also a joint-​stock company. Over 1,200 people purchased the stock of the bank, totalling £1.2  million, which was the value of the loan made to the government by the bank. The first shareholders of the BoE came from a wide variety of backgrounds; they included carpenters, grocers, merchants, knights and royalty. The Banque de France was established in 1800 by Napoleon I, with a specific remit to stabilize the currency after the hyperinflation of paper money during the French Revolution. Over time, early central banks came to serve as banks for commercial banks, holding their deposits and providing emergency loans during times of financial distress, which explains their emergence as lenders of last resort. During the gold standard period, which prevailed until 1914, central banks held gold reserves to ensure that their notes could be converted into gold. Maintaining gold convertibility served as the economy’s nominal anchor. As the price of gold was determined by market forces, early central banks were, in effect, strongly committed to price stability. During the same period, however, the first tensions between maintaining price stability and financial stability emerged. At times of financial distress central banks often refused to provide liquidity to commercial banks, opting instead to protect their gold reserves. The Bank of England, for example, was severely criticized for precipitating the panics of 1825, 1837, 1847 and 1857. Stability returned when the BoE adopted Walter Bagehot’s “responsibility doctrine”, whereby it would place the public interest above its private interest by lending freely against any sound collateral. The early history of central banking in the United States was even more turbulent than in Europe, not least because of Americans’ 2

Central bank roles: historical context

deep-​seated distrust of concentrated financial power and government intervention.1 The first two central banks, both of which were modelled on the BoE, were relatively short-​lived, as they failed to have their charters renewed when they expired. The first Bank of the United States was established in 1791 and operated until 1811. The second Bank of the United States was established in 1816 and lasted until 1836. The period that followed is known as the free banking era. It lasted until the onset of the US Civil War, in 1861 and was characterized by virtually free entry into banking, minimal regulation, several banking panics and numerous bank failures. In addition, the payments system was notoriously inefficient, because of the extremely large number of dissimilar-​looking state bank notes circulating, alongside numerous counterfeits; counterfeiting became a profitable business precisely because of the lack of a uniform currency. In 1913 the Federal Reserve was created and given a mandate of providing a uniform and elastic currency and to serve as lender of last resort. The Fed’s monetary policy in the 1920s and 1930s, however, which followed the real bills doctrine, prevented it from being effective as a lender of last resort, as reserve banks would lend only against eligible self-​liquidating collateral. As a result, the Fed failed to prevent banking panics, many banks failed, the money supply collapsed and massive deflation and depression followed. The early history of central banking in Europe and the United States reveals that central banks were created in order to supply banking services to governments and to issue and manage a country’s currency. Fairly early on in their history central banks started acting, reluctantly at first, as lenders of last resort for commercial banks facing financial distress (Goodhart 1988). It was only after the First World War that central banks began to be concerned with macroeconomic stabilization and, more specifically, employment fluctuations. This development was very much in response to the changing political economy conditions emanating from the Great Depression and the rise of labour movements worldwide. In the three decades that followed the Second World War central banks became much more activist in terms of stabilization policies, reflecting the widespread adoption of Keynesian ideas, 1. For more details of the early history of central banking in the United States, see Bordo (2007).

3

Central Bank Independence and the Future of the Euro

shaped by the failures that had led to the Great Depression. A related idea that became influential among policy-​makers during this period was the Phillips curve, which pointed to the existence of a trade-​off between inflation and unemployment. If policy-​makers wanted to reduce unemployment, they had to accept a permanently higher rate of inflation. The oil shock of the early 1970s led to the build-​up of considerable inflationary pressures, however, and “stagflation” –​namely high unemployment and inflation  –​as policy-​makers erroneously responded to a supply-​side shock by stimulating aggregate demand. These developments initially led to the adoption of monetarist ideas in the conduct of monetary policy in the 1970s and early 1980s, which involved trying to reduce the growth rate of the money supply in order to bring inflation down. In its purest form, the quantity theory of money envisages a dichotomy between real and monetary variables  –​the “classical dichotomy”  –​in which employment and GDP are determined by real factors while inflation is, as Milton Friedman proclaims, “always and everywhere a monetary phenomenon” (Friedman 1970). Monetarists challenged the idea that the trade-​off between inflation and unemployment is a permanent one by introducing inflation expectations into the Phillips curve and by arguing that, in the long run, unemployment will return to its “natural” rate, which is determined by the structural features of the labour market. Unemployment, they argued, could be kept below its “natural rate” only if inflation was not anticipated. If inflation expectations were adaptive, the attempt to keep unemployment below the natural rate required ever-​ accelerating inflation. Further refinements of these ideas were associated with the emergence of the new classical school of thought, which put forward the notion of “rational expectations” and the Lucas critique. These developments highlighted the dangers of forecasting using models that rely on empirical relationships such as the Phillips curve (Lucas 1976). If policy-​makers use –​or even abuse –​such relationships, Robert Lucas argues, they will sooner or later break down, as they are not structural relationships. Although monetarist ideas influenced monetary policy in the 1970s and 1980s, it became quickly apparent that control of the money supply was fraught with many difficulties and that, in any case, the relationship between inflation and money growth was not stable enough to conduct monetary policy on that basis. Thus, monetary targeting began to be 4

Central bank roles: historical context

abandoned from the early 1980s onwards. At more or less the same time it was also recognized that the credibility of monetary policy suffered if it was seen to be in the hands of elected politicians. As a result, monetary policy came to be increasingly delegated to independent central banks mandated with stabilizing the macroeconomy around a low target rate of inflation. This monetary policy framework  –​known as inflation targeting –​was first introduced formally in April 1988 in New Zealand, where it succeeded in bringing inflation down from around 16 per cent per annum in 1987 to around 2 per cent per annum in 1992. New Zealand’s example was followed by Australia and Sweden in January 1993 and March 1993, respectively. The Bank of England adopted an inflation target in 1992 but did not become operationally independent until 1997. The European Central Bank has been independent since its inception and has been targeting inflation since the creation of the euro on 1 January 1999. The US Federal Reserve, which has been operationally independent in the conduct of monetary policy, formally adopted an inflation target of 2 per cent in January 2012, although evidence suggests it had been informally targeting inflation at the same rate since the mid-​1980s.2 More often than not, inflation targeting emerged as a political response to the inability of elected politicians to achieve macroeconomic stability. In the United Kingdom, the BoE was made operationally independent by the newly elected Labour government of Tony Blair soon after it took office in 1997. The bank, at the same time, became accountable to meet the target; failure to meet the target came with the obligation to explain why it failed to do so in an open letter to the Chancellor of the Exchequer. Before 1997 interest rates were set by the UK government, with an eye on elections and politics (see Box 1.1). In Europe, the ECB was created from the blueprint of the German Bundesbank –​a fiercely independent central bank with an outstanding record in controlling inflation. The idea was to emulate the 2. See, for example, Taylor (1993), who shows that the historical behaviour of monetary policy in the United States was well described by an interest rate rule by which the Fed responded to deviations of inflation from 2 per cent (and output from full employment) by raising policy rates by half the deviation –​e.g. if inflation was 4 per cent, the Fed would raise interest rates by one percentage point. Conversely, if output was 2 per cent below full employment, the Fed would reduce interest rates by one percentage point. 5

Central Bank Independence and the Future of the Euro

Bundesbank’s success throughout the monetary union. For countries with a poor record in controlling inflation, such as Italy and Greece, this was a very attractive proposition, as they stood to benefit from the credibility of the ECB. Monetary policy under inflation targeting can be described in terms of two policy variables: a medium-​term inflation target, which serves as an inflation anchor; and a response of interest rates to macroeconomic shocks that create fluctuations in inflation and output. Although the overriding objective of monetary policy is to ensure that, on average, inflation is equal to the target, there is also a subordinate decision of how to respond to shocks as they occur (King 1997). The success of inflation targeting rests on the central bank’s credibility, which is critical for anchoring inflation expectations. Central bank independence (CBI) is, in fact, a sine qua non for central bank credibility. After all, the whole point of delegating monetary policy to unelected bureaucrats is to convince economic agents that politicians, who are subject to electoral pressures, are not involved in the setting of interest rates. Credibility additionally requires the central bank to communicate its actions in a clear and transparent manner and to be accountable for its actions to parliament and the general public. To this end, monetary policy decisions in an inflation-​ targeting framework are always followed by press conferences in which the decisions are communicated and explained.

BOX 1.1 HOW THE BANK OF ENGLAND WAS SET FREE

In an article in the Financial Times on 5 May 2017, former Bank of England Governor Mervyn King provides some fascinating insights into the politics behind monetary policy decisions prior to 1997. Governments would often “reward themselves” with a rate cut after a satisfactory reception of a budget. Elections influenced both the nature and timing of decisions on interest rates. Moreover, decisions would be made without systematic analysis or process. Although a more systematic approach was introduced after 1992, when an inflation target was adopted, politics was never far away. King refers to one occasion when a Chancellor of the Exchequer said at the 6

Central bank roles: historical context

beginning of a meeting to discuss interest rates: “I want to make it clear that interest rates are not going to change but now I have made that clear I would like to hear the arguments.” By contrast, today interest rate decisions are determined by majority vote of the nine-​person Monetary Policy Committee, following several days of deliberations and analysis. The Bank of England’s independence certainly helped remove inflation from a major source of concern among businesses and households. By contrast, inflation seemed like an intractable problem in the 1970s, when it reached 27 per cent. Even in the 1980s, when Margaret Thatcher was prime minister, it averaged 8 per cent. Since the Bank of England became independent in 1997 it has remained low and stable. Ironically, as King explains, the Bank of England was made independent 200 years to the month after a raid on the Bank of England’s gold reserves by the then prime minister, William Pitt, and the suspension of convertibility that led James Gillray to draw the cartoon that inspired the “Old Lady of Threadneedle Street” nickname.

Central banks and the global financial crisis The move towards inflation targeting by major central banks around the world was associated with a period of unprecedented macroeconomic stability that lasted until the mid-​2000s. Central banks and, more generally, macroeconomists believed that they had conquered inflation, and with that they had also succeeded in stabilizing the macroeconomy. It is now widely recognized, however, that other risks remained undetected, primarily because the role played by banks in the macroeconomy was largely ignored. The build-​up of system-​wide financial risks was facilitated by a relatively relaxed stance on the part of central banks and other regulators towards capital requirements and financial innovation. Having said this, it is now also recognized that monetary policy was never intended to respond to systemic financial risk, such as, for example, asset price bubbles or, more specifically, property bubbles. Similarly, even in cases when central banks had responsibility for banking supervision and regulation, they were not explicitly mandated to deal with systemic risk, as their supervision was focused on assessing the soundness of individual banks. Often central banks 7

Central Bank Independence and the Future of the Euro

had responsibility for micro-​prudential regulation but not macro-​ prudential regulation, which is intended to address system-​wide risks. The global financial crisis that ensued transformed central banks into major firefighting forces. It began with a coordinated interest rate cut in October 2008 by the Federal Reserve and the Bank of England and was followed by liquidity support to banks under stress. When interest rates reached the zero lower bound, central banks had to deploy non-​ standard measures to reduce the risk of deflation, stimulate demand and restore confidence, including quantitative easing (QE). The aftermath of the crisis has found central banks involved in regulatory reforms, including the design of new frameworks to deal with banks that are failing or are likely to fail at minimal cost to the taxpayer. The ECB has been no exception. If anything, because of the incomplete architecture of the euro, the ECB has faced more serious challenges than the Fed or the BoE. A lack of fiscal policy coordination has increased pressure on the ECB to adopt an accommodative monetary policy and stimulate aggregate demand. Moreover, the incomplete financial architecture of the euro has meant that the ECB played a central role in the political discussions related to the creation of the banking union in Europe. The expanded roles of central banks since the crisis have inevitably raised questions about the legitimacy of central banks and have created new threats for central bank independence. These threats have been compounded by the rise of populist politics, as well as geopolitical developments that represent significant new risks to the euro’s periphery, if not its core. The risks and threats to the euro can become existential ones if they are not managed effectively, for European Monetary Union (EMU) is only in theory an irrevocable monetary union. Fears about the euro unravelling first surfaced with the onset of the Greek crisis in 2010, when it became clear that there is no automatic bailout clause for member states that are facing budgetary difficulties. Grexit became a real possibility during 2011/​12 and again in the summer of 2015, when negotiations between Greece and its international creditors came close to breaking down. Although Greece was the prime example of “redenomination risk” in the euro area, it was not the only one. In March 2013 it was Cyprus that looked much more likely to be forced out of the euro, as a result of its own unprecedented banking crisis. 8

Central bank roles: historical context

Even more worryingly, at the peak of the euro crisis in mid-​2012, financial markets were spooked by fears that other countries might follow suit: Ireland, Portugal, Spain and Italy seemed next in the line of fire. Financial markets started pricing redenomination risk into the yields of several euro area member states –​a development that forced Mario Draghi to famously proclaim in July 2012 that “within our mandate, the ECB is ready to do whatever it takes to preserve the euro”. Doing “whatever it takes” resulted, however, in the ECB and Eurosystem central banks taking on even more powers, which have stretched the mandate to its limits, resulting in both legal and political backlash. The list of “non-​standard” policies that the ECB and Eurosystem central banks had to adopt is a long one. It starts from the onset of the global financial crisis in October 2008, with the provision of liquidity at fixed-​ rate full allotment, a series of long-​term refinancing operations (LTROs), the provision of emergency liquidity assistance (ELA) and the Securities Market Programme (SMP), which was adopted in 2010 and involved purchases of sovereign bonds in secondary markets by Eurosystem central banks. In 2012 the SMP was replaced by the Outright Monetary Transactions (OMT) programme, which was specifically intended to address redenomination risk. In addition, the banking union project arose, so as to address vulnerabilities in the banking systems of individual member states –​such as Cyprus in 2013 –​that had the potential not only to undermine the transmission mechanism of monetary policy but also to threaten the monetary union itself. Within it, there are three pillars: bank supervision, bank resolution and deposit insurance. The ECB assumed responsibility for the Single Supervisory Mechanism (SSM), which oversees the banking systems of all euro area member states and came into operation on 5 November 2014. In addition, more than half the euro area’s central banks have acquired bank resolution powers that allow them to deal with banks that are failing or about to fail, as part of the euro-​wide Single Resolution Mechanism (SRM). Although there is as yet no pan-​European deposit insurance, because of its implications for risk-​sharing across countries and associated moral hazard and political ramifications, there is no doubt that Eurosystem central banks will, once again, be part of these political and politicized discussions. On top of new OMT and banking union responsibilities, monetary policy itself has become increasingly unconventional: although the ECB 9

Central Bank Independence and the Future of the Euro

was the last among major central banks to adopt QE, its large-​scale asset purchase programme has proved to be more controversial than that of other central banks, in light of the legal set-​up of the ECB and political sensitivities in Germany. There is no doubt that the ECB has done “whatever it takes” to prevent the euro from unravelling and has stretched its mandate to its legal limits. But at what cost? All the above policies and discussions have meant that the ECB has faced legal, as well as political, backlash, not least because the enlarged tasks and responsibilities were adopted without changes to the TFEU (which require unanimity among all 28 EU members, and are therefore much harder to agree). The first political shockwaves were in Germany itself, following the resignations in 2011 of the two German members of the ECB’s Governing Council due to disagreement with the new policies. Axel Weber, president of the Bundesbank, was the first to step down, and he was followed by ECB executive board member Jürgen Stark. Their replacements did little to change sentiment within Germany about the ECB’s widened role; the ECB and the Bundesbank faced renewed legal and political challenges relating to the Bundesbank’s participation in the OMT programme and, more recently, the asset purchase programme. Under threat: central bank independence Developments outside Germany have, if anything, been even more damaging for the Eurosystem, as they have resulted in de facto erosion of its legal foundations –​its independence to decide monetary policy without interference from domestic, EU or foreign politicians or other external sources of influence. The ECB, including the Eurosystem of central banks, is widely considered to be one of the most independent central banks in the world. What is becoming increasingly apparent, however, is that the ECB perceives its own independence rather narrowly: it interprets it as applying to monetary policy much more than to any other functions and tasks. Thus, independence safeguards for banking supervision and bank resolution have remained vague, in so far as they relate to Eurosystem central banks. As a result, central banks in the euro’s periphery that had to deal with failing banks and impose losses on investors have found themselves embroiled in political and 10

Central bank roles: historical context

often legal battles, which they were unprepared for. The Cypriot and Slovenian central bank governors resigned from their posts, following political pressures and death threats, while the Latvian one was, in effect, dismissed from duty without due process. Moreover, the new vice president of the ECB –​appointed in summer 2018 –​had been a finance minister in Spain before taking office. This represents a departure from the unwritten rule that active politicians are not appointed to the ECB’s executive board. This is intended to keep politics separate from central banks  –​a separation akin to the judiciary. Times are changing, however, and unwritten rules may be the first victim. In addition to Cyprus and Slovenia, Greece’s central bank governor, Yiannis Stournaras, has been subjected to unprecedented political attacks and calls for his resignation. Perhaps more alarmingly, appointments of the new breed, replacing those who have stepped down, have remained remarkably silent, suggesting that behaviour may be changing. Furthermore, the ECB has faced numerous legal and political challenges from within Germany. The outgoing ECB president, Mario Draghi, has withstood several political storms, but has felt compelled to defend his actions in the Bundestag –​even though he has no legal requirement to do so. The ECB is accountable to the people of Europe, through the European Parliament and Council, not exclusively to the people of Germany. Last but not least, recent developments involving illicit financial flows from Russia and other former Soviet republics into the euro area’s periphery –​for example, Cyprus, Estonia, Latvia and Malta –​are creating new, potentially existential, threats to the euro. Although the ECB seems so far to be treating allegations of money-​laundering in the periphery as merely a source of reputational risk, there may be much more at stake. In Latvia, for example, the central bank governor was, in effect, removed from office within 48 hours as a result of corruption allegations made by a small Russian bank. New questions have, therefore, been raised about the ability of the ECB to safeguard the independence of euro area central bank governors. Although the European Court of Justice has determined that the action by the Latvian authorities violated the TFEU, the fact remains that the Latvian central bank governor was, in effect, dismissed from office without due process. Increased Russian influence in the eurozone’s periphery is also evident in Cyprus, where the country’s largest bank remains under partial control of Viktor 11

Central Bank Independence and the Future of the Euro

Vekselberg, a Russian oligarch who is on the US sanctions list –​an unintended consequence of bailing in uninsured depositors in the country’s 2012/​13 banking crisis. These new geopolitical risks are creating new threats to central bank independence and, consequently, the sustainability of the monetary union. All the above developments are tantamount to setbacks for central bank independence in the euro area in recent years, while the commitment of Germany itself to the euro and the ECB has waned. This was undoubtedly the result of the ECB and Eurosystem central banks engaging in unconventional monetary policy and taking on new responsibilities, including resolving failing banks. The new ECB president will inevitably be faced with the question of whether to retreat from these additional responsibilities; if it is decided to continue, it may be found necessary to defend more vigorously the Eurosystem’s independence, if not to push for greater independence. The status quo is clearly not sustainable, as it is likely to result in the ECB gradually succumbing to short-​term political pressures on many fronts –​hardly an ideal scenario to ensure that the euro survives in the longer term. On the other hand, if the ECB adopts the German preferred option, and refocuses on conventional monetary policy alone, the commitment to do “whatever it takes” to protect the euro will become doubtful. The Single Supervisory Mechanism will need to remain within the ECB, however, unless the TFEU can be changed, which requires unanimity and is, therefore, unlikely. It is nevertheless an open question as to whether the new president of the ECB, Christine Lagarde, who will succeed Draghi in November 2019, will continue the policy of “whatever it takes”. Meanwhile, discussions about the incomplete architecture of the euro continue unabated, with Draghi recently proposing an “additional fiscal instrument to maintain convergence during large shocks”, as well as stressing the need for a properly designed European deposit insurance scheme (Draghi 2018). By highlighting the incompleteness of the euro’s architecture even while entering his last year of office, Draghi may be thinking that he is continuing to “do whatever it takes to save the euro”, and that this will be his long-​term legacy. Inevitably, however, his legacy will be re-​examined if his lack of attention to the more mundane civil engineering side of the project results in further erosions of the very foundation of the monetary union –​namely central bank independence. 12

Central bank roles: historical context

This work evaluates the extent to which central bank independence in the euro area has already been eroded and why that represents a threat to the future of the euro. It also endeavours to provide answers that could minimize those risks. It sets off in Chapter 2 by examining the case for CBI and reviews its origins, scope and limits in the context of Europe. Chapter 3 ties together the theoretical contribution of the book by bringing in the multiple elements of crisis management and prevention. Chapter 4 focuses on the ECB’s policies during the crisis, and explains why the central bank had to introduce non-​standard measures, including its controversial bond-​purchasing programme and quantitative easing. Chapter 5 explains how the ECB addressed redenomination risk in 2012 with the advent of the Outright Monetary Transactions programme, which was meant to provide substance to “whatever it takes”, highlighting its neglected dimension of “within our mandate”, which involved considerable conditionality. Chapter 6 provides an overview of the banking union: its rationale, limitations and, as yet, incomplete architecture. Chapter 7 looks at small countries and explains why they matter; in a nutshell, the monetary union is as strong as its weakest link, so turning a blind eye to what is happening in the periphery is, therefore, naïve, if not also reckless. Chapter  8 discusses political money-​ laundering, in light of the newly emerged Russian threat and related geopolitical risks. Chapter  9 argues that the monetary union is now more vulnerable to shocks because of the erosion of its foundations, and puts forward six policy recommendations that, if implemented, would help to make it much more resilient.

13

2

Central bank independence in Europe: origins, scope and limits

Central bank independence and price stability There is a broad consensus within economics, based on both economic theory and empirical evidence, that central bank independence is a necessary condition for low and stable inflation.1 The idea behind CBI is a simple one: without it, elected politicians are likely to “bribe” voters by lowering interest rates before elections. Such reductions in interest rates will increase employment and output temporarily, but at the cost of permanently higher inflation. The backbone to this prediction is the notion that there is no permanent trade-​off between inflation and unemployment, typified by a vertical Phillips curve (see Box 2.1). In a world in which economic agents are rational, if monetary policy is in the hands of government, inflation targets will not be credible and an inflation bias will be created. Only by delegating monetary policy to independent central bankers is there a hope to remove inflation bias from the economy. CBI provides the foundations for low and stable inflation. On its own, however, it is not a sufficient condition. To start with, there are various degrees of independence. A central bank may have operational independence over the setting of policy rates but very little else. It may, for example, be compelled to finance government deficits –​a situation described as fiscal dominance. Under this scenario, the job of getting inflation under control can become a poisoned chalice. It means that the central bank should raise interest rates much more than would normally be the case, in order to curb the effects of

1. See, for example, Cukierman (1992), Alesina & Summers (1993) or Eijfinger & de Haan (1996). .

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Central Bank Independence and the Future of the Euro

fiscal profligacy on aggregate demand through crowding out private investment and consumption. Ideally, therefore, central banks must be independent enough to be able to refuse the financing of government deficits. Even so, to keep inflation under control, central banks must have a communication framework in place that helps them explain monetary policy decisions in a clear and transparent manner. The credibility of monetary policy and any inflation targets critically depends on such communication. In Europe, the architects of the Economic and Monetary Union (EMU) recognized the importance of central bank independence for the achievement of price stability and placed both at the heart of their project. Moreover, they included provisions that rule out the financing of government deficits, as well as strong independence safeguards for its central bankers, providing therefore what seemed like a solid foundation for the monetary union. The rest of this chapter provides the details, drawing on economic theory, empirical evidence and practice. Importantly, it also highlights the limited scope of central bank independence in the euro area and exposes some little-known weaknesses. The origins of CBI and EMU The historical origins of CBI can, in fact, be found in Germany during the aftermath of the Second World War, although Otmar Issing (2018) suggests that it was the Allies –​more precisely, the Americans –​who imposed it on the Bank deutscher Länder (BdL), the predecessor of the Bundesbank.2 That independence was codified in the Bundesbank Law of 1957, notwithstanding initial opposition by the then German chancellor, Konrad Adenauer. In the short period of its existence the BdL had earned considerable reputation and sufficient public support to overcome the German chancellor’s resistance. The Bundesbank clearly built on that reputation. In the three decades that followed, Germany had the lowest and most stable inflation rate among developed economies. That record certainly did not go unnoticed by the architects of EMU. But the Bundesbank itself was not a passive 2. The idea that central banks should not directly finance public deficits dates back to David Ricardo and John Maynard Keynes.

16

Central bank independence in Europe

actor in this process. During early discussions about EMU it removed its own objections to the establishment of the Delors Committee only when it was satisfied that the new system of central banks would be independent of political influence. To this end, the Delors Committee, established in June 1988 and chaired by the then president of the European Commission, Jacques Delors, did not include finance ministers at all, instead consisting of central bank governors, academics and Alexandre Lamfalussy, the then general manager of the Bank for International Settlements (BIS). The strong independence blueprint in the design of the European System of Central Banks (ESCB) was no accident. The architects of the European Union envisaged not only a single market for people, goods, services and capital but also the introduction of monetary union through a single currency, as the final stage of economic integration in Europe. The single currency was seen as demonstrating the irreversibility of the monetary union, as well as reducing transaction costs in the single market. The institutional architecture laid out in the “Delors Report” (Committee for the Study of Economic and Monetary Union 1987) guided the introduction of the single currency, through the creation of the ESCB, with price stability as its primary objective; supporting the economic policy of the “Community”  –​as the European Union was known then –​was a secondary objective. The structure envisaged the creation of an ESCB Council, comprising the governors of the central banks and a board that would oversee the implementation of the common monetary policy. Importantly, the ESCB Council was intended to be independent of national governments and “Community” authorities. This was expected to be achieved through appropriate security of tenure. The ESCB’s independence went hand in hand with its accountability to the European Parliament and the European Council. The European Central Bank, which is at the heart of the monetary union, was established by statute in 1998, alongside the European System of Central Banks. The latter comprises the national central banks (NCBs) of all EU member states, whether they have adopted the euro or not. By contrast, the Eurosystem (of central banks) comprises the ECB and the NCBs of member states that have adopted the euro. The NCBs of euro area member states are not totally separate from the ECB, as their governors are members of the ECB’s highest body –​the 17

Central Bank Independence and the Future of the Euro

European Central Bank

Governing Council. The ECB Governing Council additionally includes the ECB’s six executive board members, two of which are the president and vice president. The Eurosystem’s governance is thus interlinked and interconnected; ECB decisions can be influenced by the NCBs (see Figure  2.1). Ultimately, the ECB’s ability to act independently from national governments is, therefore, inextricably linked to the independence of the governors of the 19 euro area NCBs. Largely for this reason, the full minutes of the ECB Governing Council remain secret for 30 years. This is intended to protect NCB governors from undue political pressure from their national governments. The ECB also has a General Council, which includes the governors from all EU member states’ central banks. The General Council is not a decision-​making body, however, as the ECB can determine policy only for the euro area. The General Council, therefore, meets less frequently than the Governing Council. The euro area was created in January 1999, initially with 11 member states (Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain), although euro banknotes did not start circulating until 1 January 2002. Currently there are 19 countries that have adopted the euro: Greece, which joined in 2001; Slovenia, in 2007; Cyprus and Malta, in 2008; Slovakia, in 2009; Estonia, in 2011; Latvia, in 2014; and Lithuania, in 2015.

Governing Council

Executive board members + governors of 19 eurozone central banks

Executive Board

ECB president and vice president + 4 executive members appointed by eurozone leaders

General Council

ECB president and vice president + governors of 28 EU member state central banks

Figure 2.1  ESCB governance 18

Central bank independence in Europe

The independence of both the ESCB and the ECB is laid out in Article 130 of the Treaty on the Functioning of the European Union, which states: When exercising the powers and carrying out the tasks and duties conferred upon them by the Treaties and the Statute of the ESCB and of the ECB, neither the European Central Bank, nor a national central bank, nor any member of their decision-​making bodies shall seek or take instructions from Union institutions, bodies, offices or agencies, from any government of a Member State or from any other body. The Union institutions, bodies, offices or agencies and the governments of the Member States undertake to respect this principle and not to seek to influence the members of the decision-​making bodies of the European Central Bank or of the national central banks in the performance of their tasks. (European Commission 2012b: 104) This is widely considered as a relatively strong definition of independence because of the two-​way prohibition:  the ECB and ESCB are prohibited from seeking instructions from governments or EU institutions and governments, and EU institutions are prohibited from trying to influence the ECB or ESCB. In addition, as the independence is enshrined in the TFEU, it is very difficult, if not impossible, to modify. This does not of course mean that the independence is respected by the governments of all member states in practice and at all times. In fact, many of the examples provided elsewhere in this book (e.g. Cyprus, Greece, Hungary, Latvia, Slovenia) suggest that breaches of independence in relation to Eurosystem central banks –​whereby governments or other national bodies try to exert influence on their decisions –​are both frequent and not without consequences. Dynamic inconsistency In macroeconomics, the origins of the idea that CBI is essential for price stability can be found in the influential work of Finn Kydland and Edward Prescott (1977), which introduces the broader concept 19

Central Bank Independence and the Future of the Euro

of dynamic inconsistency into the context of rational expectations. Kydland and Prescott highlight a paradox present in dynamic economic systems in which economic agents form expectations about future policy actions. If agents expect policies to change in the future, as a result of changing economic circumstances, optimal actions by policy-​ makers today that do not take that into account can prove to be suboptimal in the future. This is because economic policy-​makers do not take into account the effect their policy rule has on the optimal decision rules of economic agents. One of the examples used by Kydland and Prescott to illustrate this problem is the trade-​off between inflation and unemployment, known as the Phillips curve, which depends on actual inflation turning out to be higher than expected. Policy-​makers who use discretion instead of rules can exploit the trade-​off in the short-​run to generate more employment at the cost of higher inflation. Rational economic agents are aware that policy-​makers have an incentive to do this, however, and will therefore maintain their expectations at a level that is above the optimum. As a result, consistent policy-​making creates a positive inflation bias and is time-​inconsistent. By contrast, committing in advance to a rules-​based policy, if it is credible, can eliminate the inflation bias.

BOX 2.1 THE PHILLIPS CURVE AND RATIONAL EXPECTATIONS

The Phillips curve is a term that is often used by economists to portray the short-​run trade-​off between inflation and unemployment. It is usually drawn as a non-​linear relationship, with inflation approaching infinity as unemployment approaches zero, and vice versa. The relationship was named after William Phillips, an economist born in New Zealand who, in 1958, published a paper showing an inverse relationship between the rate of change of money wages and unemployment in the British economy from 1861 to 1975 (Phillips 1958). The Phillips curve gained popularity in the 1960s once leading American economists Paul Samuelson and Robert Solow made the link between (price) inflation and unemployment more explicit. In the 1970s, however, as both inflation and unemployment were rising –​a situation described as stagflation –​the Phillips curve came under severe

20

Central bank independence in Europe

criticism. Monetarist economists, such as Milton Friedman, put forward the idea that the Phillips curve was only a short-​run phenomenon and that there could be no permanent trade-​off between inflation and unemployment. Friedman and other economists proposed augmenting the Phillips curve by introducing inflation expectations into the analysis. There was a different Phillips curve for each and every rate of expected inflation. The trade-​off existed as long as actual inflation differed from what was expected –​and this was possible only in the short run. Policy-​makers could still buy lower unemployment but only if they managed to “fool” economic agents by engineering higher inflation. In the long run, however, when actual and expected inflation are equal, unemployment would return to its “natural rate”, determined by the structural features of the labour market. A new wave of attacks on the Phillips curve emerged from the new classical school, led by economists such as Robert Lucas and Thomas Sargent, who put forward the idea of rational expectations, by which economic agents could not be fooled even in the short run. Rational economic agents, they argued, would try to use the true model of the economy and take into account all available information when forming inflation expectations. Thus, any short-​run trade-​off between inflation and unemployment would quickly disappear as economic agents learn about the true model of the economy. The idea –​which became known as the Lucas critique –​means that, under rational expectations, there is very little scope for meaningful stabilization policy, even in the short run. There is now widespread consensus among economists that equilibrium unemployment is determined by the structural features of the economy. No sensible policy-​maker would, therefore, attempt to keep unemployment below its equilibrium level. The Phillips curve idea of a short-​run trade-​off between inflation and unemployment has survived the test of time, however. Expectations-​augmented Phillips –​even with some form of rational expectations –​can be useful for analysing policy choices in the short run. Having said this, the theoretical underpinnings of any short-​run trade-​off between inflation and unemployment rely more on labour market imperfections or sluggish dynamics than on economic agents being “fooled” by policy-​makers.

21

Central Bank Independence and the Future of the Euro

Kydland and Prescott conclude that economic policy should be based on simple and easily understood rules, and mention that “there could be institutional arrangements that make it difficult and time-​consuming process to change the policy rules in all but emergency situations” (Kydland & Prescott 1977: 487). They do not so much as mention central banks, however, let alone CBI. It was Robert Barro and David Gordon (1983a; 1983b) who developed the idea further into the realm of central banks, in their attempt to explain why many countries had failed to reduce inflation. Specifically, they embedded the simple Phillips curve model of Kydland and Prescott into a repeated game framework, which allowed them to examine questions of central bank credibility and reputation. The conclusion that emerged from their work was that the time inconsistency problem could be mitigated by a central bank that wanted to protect its reputation. The idea that an independent and conservative central banker could restore central bank credibility was put forward by Kenneth Rogoff (1985), however. The earliest empirical work to show an inverse relationship between the degree of CBI and inflation was a paper by Robin Bade and Michael Parkin (1980) that was never published –​which seems to indicate that the idea of CBI was not particularly popular at that time. Political business cycles The view that CBI is important for price stability started gaining momentum in macroeconomics in the late 1980s, following influential contributions by Alberto Alesina (1988), Alex Cukierman and Allan Meltzer (1986) and Kenneth Rogoff and Anne Sibert (1988). These papers resuscitated earlier work on political business cycles by William Nordhaus (1975) that had remained largely neglected by macroeconomists because of its apparent inconsistency with rational expectations. Nordhaus proposes that inflation bias arises because governments overstimulate the economy before elections and then reduce inflation with a recession at the start of their new term of office. This, in effect, implicitly assumes that voters are systematically fooled by politicians. As such, it contrasts sharply with the idea of rational expectations, which was becoming popular in macroeconomics in the 1970s. As Alesina (1988) explains, however, Nordhaus’s idea can be 22

Central bank independence in Europe

reconciled with rational expectations, as long as voters have imperfect information about some aspects of policy-​makers’ preference or the economic environment in which they are operating. This can be about the realization of shocks (Cukierman & Meltzer 1986) or the competence of policy-​makers (e.g. Rogoff & Sibert 1988). Politicians who want to appear competent may engage in highly visible expenditures, such as personal transfers, prior to an election financed by monetary financing from the central bank. Voters may be fooled if they do not have enough information about the inflationary consequences of such actions but need not be irrational (this may be because they do not have full information about the budget). A broad conclusion that emerges from the theoretical literature, irrespective of model specifics, is that elected politicians who commit to keep inflation low will always have an incentive to generate higher inflation before an election in order to reduce unemployment.3 This can happen even with rational expectations, as long as there are information imperfections. Thus, a political business cycle can be generated with higher public spending prior to elections, financed by central bank money that generates an inflation bias. Rational economic agents know this and will, therefore, not believe the commitment when it is announced. The commitment to keep inflation low and stable is, therefore, dynamically inconsistent. This inflation bias has no benefit, in terms of reducing unemployment, as the Phillips curve is vertical in the long run. The long run occurs when actual and expected inflation are equal and unemployment is at its “natural rate”. By contrast, if monetary policy is delegated to an independent central bank that is inflation-​averse, there will be no incentive to inflate before an election. Delegation to an independent central bank can therefore act as a credible commitment device. Inflation bias will disappear and inflation will, in equilibrium, be lower than otherwise 3. A more nuanced version of the political business cycle is offered by Paul Tucker (2018), who argues that, even in the middle of their term, politicians have an incentive to inflate in order to boost approval ratings in opinion polls. That may explain why political business cycles are not very pronounced in the data, and provides an additional reason why the delegation of monetary policy to an independent central bank eliminates inflation bias.

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Central Bank Independence and the Future of the Euro

without unemployment being higher. For delegation to succeed, central bankers need to be more inflation-​averse than the “median voter”, and it should not be possible for the “median voter” –​who may be time-​ inconsistent –​to remove them from office. Moreover, the commitment of the central bank to low inflation can be further enhanced if the central bank is prohibited from financing government deficits by law, as is the case with Eurosystem central banks. Empirical evidence The early empirical evidence on the relationship between macroeconomic performance and CBI (e.g. Alesina & Summers 1993) utilized measures of “political independence” and “economic independence”. The former was based on the relationship between the central bank and the government and included the procedure for the appointment and dismissal of central bank governors, the length of term of central bank governors, the presence and role of government officials on central bank boards (e.g. do they have veto power on central bank decisions?) and the frequency of contact between the central bank and the government. “Economic independence” takes into account the extent to which the central bank is free to choose instruments of monetary policy. A common restriction is the requirement placed upon a central bank to finance the government deficit. If it is easy for the government to finance its deficits through the creation of central bank money, the central bank is deemed to lack economic independence. The central banks that emerge at the top of both the political and the economic independence rankings in the study by Alberto Alesina and Lawrence Summers (1993) were the Bundesbank and the Swiss National Bank. When the two indices are combined the Fed was found to be the third most independent central bank, followed by Canada, Denmark, Japan and the Netherlands. At the other end of the spectrum were New Zealand, Spain and Italy. Alesina and Summers (1993) find a strong negative relationship between both the level and variability of inflation and CBI. This suggests that countries with more independent central banks, such as Germany, experience lower and more stable inflation (see also Figure 2.2). The early empirical studies did not find evidence of a significant relationship between CBI and other 24

0 1945 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Inflation Rate

newgenrtpdf

30

25

20

15

10

5

-5 Year

(West) Germany

Figure 2.2  Inflation rates in selected countries, 1945–​2017 United Kingdom New Zealand United States

Central Bank Independence and the Future of the Euro

indicators of macroeconomic performance, however (see Eijffinger & de Haan 1996).4 New Zealand was, in fact, the first among the developed countries to move towards greater CBI in an attempt to improve its record on inflation. To this end, in April 1988 New Zealand also adopted an inflation target that would serve as an anchor for expectations. New Zealand’s success in bringing down inflation rapidly and at relatively little output loss meant that the idea caught on quickly:  Sweden and Australia followed in 1993. The Bank of England was granted operational independence in 1997, under the New Labour government of Tony Blair. Previously, Conservative prime ministers John Major and Margaret Thatcher had rejected the idea, refusing to give up government control over interest rates. Goal versus instrument independence CBI is often defined in relation to central bank goals or instruments. Goal independence refers to the ability of the central bank to set its own goals for monetary policy, while instrument independence refers to the ability of the central bank to decide on the instruments of monetary policy without political interference. Central banks that have both goal and instrument independence are clearly more independent than those that have instrument independence alone. The case for instrument independence is a compelling one, if not also a minimal requirement for CBI. It is hard to see how a central bank can function independently of government without being able to choose the instruments of monetary policy. The Bank of England is a good example of a central bank that has instrument independence but not

4. More recent studies are consistent with the early empirical literature. For example, Nergiz Dincer and Barry Eichengreen (2014), who construct comprehensive measures of CBI for more than 100 central banks, find that inflation variability is affected by both central bank independence and transparency. Their caveat is that it is difficult to disentangle the impact of CBI from central bank transparency, as both measures of central bank arrangements increased steadily during the period under consideration (1998 to 2010).

26

Central bank independence in Europe

goal independence. The UK government sets the inflation target at 2 per cent. The standard instrument used by the BoE has been the bank rate. During the crisis, however, when rates hit the floor, the bank undertook QE –​large-​scale asset purchases of mainly UK government bonds, or gilts, which began in 2009. The case for goal independence is much less compelling than the one for instrument independence. In fact, in a democratic society, it is not obvious why the goals of monetary policy should be delegated to unelected officials. Having clear and transparent goals decided democratically by the electorate through the political process makes it easier to hold central banks accountable, which enhances the legitimacy of CBI. Although this is true, if these goals are too prescriptive –​for example, a specific inflation target as opposed to the broad objective of “price stability” –​the independence of the central bank, as well as accountability, can be eroded. This can happen if governments change the inflation target frequently, or introduce additional objectives. By itself, such a scenario can reintroduce the dynamic inconsistency problem, if not also the political business cycle, through the back door. Goal independence is, therefore, helpful to protect against possible dynamic inconsistency, and can be reconciled with accountability and legitimacy with a clear mandate that cannot easily be changed. The ESCB is a good example in this regard. Its primary objective, which is defined in Article 127 of the Treaty on the Functioning of the European Union, is to maintain price stability. This broadly defined objective cannot easily be altered, as changing the TFEU requires unanimity by all EU member states. The Governing Council interprets the objective as keeping inflation rates below, but close to, 2 per cent over the medium term. In this sense, the ECB has goal independence, within its broad mandate of price stability, which has been democratically decided. Although the target has never been changed since 1998, the year the ECB was founded, it can, in principle, be changed if economic circumstances dictate a different interpretation of price stability. Even if the headline target of “below, but close to, 2 percent” is not changed, a different or more precise interpretation of what is “below, but close to, 2 percent”, and/​or the “medium term”, is well within the Governing Council’s authority.

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Central Bank Independence and the Future of the Euro

Fiscal dominance versus monetary dominance Part of the reason why independent central banks, including the Bundesbank, have been successful in controlling inflation is that they were prohibited from financing government deficits. If a central bank is forced to print money to finance government deficits, its ability to control inflation is severely undermined. No amount of independence over instruments or goals of monetary policy can overcome the inflationary consequences of deficit financing. The situation in which a central bank systematically finances government deficits is known as “fiscal dominance” and is clearly inconsistent with a mandate of price stability. Independence means little in these circumstances. Even if central banks are not compelled to finance government deficits, if they are not legally prohibited from doing so, it is inevitable that they will come under political pressure when governments are in  difficulty; given the pressures on politicians, this is likely to be often. Even fiscally responsible governments will be compelled to resort to central bank borrowing when the economy is hit by negative shocks. The ECB and ESCB, with the exception of the United Kingdom,5 are explicitly prohibited from financing government deficits; this is known as “the prohibition of monetary financing”. Specifically, Article 123 of the TFEU, from which the United Kingdom is exempt, states: 1. Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as “national central banks”) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public

5. The United Kingdom has a special and unique status, as it has refused to accept the objective of a monetary union. It has, therefore, retained its powers in the field of monetary policy according to national law, and is not bound by the articles relating to the independence of the central bank and the obligation of compatibility of its legislation with the treaty. Denmark has a similar “special” status, which allows national law to apply to monetary policy.

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Central bank independence in Europe

undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments. 2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions. (European Commission 2012b: 99) The prohibition of monetary financing shields the ECB and national central banks from undue political pressures to finance government deficits and is intended to create stronger incentives for sound fiscal policies. Thus, the euro area can, in principle, be characterized as an area of “monetary dominance” over “fiscal dominance”. Even so, at times of difficulty Eurosystem central banks have come under pressure by their respective governments to help reduce public debt through sales of gold reserves.6 Financial and personal independence Monetary dominance clearly helps to safeguard CBI, but by itself it is not sufficient to ensure that a central bank can act independently from the government. Financial independence of the central bank is another important dimension. If a central bank budget needs to be approved by government or parliament, a central bank will almost certainly come under political pressure that would jeopardize its independence. Financial independence for a central bank entails having sufficient resources to carry out all the tasks and functions it deems necessary to achieve its objectives. To this end, the central bank needs to generate enough revenue through its monetary

6. During the crisis in 2013 the Cypriot government exerted political pressure on the central bank, through public statements, as well as the central bank board, to sell its gold reserves. For more details, see Demetriades (2017b).

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Central Bank Independence and the Future of the Euro

policy operations, investments and other activities to cover its costs. Importantly, it should be able to attract and retain sufficiently high-​ quality staff and have adequate premises, infrastructure and facilities. Any profits generated can be distributed back to government only once adequate provisions are made and only if the central bank is adequately capitalized. Adequate levels of central bank capital are needed to protect the central bank against losses, which may occur, for example, if a bank that has borrowed from the central bank fails or if there is a decline in the value of a central bank’s portfolio of assets. Central bank investment policy needs therefore to be sufficiently prudent to minimize losses, although that has to be balanced against the need to generate sufficient income. In the case of the ECB, its financial independence is enshrined in Article 282(3) of the TFEU, which is interpreted as meaning that it has “budgetary autonomy, sufficient capital, staff and income to perform independently the tasks conferred on it by the Treaty and the Statute of the ESCB” (Mersch 2017). The ECB’s capital is subscribed and paid by the euro area NCBs. Its accounts are audited by independent external auditors recommended by the ECB and approved by the Governing Council, while the competence of the European Court of Auditors (ECA) is limited to examining the operational efficiency of the management of the ECB. Other provisions of CBI relate to the personal independence of monetary policy decision-​makers, which is aimed at safeguarding their ability to make decisions free from external influence. To this end, central bank governors are appointed for a minimum term of five years and can be removed from office only in the event of incapacity or serious misconduct.7 The five-​year minimum term applies to all ESCB governors; some (e.g. the Netherlands) have terms that are longer than the electoral cycle. In the case of the ECB, members of the executive board, including the president and vice president, are appointed for a period of eight years and cannot be reappointed. The dismissal of any member of the ECB Governing Council (executive board member or Eurosystem

7. This is usually taken to mean being found guilty by a criminal court for a serious criminal offence.

30

Central bank independence in Europe

central bank governors) is subject to the scrutiny of the Court of Justice of the European Union. By contrast, however, the personal independence of other members of a central bank’s governing body, including deputy governors and non-​executive members of a central bank’s board, is not protected by the TFEU and can, as a result, vary widely even within the Eurosystem. Governments can easily lean on members of central bank boards whose independence is not protected. That can limit the financial and personal independence of governors, as more often than not central bank budgets need to be approved by the boards. Scope of central bank independence In terms of macroeconomic theory, central bank independence is almost always rationalized in the context of achieving low and stable inflation. Central banks often carry out many other functions, however, such as bank supervision and resolution. The question therefore arises as to whether the scope for CBI covers these additional functions. This is particularly important in the context of the euro area, for two reasons. First, many euro area central banks have supervisory and/​or resolution mandates. Second, the ECB has been supervising banks through the Single Supervisory Mechanism since 2014. Interestingly, the SSM regulation was introduced without a change in the treaty but with secondary legislation, the advantage being that it was possible to put it together in record time, as the idea of a banking union started being discussed only in 2012. A change in the TFEU, which requires unanimity, would have taken much longer, if indeed it could ever be agreed. The SSM was established through European Council Regulation no. 1024/​2013 of 15 October 2013, which confers specific tasks on the ECB concerning policies relating to the prudential supervision of credit institutions. The SSM regulation confers powers on the ECB to oversee banking supervision in cooperation with the national supervisors (about a half of which are the NCBs). All euro area countries participate automatically in the SSM, while other EU countries can choose to participate through “close cooperation” with the ECB. The ECB directly

31

Central Bank Independence and the Future of the Euro

supervises 119 significant banks, which hold almost 82 per cent of banking assets in the euro area. Less significant institutions continue to be supervised by their national supervisors in close cooperation with the ECB. At the heart of the SSM there is a supervisory board, consisting of a chair, a vice chair, four ECB representatives and representatives of national supervisors. The board meets twice a month to discuss, plan and carry out the ECB’s supervisory tasks. Regulation no.  1024/​ 2013 envisages that supervisory functions should be carried out in full separation from monetary policy, in order to avoid conflicts of interest and to ensure that each function is carried out in accordance with its applicable objectives. Article 19 in the regulation provides the provisions of the SSM’s independence. It stipulates that the members of the supervisory board “shall act independently and objectively and in the interests of the Union as a whole and shall neither seek nor take instructions from the institutions of bodes of the Union, from any government of a Member State or from any other public or private body”. SSM is, therefore, in theory independent, although its independence safeguards are hardly comparable to those pertaining to the monetary policy function. Members of the supervisory board other than the chair, vice chair and ECB representatives have no safeguards as to their own personal independence. They are normally employees of the national competent authorities, and, as such, they can be vulnerable to political and other pressures. They have no minimum term of office and may also be arbitrarily dismissed. This may be particularly problematic in cases when the national competent authority is not a central bank and lacks sufficient budgetary independence. Even in cases when the national competent authority is a central bank, if a supervisor has no protection for their personal independence, they could still be subjected to undue political influence. For example, a deputy central bank governor, who may be a member of the supervisory board, can be dismissed arbitrarily, and can therefore be more susceptible to influence by a national government or powerful private sector bodies. Yves Mersch (2017) provides a rationalization of the current set-​up, although it is hard to accept that, even if the architecture was designed from scratch, the current arrangement would be anything other than second best. Specifically, he argues that the ECB’s independence, albeit

32

Central bank independence in Europe

strong, is defined very narrowly as it is aimed at protecting its monetary function in its pursuit of its primary objective of price stability. The key advantage of such a narrow definition is that it enhances the central bank’s legitimacy, as independence places a central bank outside the normal process of democratic and political accountability. A clear and narrow mandate, Mersch (2017) argues, makes it easier for citizens to monitor its performance. Mersch (2017) also explains that the principle of independence, as stipulated by Article 130 of the TFEU, cannot be applied to the ECB’s supervisory functions, as the SSM regulation constitutes secondary legislation and has little to do with the pursuit of the price stability mandate. Indeed, he also argues that the ECB’s discretion in carrying out its supervisory tasks is confined by decisions taken by European or national legislators or regulators, such as the European Banking Authority (EBA) and the European Commission. As supervisors are required to act in response to actions or decisions made by other policy-​makers and other supervisors, he concludes that “the high level of protection from external influence that is guaranteed under Article 130 of the Treaty is not appropriate for these tasks”. Moreover, he explains that the personal independence of the members of the supervisory board, apart from the chair, vice chair and ECB representatives, is not protected under the SSM regulation. As a result, they can be arbitrarily dismissed and have no minimum term of office. Such a narrow interpretation of the scope of the ECB’s independence could prove highly problematic for bank supervisors in the euro area, however, since it appears to be inconsistent with the Basel Committee’s Core Principles for Effective Banking Supervision, as revised in 2012. Principle 2 states: Principle 2 –​Independence, accountability, resourcing and legal protection for supervisors: The supervisor possesses operational independence, transparent processes, sound governance, budgetary processes that do not undermine autonomy and adequate resources, and is accountable for the discharge of its duties and use of its resources. The legal framework for banking supervision includes legal protection for the supervisor. (Basel Committee on Banking Supervision 2012: 10)

33

Central Bank Independence and the Future of the Euro

The extent to which the SSM adheres to principle 2 is, therefore, ambiguous. Mersch’s interpretation, in particular, suggests that the ECB would be reluctant to defend the independence of supervisors in practice. The above analysis is also relevant to banking supervision in the cases when it is housed within Eurosystem central banks, as TFEU protection is offered only to their governors and only in relation to monetary policy decision-​making. National law applies to the central bank itself but the extent to which this protects supervisory functions is subject to national law. The extent to which banking supervision enjoys the same independence as the monetary policy function remains, therefore, a matter of interpretation and considerable doubt. The interpretations provided by Mersch –​who has responsibility over legal services at the ECB –​cannot be reassuring for supervisors in the euro area, whether they are located in Frankfurt or member states.8 Limits of CBI in the euro area Although Eurosystem central banks are independent, personal independence safeguards are available only for governors. Such safeguards do not usually apply to deputy governors or other members of central bank governing bodies. In practice, this can prove to be highly problematic, and can encroach on the independence of the institution and its governor alike. By controlling the central bank board, a member state government can undermine both the financial independence of the central bank, through control of its budget and resources, and the independence of its governor. A number of examples of how this can happen in practice are available in Demetriades (2017b) (see also Chapter 7). It is not an exaggeration to say that a Eurosystem central bank governor’s 8. Legal scholars, such as Rosa Lastra (2017), acknowledge that the design of central bank independence for financial stability goals is much more complex than that of monetary policy. This is because monetary policy responsibilities are relatively simple and are characterized by perfect correspondence between one goal –​price stability –​and one instrument –​monetary policy. By contrast, the pursuit of financial stability is characterized by multiple instruments (supervision, regulation, crisis management, lender of last resort), and often supervision is also aimed at other goals, such as consumer protection.

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Central bank independence in Europe

independence can be almost nullified when it comes to any central bank function other than monetary policy. Last but not least, as former ECB executive board member Lorenzo Bini Smaghi put it in a speech at the Hungarian National Assembly in 2007, “legal provisions are necessary, but not sufficient to ensure central bank independence. The incentives to circumvent the legal framework, with a view to influencing the behaviour of the central bank, are always looming” (Smaghi 2007). He explains that, when the central bank is involved in banking supervision, its financial and personal independence are likely to come under pressure, and he argues that, “in such cases, central bank independence should be monitored particularly attentively”. Smaghi’s speech was clearly made in anticipation of trends in Hungary, but proved rather ineffective in deterring the erosion of the Hungarian central bank’s independence that followed. On 17 January 2012 the European Commission launched an infringement procedure against Hungary over the independence of its central bank, Magyar Nemzeti Bank (MNB). On 19 July 2012, however, it announced that it had closed the procedure “thanks to the adoption by the Hungarian Parliament of legal amendments to the central bank statute”, and went on to say: “The Commission will now scrutinize closely the implementation of Hungary’s commitment to respect the independence of the MNB” (European Commission 2012a). The Commission’s actions were hardly effective. In February 2014 the ECB had to issue a new warning to Hungary to the effect that the government could not threaten central bankers with dismissal. In 2016 the ECB criticized the MNB for taking over state tasks, potentially conflicting with the monetary financing prohibition. Although Hungary is widely believed to provide the most serious example of violation of the provisions of the TFEU relating to central bank independence to date, it is by no means the only one. The case of Cyprus during 2013/​14 was equally serious, and resulted in several public warnings to the Anastasiades government, issued by both the ECB and the Commission. As the infringement procedure was never initiated by the Commission, however, these warnings did nothing to change the situation, which eventually led to the resignation of the governor in April 2014 (Demetriades 2017b). Slovenia and Latvia also witnessed serious violations of their central bank governors’ independence that culminated, respectively, in their 35

Central Bank Independence and the Future of the Euro

resignation and suspension from office. Bostjan Jazbec, Slovenia’s governor, announced his resignation in March 2018 and referred to “intolerable” death threats to himself and his children, which he believed were related to the bail-​in of local banks in 2013. In addition, Jazbec was subjected to police investigations, as well as a campaign of intimidation by local media that included comments about “lynching” by readers. The case of the Latvian central bank governor, Ilmārs Rimšēvičs, erupted unexpectedly in February 2018, following allegations of corruption made by a small Russian-​owned bank. The response of the Latvian authorities was immediate: the governor was suspended from duty at the central bank and prevented from attending ECB Governing Council meetings in Frankfurt. The ECB subsequently applied to the European Court of Justice (ECJ) to opine whether the actions taken by the Latvian authorities were consistent with the TFEU. The court’s verdict, issued on 1 December 2018, found that Latvia had violated EU law by barring its central bank governor from office. According to a statement by the ECJ, “There is, therefore, no evidence before the Court that would allow it to ascertain whether the allegations made against Mr Rimšēvičs are well founded.” Nonetheless, Latvia continues to prosecute Rimšēvičs for corruption under national law, notwithstanding the ECJ verdict. This situation has set a new precedent in the euro area, whereby central bank governors can, in effect, be removed from office expeditiously and without due process. Concluding remarks Although central bank independence in Europe has strong legal safeguards, it is narrow in scope in that it protects only members of the Governing Council and only when it is clearly in relation to their monetary policy functions. Much else remains in a grey area, although legal scholars have argued that the tasks and duties of the ECB and the Eurosystem are not limited to monetary policy. Enforcement by the European Commission  –​which has the mandate to uphold EU law –​has been ineffective, however, especially in relation to the independence of the central banks of member states. This may reflect the lack of a sufficient range of enforcement mechanisms in combination with the “realpolitik” that successive European Commissions have 36

Central bank independence in Europe

engaged in. Often the Commission has protected certain governments by turning a blind eye to violations, perhaps because it did not consider them serious enough to take drastic action (see, e.g., Vassileva & Demetriades 2019). The only enforcement mechanism available is indeed a drastic one, and comprises the launch of infringement proceedings. The Commission has been reluctant to take such drastic action, however, even in the face of blatant violations of CBI, as was the case with Hungary and Cyprus. Warnings issued by the ECB itself have certainly proved ineffective. The protection of the independence of Eurosystem central banks is, therefore, proving to be illusory, notwithstanding the provisions of the TFEU.9

9. One might argue that the independence of the ECB itself is not affected, but that would be wrong. After all, on the Governing Council of the ECB, 19 of the 25 members of the ECB’s Governing Council are the Eurosystem central bank governors. 37

3

Crisis management and legitimacy

Central banks as firefighters When the global financial crisis erupted in 2007, central banks were unprepared. Their policies, since adopting inflation targeting, formally or informally at different points since the 1980s, had focused almost exclusively on achieving their inflation targets. Price stability was, of course, intended to provide the basis for economic and financial stability. The crisis was not meant to happen. Central banks –​more broadly, macroeconomics –​failed to see it coming. This was the first blow to their credibility, even though central banks were, in a sense, a victim of their own success. A decade of macroeconomic stability sowed the seeds for the subprime crisis. Risks were neglected or underestimated, very much in line with Hyman Minsky’s (1992) financial instability hypothesis or Claudio Borio and William White’s (2004) “paradox of credibility”. Distorted incentives in the financial system, combined with imperfect information, meant that complex and opaque financial instruments, such as collateralized debt obligations (CDOs) backed by mortgage-​ backed securities (MBSs), could be created. These instruments transferred risk from those who originated subprime loans in the United States to banks not only in that country but also in the European Union and Iceland. Total risks on bank balance sheets were underestimated, partly because of grade inflation by credit rating agencies and partly because of lax regulatory practices that allowed large international banks to use their own risk models. As a result, banks did not have sufficient capital to absorb losses, although their capital adequacy met regulatory standards. This was reflected in a dramatic increase in bank leverage –​the ratio of bank assets to equity –​as leverage that does not

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Central Bank Independence and the Future of the Euro

depend on risk weights. Risk weights themselves were falling, because of the proliferation of triple-​A-​rated assets, while aggregate risk in balance sheets, as well as in the financial system, was rising.

BOX 3.1 HYMAN MINSKY AND THE FINANCIAL INSTABILITY HYPOTHESIS

Hyman Minsky (1919–1996) was a distinguished scholar at the Jerome Levy Economics Institute of Bard College and professor of economics at Washington University in St Louis. His views were influenced by John Maynard Keynes and Alvin Hansen, one of the leading disciples of Keynes in the United States. Minsky was uncomfortable with the way in which many mainstream economists interpreted Keynes, however, and rejected conventional ideas, such as the efficient market hypothesis (EMH). Instead he put forward what he called the “financial instability hypothesis”, for which he became famous posthumously. Minsky, somewhat prophetically, argued that, during a prolonged period of prosperity, investors take on more and more risk, until a point is reached at which lending exceeds what borrowers can repay from their income. Sooner or later such over-​indebtedness results in forced sales of assets and a downward spiral in financial markets, creating a severe demand for cash –​an event now known as a “Minsky moment”. In Minsky’s financial instability hypothesis, over-​indebtedness is the result of false beliefs about risk. As such, it is at odds with neoclassical economics, which assumes that agents are rational, know the true model of the economy and cannot be systematically misled. Minsky’s ideas are much more palatable nowadays, however, as behavioural approaches to economics are gaining popularity. Minsky’s logic has been described as the “paradox of credibility” by economists at the Bank for International Settlements (Borio & Lowe 2002; Borio & White 2004). When everyone believes that risk has declined, they behave in such a way as to make the economy riskier. Although many economists may be uncomfortable with models based on “false beliefs”, Minsky’s ideas provide useful insights into the circumstances that led to the build-​up of risk prior to the eruption of the subprime crisis in the United States, as well as the subsequent financial crisis.

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Crisis management and legitimacy

When the US property bubble finally burst, and risks began to be reassessed, money markets started to freeze, from the autumn of 2007. The collapse of Lehman Brothers on 15 September 2008 was a massive shock to confidence: if Lehman could collapse without being bailed out, no bank could be considered safe. Central banks and governments had to act, and had to act quickly. But their legitimacy and credibility were already waning. Policy rates were quickly brought down to near zero, first in the United States and the United Kingdom, and eventually also in the euro area (see Figure 3.1). Governments provided bailout funds to shore up the depleted capital buffers of systemic banks, to prevent them from failing, as bank balance sheets were impaired due to asset revaluations or write-​downs. With bank solvency restored by governments, central banks could then provide the necessary liquidity to prevent financial meltdown. Aggregate demand had collapsed because of the credit crunch, however. Limited fiscal space, partly as a result of the pressures on public finances exerted by bank bailouts, meant that any fiscal stimulus in response to the crisis –​ provided soon after the crisis erupted –​was short-​lived. Markets started punishing governments whose public finances were deteriorating with higher borrowing costs. Economies went deeper into recession (see Figure  3.2). Aggregate demand collapsed and conventional monetary policy had reached its limits. Bank balance sheets deteriorated further 6

Policy rate (%)

5 4 3 2 1 0

2007

2008

2009

2010

2011 2012 Year

United Kingdom

2013

United States

2014

2015

2016

Euro area

Figure 3.1  Policy rates United Kingdom, United States and euro area, 2007–​2016 Sources: Bank of England, European Central Bank and Federal Reserve. 41

Central Bank Independence and the Future of the Euro

United Kingdom

United States

Euro Area

4.5 4.0 3.5 3.0

%

2.5 2.0 1.5 1.0 0.5 0.0 –0.5

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

–1.0 Euro Area

United Kingdom

United States

4.0 3.0 2.0 1.0 %

0.0 –1.0

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

–2.0 –3.0 –4.0 –5.0

Figure 3.2  Inflation rates (top) and GDP growth rates (bottom), 2007–​2016

and inflation rates started declining towards negative territory (see Figure 3.2). The ugly head of debt deflation was beginning to show its face. Central banks faced another challenge to their credibility. Not only did they not foresee the global financial crisis, they were criticized for not doing enough to prevent the economy from falling into the deflation trap. In response, central banks attempted to stimulate aggregate demand by making large scale asset purchases of securities in secondary markets. This non-standard policy, widely known as quantitative easing, allowed commercial banks to offload unwanted securities and eased 42

US$ billions

Crisis management and legitimacy

5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0

2007

2008

2009

Bank of England

2010

2011 2012 Year Federal Reserve

2013

2014

2015

2016

European Central Bank

Figure 3.3  Central bank balance sheets BoE, Fed, ECB, 2007–​2016 Sources: Bank of England, European Central Bank, Federal Reserve.

market liquidity conditions but inevitably resulted in a substantial expansion in central bank balance sheets (see Figure 3.3). Politicization of central banks Inadvertently, central banks became politicized. As markets began to punish governments whose public finances were going out of control, fiscal tightening or austerity became the norm. Legitimacy questions arose naturally. Banks were being propped up while ordinary citizens had to face cuts in public services and/​or higher taxes. At the same time central banks started using unconventional monetary policies to inject liquidity in the economy, which helped mitigate the impact of the crisis on asset prices. Arguably, such policies artificially inflated asset prices, raising questions about their distributional consequences;1 central banks were once again in the firing line, portrayed as helping the rich at the expense of the poor. This was a lose-​lose situation for central banks. Doing nothing would have resulted in financial meltdown and a repetition of the Great Depression of the 1930s. Acting as they did meant that they could be criticized for 1. For a political science analysis of the politicization of central banks due to their expanded roles in the crisis and the resulting democratic legitimacy questions, see Fernández-​Albertos (2015) and Jones and Matthijs (2019). 43

Central Bank Independence and the Future of the Euro

doing too much, not sticking to their mandates or adopting the wrong policies. Although central bankers such as the Federal Reserve’s Ben Bernanke understood that they were acting to prevent a catastrophe, the public at large, whose interest they were ultimately serving, remained sceptical, at best. This was partly because the public at large may not be familiar with the Great Depression, or, indeed, the concept of financial meltdown. Explaining what central banks are doing in normal times is one thing. But explaining what they are doing amidst a crisis, and why they are doing it, is much more challenging. To start with, the public is likely to be hostile to bankers, in any shape or form, who are seen as the cause of the crisis. Furthermore, while central bankers are busy firefighting, politicians can step into the communication vacuum and can either inform or misinform the general public. In such circumstances, fake narratives can easily be created, which may ultimately undermine central bank credibility and independence.

BOX 3.2 FAKE NARRATIVES IN THE CYPRUS CRISIS

In 2012/​13 Cyprus experienced the second most intense banking crisis in recorded history. At 57 per cent of national output, bank rescue costs equalled Indonesia’s in 1997 –​the world’s costliest banking crisis. In Indonesia the crisis resulted in the downfall of the regime of President Suharto. In Cyprus it resulted in the creation of a fake narrative that led to the erosion of the central bank’s independence. In March 2013 the newly elected government of Nicos Anastasiades faced some tough choices. The country’s two biggest banks were about to fail but had become too big to save with public money; their combined balance sheets had reached four times the country’s GDP, doubling in size from 2005 to 2010, largely due to the influx of Russian and Ukrainian  money. Loss-​ absorbing capacity within the banks was limited; even after bailing in shareholders and bondholders there was a shortfall of €5.8 billion (equivalent to over 30 per cent of GDP). Debt sustainability analysis by the International Monetary Fund (IMF) suggested that the only realistic way forward was a bail-​in of uninsured depositors. Anastasiades, however, had committed himself to not accepting a deposit “haircut” days before the election. Striving to rescue his credibility, he blamed the ECB for putting a “gun to his head” and the Central Bank of Cyprus for allegedly providing

44

Crisis management and legitimacy

the weapon of “blackmail” to the ECB. The “blackmail” boiled down to the Eurosystem continuing to supply liquidity to an insolvent banking system; without an economic adjustment programme, both the sovereign and the banks were insolvent. Since much rested on the estimates of the independent diagnostic exercise that exposed the true state of the banks, Anastasiades sided with bankers who had claimed that their banks were healthy. Conveniently, the bankers and the government criticized the central bank and PIMCO –​the company that carried out the diagnostic ­exercise –​for the adverse scenario in the stress test being too adverse. With the public at large not familiar with bank stress test methodology, even the existence of an adverse scenario sounded like a conspiracy by the central bank to “destroy our banking system” when the right spin was attached to it. With the help of large sections of the media –​which relied on the banks for much of their advertising revenue –​the fake narrative deflected attention from the deeper underlying cause of the crisis. This was none other than the business model created by Cyprus’s ruling elite, involving not only banks but also politically connected law firms, which helped introduce wealthy Russian and Ukrainian clients to the banks; one such firm belonged to the president’s immediate family. Although over time the fake narratives fizzled out, the damage to the central bank’s credibility and independence was long-​lasting. In the summer of 2013 changes to central bank governance were enacted that eroded the independence of the governor, notwithstanding a negative legal opinion issued by the ECB. These “reforms”, which included the creation of two new executive director posts reporting to the board of directors and not the governor, remain in place at the time of writing (March 2019), although there have been recent proposals for a new amendment to the central bank law, which have been met with a more positive response by the ECB.

The European dimension: the role of the ECB in the troika In Europe, lower policy rates were hitting savers in the North and were not fully transmitted to borrowing costs in the South. It was a lethal mix. The eruption of the Greek crisis found Europe unprepared for what was to follow. When the crisis became existential for the euro, 45

Central Bank Independence and the Future of the Euro

the ECB was forced to go much further into unconventional territory. Besides unconventional monetary policies such as outright monetary transactions (see Chapter  5), aimed at addressing the euro’s likely unravelling, the ECB took the lead in proposing banking reforms that would eventually create the banking union (discussed in Chapter  6), whose purpose was to break the sovereign-bank doom loop. Inevitably, and perhaps inadvertently, it was becoming more political. But what made it even more political and politicized was its involvement in the bailout programmes for Greece, Ireland, Portugal and Cyprus. The ECB, alongside the European Commission and the International Monetary Fund, became part of the “troika”2 of institutions that helped design and monitor economic adjustment programmes for all the troubled countries of the eurozone. As such, it became part of the design and enforcement mechanism of the conditionality of bailout programmes that involved extensive fiscal and structural adjustment policies. The fiscal policies in particular involved austerity measures aiming to reduce government deficits and public debt. Structural reforms often involved the privatization of state-​owned enterprises and labour and pension reforms. All these policies are, of course, highly political and politicized; central banks normally have no say over such policies. This was even more problematic in the case of the ECB, which has a narrower mandate than most other central banks, which aims at price stability. The ECB’s role in the troika has been widely criticized by legal scholars (e.g. Dermine 2019). It was also heavily criticized in a report published by anti-​corruption watchdog Transparency International (Braun 2017). The report, which was authored by Harvard economist Benjamin Braun, concludes that the ECB did not have an appropriate accountability framework for the far-​reaching economic reforms that it was involved in as part of the troika. It recommended that the ECB should withdraw from the troika and should avoid “mission creep” and further political interference by first gaining the assent of the Eurogroup3 president and the European Parliament before it makes 2. The term “troika” in reference to the institutions that oversaw economic adjustment programmes in Europe (the IMF, EC and ECB) became popular during the Greek crisis but does not have Greek origins. It originates from Russian, and it means a triad. 3. The Eurogroup is an informal body, comprising the finance ministers of all the euro area member states, which coordinates economic policy in the euro area. The 46

Crisis management and legitimacy

any demands on governments in exchange for its financial support. The ECB’s president, Mario Draghi, welcomed the recommendations but explained that some of them fell outside the mandate and its obligations as set out in the treaties. He did concede, however, that “it is the duty of European institutions to further strengthen their legitimacy both by increasing their democratic accountability and by showing that they meet the objectives they’ve been entrusted with”. Concluding remarks “Mission creep” was clearly the order of the day for central banks during the global financial crisis, and the ECB was no exception. If anything, the ECB went further than most, not least because of its involvement in the design of economic adjustment programmes for Cyprus, Greece, Ireland and Portugal. There was, of course, demand by politicians for the ECB to play that role, but it was clearly a role that was not consistent with its narrow monetary policy mandate and has raised serious questions about the ECB’s legitimacy by political scientists and legal scholars (e.g. Jones & Matthijs 2019; Fromage et al. 2019).4 But, as we shall see in Chapter 4, even in relation to monetary policy the Governing Council had to stretch the mandate to its limits in order to preserve the euro.

Eurogroup was the forum in which the terms of the bailouts of Greece, Ireland, Portugal, Spain and Cyprus were agreed. The Eurogroup’s meetings are attended by the ECB president, the commissioner for economic and monetary affairs and the chairman of the euro working group (a technical committee to which the European Commission’s troika technocrats report). During the crisis the IMF managing director was also in attendance as an observer. 4. See also the rest of papers in the special issue of the Maastricht Journal of European and Comparative Law in which the study by Diane Fromage et  al. (2019) is published. Erik Jones and Matthias Matthijs (2019) emphasize the distributional consequences of central banks going beyond their narrow monetary policy mandates, which can be substantial and raise questions of political accountability and democratic legitimacy. 47

4

The European Central Bank’s policies during the crisis

Monetary policy during normal times During normal times inflation-​targeting central banks, including the ECB, the Bank of England and the Fed, use interest rates to respond to macroeconomic shocks that push inflation above or below target. Central banks react to positive inflation shocks by raising official rates and to negative shocks by cutting official rates. The standard transmission channels of monetary policy include (a) expectations; (b) money market interest rates, which, in turn, affect bank lending rates; (c) asset prices; (d) money and credit; and (e) the exchange rate. All five of these channels influence supply and demand in goods and labour markets, which determine both domestic and import prices. A schematic illustration of the transmission mechanism, as viewed by the ECB, is provided in Figure 4.1. The primary objective of the ECB, established by the Treaty on the Functioning of the European Union, is price stability. Although the treaty does not give a precise definition of price stability, the Governing Council defines it as “a year-​on-​year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area of below 2%”. The Governing Council has, in addition, clarified that it aims to maintain inflation rates “below, but close to, 2% over the medium term”. The main idea behind putting a figure on price stability is that it makes monetary policy more transparent. There are several reasons for aiming at below, but close to, 2 per cent, some of which are technical, but the main one is that it provides an adequate margin to reduce the risk of deflation. Central banks fear deflation more than inflation; this is because there are limits to how much interest rates can be cut when inflation is

49

Central Bank Independence and the Future of the Euro

Figure 4.1  The transmission mechanism of monetary policy Source: European Central Bank.

negative. Specifically, negative interest rates on savings can be disruptive to the financial system, because they encourage firms and households to hold cash or real assets instead of bank deposits. Negative interest rates can, therefore, lead to financial disintermediation –​a reduction in savings held by the financial system, which can be severely detrimental to the financing of small and medium enterprises, as well as households. At very low or even negative interest rates, standard monetary policy can become both infeasible and ineffective. It was precisely the fear of deflation during the later stages of the global financial crisis that led many central banks to adopt non-​standard policies. As official rates began approaching their zero lower bound, central banks started becoming more and more inventive. Although the most well-​known non-​standard policy has been QE, which involves large-​ scale purchases of assets by the central bank, other policies were also adopted. The rest of this chapter reviews the various non-​standard policies used by the ECB during different phases of the crisis and examines the extent to which criticism of such measures on economic, legal or political grounds was justified. 50

The ECB’s policies during the crisis

Phase I: the credit crunch When the crisis erupted during 2008 the interbank market dried up: banks became reluctant to lend to each other, not least because any bank that invested heavily in subprime instruments could default. The first step taken by the ECB to ease liquidity stress in markets was to provide unlimited credit to banks at a fixed rate. This approach became known as fixed-​rate full allotment and contrasted sharply with the ECB’s approach prior to the crisis, when it was supplying a pre-​set amount of credit through auctions in which banks put up collateral to guarantee the loans. Furthermore, the ECB expanded the range of eligible assets that could be used as collateral in refinancing operations, easing liquidity conditions in interbank markets further (see Figure 4.2). Solvent banks facing liquidity problems during the crisis could also access emergency liquidity assistance provided by national central banks. Such access was vital for banks in the periphery that were often constrained by the lack of ECB-​eligible collateral. In general, the ECB collateral rules stipulate that only marketable assets are eligible collateral, which, in effect, means that loans to SMEs or households are not eligible collateral for monetary policy operations unless they are securitized. During the crisis ELA became a lifeline for many banks in the periphery, precisely because of collateral scarcity. The rules surrounding its provision meant that it inadvertently politicized the ECB, however. This was largely because the rules were not made public until 2013. Such secrecy meant that narratives involving ECB blackmails could easily be created by politicians looking for scapegoats (see Box 4.1).

BOX 4.1 ELA AS A WEAPON OF “BLACKMAIL”

During the fall of 2010 the then ECB president, Jean-​Claude Trichet, sent two letters to the Irish finance minister, Brian Lenihan. Both were about the provision of liquidity by the Eurosystem to Irish banks. In the first one, dated 15 October, Trichet describes the provision as “extraordinarily large” and explains that it is subject to Eurosystem rules, including the financial soundness of counterparties and their ability to post adequate collateral. The letter goes on to explain that the Governing 51

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Council may “limit, suspend or exclude” counterparties’ access to monetary policy instruments on grounds of prudence. In addition, it also explains that the access of Irish banks to emergency liquidity assistance provided by the Central Bank of Ireland is “closely monitored by the Governing Council as it may interfere with the objectives and tasks of the Eurosystem and the prohibition of monetary financing under the Treaties”. The letter also explains that such access cannot be taken for granted and is dependent on the Irish government’s four-​year economic strategy, not only because a significant part of the Irish banking system is wholly or partially government-​owned but also because Eurosystem liquidity is partly collateralized by securities issued by the Irish government. The second letter, dated 19 November, is much more assertive in its tone. It stipulates the Governing Council’s conditions for the continuation of ELA to Irish banks. These conditions include Ireland applying for financial support from Eurogroup, commitment to take decisive actions in terms of fiscal consolidation, structural reforms and financial sector restructuring, in agreement with the European Commission, the IMF and the ECB, and recapitalization of the banking system with government funds and guarantees by the Irish government. Trichet’s letter, which was made public only in 2014, was instrumental in persuading the Irish government to apply for a bailout from Eurogroup and the IMF. In Ireland, however, it was widely perceived as an ECB blackmail that pushed the country into the arms of the troika. It could not have helped that, although the existence of such a letter was known, its contents remained “secret” for four years. The perception that the ECB was blackmailing countries to carry out unpopular reforms became common in Cyprus and Greece during their respective crises. In March 2013 the newly elected president of Cyprus, Nicos Anastasiades, claimed publicly that ECB executive board member Jörg Asmussen had put a “gun on his head” by threatening to cut off ELA to Cypriot banks. In Greece the finance minister, Yanis Varoufakis, launched a vicious critique of the ECB for imposing ceilings on ELA provision to Greek banks, which eventually forced the SYRIZA government to accept additional austerity measures and structural reforms demanded by Eurogroup. No doubt, these perceptions go some way in explaining why the euro has the lowest acceptance ratings in Greece and Cyprus.

52

The ECB’s policies during the crisis

Figure 4.2  Eligible marketable assets, 2007–​2012 Notes: Nominal amounts; averages of end-​month data. Source: European Central Bank. .

53

Central Bank Independence and the Future of the Euro

Although ELA is provided by national central banks, it is subject to the non-​objection of the Governing Council. This is meant to ensure that its provision does not interfere with the objectives and tasks of the Eurosystem. Put differently, the provision of ELA should not violate the prohibition of monetary financing. The solvency of banks often depended on the ability of the sovereign to bail them out, as the crisis had wiped out their capital buffers. In countries such as Greece, Ireland, Portugal and Cyprus, the solvency of the sovereign during the crisis, in turn, depended on bailout funds from Europe and the IMF. These were, in turn, conditional on unpopular economic adjustment programmes that could pass IMF tests regarding the sustainability of the receiving country’s public finances. As bailout negotiations were inevitably political and often toxic, the ECB became embroiled, albeit reluctantly, in those heated political discussions. Moreover, ELA rules are such that, although the ECB could cut off ELA to “misbehaving” countries, they also allowed it to claim, when challenged, legally or politically, that the solvency judgements were the responsibility of the NCB. Although the Governing Council was making a judgement about the solvency of the sovereign, ELA rules stipulated that the solvency assessment for the bank concerned was the responsibility of the NCB. Clearly, this was a no-​win situation for NCBs. If they had refused to provide ELA, they would have been blamed by their own governments for any financial meltdown that could have forced a euro exit –​ultimately, the most political decision. If they had provided it, they could have been seen as responsible for the ECB’s “blackmail”. This was, in fact, one of the biggest challenges that faced the Central Bank of Cyprus after it had managed to stabilize the banking system in 2013: politicians turned against it because they felt it had provided the ECB with the weapon of blackmail (see Box 4.1 for more details). Phase II: the sovereign debt crisis During 2009 the credit crunch evolved into a sovereign debt crisis. Bank bailouts in Ireland started raising questions about the sustainability of the country’s public finances while the true state of Greece’s public finances became apparent soon after the new socialist government took office (Papaconstantinou 2016). In May 2010 Greece entered 54

The ECB’s policies during the crisis

8 7

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Figure 4.3  Borrowing costs, 2000–​2018 Source: European Central Bank.

an economic adjustment programme financed by Europe and the IMF. Ireland followed in December 2010, while Portugal, which had also been affected severely by the crisis, entered its own programme in May 2011. During the sovereign debt phase of the crisis the monetary transmission mechanism became severely impaired, in that borrowing costs for households and firms remained stubbornly high (see Figure 4.3). Lower official rates were simply not benefiting the economies in which they were most needed. As sovereign bond yields rose, reflecting market’s perceptions of likely sovereign default, lending rates to firms and households also diverged (see Figure 4.4). During this phase the ECB introduced a range of non-​standard measures aimed at addressing market “malfunctioning” and reducing differences in the financing conditions faced by households and firms in different euro area countries. The first, and perhaps most important, measure was introduced in May 2010 and involved the purchase of debt securities of the countries most affected by the sovereign debt crisis (Greece, Ireland, Portugal, Spain and Italy). It became known as the Securities Market Programme. From 2010 to 2012 about €220 billion of government bonds were 55

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purchased under the SMP. Other actions included very long-​term refinancing operations (VLTROs) and the Outright Monetary Transactions programme (see Chapter 5). The SMP contrasted sharply with the Fed’s large-​scale asset purchases and the Bank of England’s QE, both of which involved assets for which long-​term yields and yield volatilities were relatively low and default probabilities were negligible. By contrast, the bonds purchased by the ECB during the most severe phase of the sovereign debt crisis had very high and rising yields, which were also volatile, reflecting market perceptions of default. Another important difference was that the SMP was not transparent; neither the total amounts purchased nor the targeted securities or the duration of the programme were disclosed while the programme was active. Purchases were implemented in a non-​ anonymous dealer market. Research conducted by the ECB suggests that the programme was effective in terms of reducing bond yields (Eser & Schwaab 2013). Specifically, the research shows that there were large and economically significant announcement effects, as well as impacts at the five-​year maturity, that were most pronounced for Greece, and to a lesser extent for Portugal, Spain and Ireland. Not surprisingly, the SMP was marred by considerable controversy. Its critics raised questions not only about its legality but also about its legitimacy. In a letter to the Financial Times, Otmar Issing  –​former chief economist of the ECB and one of the founding fathers of the 56

The ECB’s policies during the crisis

euro –​argued that the ECB, through the SMP, was breaching its own independence by helping to bail out countries such as Greece. Legal scholars, even in Germany, were more sceptical than Issing, however. Peter Sester (2012), for example, concludes that the ECB acted within the limits of its competence but accepts that this judgement rests on an “aggressive” interpretation of the TFEU. Legal criticisms of the SMP focused on the likelihood of possible “haircuts” on the bonds; had the ECB made significant losses by buying distressed bonds, due to haircuts, it would have been a violation of the prohibition on monetary financing (Article 123 of the Treaty). Criticism from economists, on the other hand, emphasized the moral hazard that was being created for governments when the ECB bought their bonds in secondary markets. Such purchases, it was argued, ease the pressure on governments to reduce deficits. There is clearly some merit in these arguments, although one cannot ignore the fact that these were extraordinary actions in extraordinary times. Without the ECB actions, the euro area might have unravelled. Questions regarding the legitimacy of the ECB’s interventions should also be seen in this light. Those who believe that the ECB should do whatever it takes to preserve the euro will find the actions legitimate. Others, who perhaps believe that this is too political a stance for a central bank, will no doubt disagree. VLTROs were introduced in December 2011 and were intended to increase bank lending and liquidity in the euro area money market. They involved conducting two longer-​term refinancing operations with a maturity of 36 months, and the option of early repayment after one year. This was accompanied by a reduction in the reserve ratio from 2 per cent to 1 per cent and a loosening of collateral requirements. The operations were conducted as fixed-​rate tender procedures with full allotment. In other words, the ECB was providing unlimited credit with a maturity of three years. Unlike the SMP, VLTROs were available to all banks in the euro area, although collateral availability in the distressed countries appears to have been a binding constraint. Phase III: deflation risk The third phase of the crisis was one on which deflation risk became very prominent. Notwithstanding the success of the ECB in the first stage of 57

Central Bank Independence and the Future of the Euro

the crisis, in which a short period of falling prices in 2009 was followed by inflation rising to 3 per cent towards the end of 2011, inflation started falling again during 2013 (see Figure 4.5). By the end of the year it had declined to 0.8 per cent, well below the 2 per cent target, although the Governing Council reduced the main ECB interest rates twice during that year. At the beginning of 2014 the rate on the ECB’s main refinancing operations (MRO) stood at 0.25 per cent. Inflation continued to decline during 2014, however, notwithstanding three further cuts in the MRO, which brought it down to 0.05 per cent, and the introduction of new targeted longer-​term refinancing operations (TLTROs), which provided financing to credit institutions for periods of up to four years. The aim of TLTROs was to provide long-​term funding at attractive conditions to banks with a view to stimulating bank lending to the real economy. In addition, the ECB introduced a negative rate on its deposit facility of –​0.10 per cent in June 2014 and reduced it further to –​0.20 per cent in September. Banks were, in fact, being penalized for not lending to the private sector. Notwithstanding these measures, by December 2014 inflation was down to –​0.2 per cent. In January 2015 inflation fell to –​0.6 per cent. The news was released by Eurostat in a flash estimate on 30 January 2015. Deflation risk was very real. The ECB had pre-​empted this announcement, however, as it had already taken decisive action at the Governing Council meeting that took place on 22 January 2015. During that meeting the president announced that the Governing Council had decided to launch an expanded asset purchase programme, which would be implemented from March 2015 and would involve making monthly purchases of public sector and private sector securities amounting to €60 billion. The ECB was, finally,1 introducing its own QE programme, in the form of four asset purchase programmes (APPs):  a corporate sector purchase programme (CSPP); a public sector purchase programme (PSPP); an asset-​backed securities purchase programme (ABSPP); and a covered bond purchase programme, the ECB’s third (CBPP3). Asset purchases continued at €60 billion per month until March 2016. By July 2015 inflation had risen to 0.5 per cent, but it started falling again a month later, declining to  –​0.1 per cent in February 2016. In 1. For some of its critics, the ECB was too late in introducing QE (e.g. Mody 2019). 58

The ECB’s policies during the crisis

BOX 4.2 DEBT DEFLATION AND THE GREAT DEPRESSION

Much of the aversion to deflation by economists dates back to the ideas put forward by Irving Fisher (1933), which highlight the significant role that deflation played in the Great Depression. Fisher offers an innovative view of the 1930s crisis by focusing on the meltdown of financial markets, the downward spiral between asset price deflation and goods prices and the severe consequences of the process of deleveraging by households and firms on economic activity. Fisher explains that, when economic agents are overindebted, they will be forced to liquidate their assets through distressed selling, which causes prices to fall. This will, in turn, increase the real value of existing debt and reduce the net worth of businesses, precipitating bankruptcies. As a result, output, trade and employment will decline, causing further loss of confidence, hoarding and a slowing down of the velocity of circulation of money. As more and more economic agents become unable to service their debts and default on their loan obligations, more and more lenders become insolvent. As banks become insolvent and start collapsing, confidence in the banking system is eroded. Financial instability breeds economic instability. Irving Fisher’s ideas have regained popularity in economics, as they are capable of explaining much of what happened during the global financial crisis, as well as highlighting the significant risk that deflation poses, which prompted central banks to reduce interest rates to zero and introduce quantitative easing programmes (e.g. Mendoza 2009). They tend to complement Hyman Minsky’s financial instability hypothesis (see Box 3.1), which explains how bubbles are formed and how a state of overindebtedness can be reached by underestimating risk during good times. Between them, Minsky’s and Fisher’s ideas provide a plausible explanation of the upswing and downswing of the financial cycle, although it deviates considerably from the world of rational expectations, which has dominated thinking in macroeconomics since the 1980s.

April 2016 asset purchases were increased to €80 billion per month and the MRO was reduced to 0.00 per cent. The rate on the deposit facility was lowered to  –​0.40 per cent. Inflation started responding to the 59

Central Bank Independence and the Future of the Euro

monetary stimulus in the second half of 2016, and by December 2016 it had increased to 1.1 per cent. During 2017 it started moving closer to the 2 per cent target, hovering around 1.5 per cent. Asset purchases were reduced from €80 billion to €60 billion per month from April 2017 and to €30 billion per month from January 2018. In October 2018 they were further reduced, to €15 billion per month, and they came to an end in December 2018. The ECB continues to reinvest in assets as they mature, however, which means that the accumulated stock  –​around €2.5 trillion –​will remain on the ECB’s balance sheet in the foreseeable future. At the end of 2018 inflation stood at 1.5 per cent, and the ECB president made it clear that the ECB intended to maintain low interest rates until at least the summer of 2019 (which was confirmed at its July 2019 monetary policy meeting). Legal and political challenges The ECB faced various legal challenges in relation to its asset purchase programme. These were initially submitted to Germany’s Federal Constitutional Court, which decided, however, to seek guidance from the European Court of Justice –​the top court in the European Union. Several claimants in Germany argued that the ECB was engaged in “opaque and omnipotent activities” and breaching Article 123 of the TFEU –​the prohibition of monetary financing of government deficits. They also suggested that the programme went far beyond the powers of the ECB and, therefore, failed to observe the division of competences between the European Union and its member states. The ECJ on 11 December 2018 ruled in favour of the ECB. In its binding decision, the court stated that the APP “does not exceed the ECB’s mandate and does not contravene the prohibition of monetary financing”.2 Interestingly, the ECJ took into account that key ECB interest rates were already at their lower bound and that the programme involved purchases of both private sector assets and public sector ones. Furthermore, the 2. According to Bloomberg, the case was a carbon copy of a previous legal dispute about the ECB’s Outright Monetary Transactions programme (see Bodoni 2018). EU judges cleared that programme with minor strings attached, and the German tribunal “reluctantly followed that direction in its final judgement”. 60

newgenrtpdf

Figure 4.5  Euro area inflation rates, January 1996–​February 2019 Notes: Year-​on-​year changes in the Harmonised Index of Consumer Prices (HICP); latest (February 2019) 1.5%. Source: European Central Bank.

Central Bank Independence and the Future of the Euro

ECJ explained that preventing the ECB from taking such measures might represent an “insurmountable obstacle” for the central bank to accomplish its tasks, particularly “in the context of an economic crisis entailing a risk of deflation”. The ECJ additionally explained that the ECB had not violated the monetary financing prohibition, as the programme did not involve purchases of government bonds in primary markets. Although the ECB may have acted on solid economic and legal grounds in introducing its APP, legitimacy questions have remained, and these have fuelled political controversy. Some of the political challenges are clearly either misguided or not well founded. For example, as explained by Jean Pisani-​Ferry (2015), some of the ECB’s critics mistakenly treat zero inflation as a blessing, failing to understand its numerous negative real consequences. Besides being uncomfortably close to deflation, zero inflation makes adjustment of relative prices and wages more difficult, because of nominal rigidities; it is easier to keep wages constant than cutting them. In a world in which there is no inflation, the only way for real wages to decline is cutting the nominal wage. By contrast, with 2 per cent inflation, real wages decline by 2 per cent per year if nominal wages remain unchanged. Another political challenge has been that QE may create moral hazard for governments. Klaus Tuori (2019) points out that, through QE, the ECB has become member states’ largest creditor, when it was not supposed to finance them. As it lowers member states’ borrowing costs, QE eases the pressure to engage in politically costly fiscal or structural reforms. Although there is some merit in this criticism, such distorted incentives, if they are indeed created by QE, need to be addressed by the economic policies of the European Union. QE lowers borrowing costs not only for the public but also the private sector; it is a macroeconomic tool that is primarily aimed at preventing deflation. The ECB would be failing to fulfil its mandate if it did nothing to address such a serious macroeconomic risk for fear of second-​order distortions that may or may not be significant. A more valid criticism is that QE may cause asset prices to be artificially higher. As such, it can have distributional consequences, by disproportionately benefiting asset holders. To address such criticism, central banks need to be able to demonstrate convincingly that such programmes also benefit the poor, even if they do so indirectly, by 62

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reducing unemployment and increasing growth.3 Until they are able to do so, such questions will remain, and they can be a threat to their independence. Last but not least, in the case of the ECB, questions remain as to how far the ECB should be prepared to act to preserve the euro. The euro is certainly the raison d’être for the ECB. But that clearly creates a conflict of interest if the ECB is seen to be trying to preserve itself and concentrating much power in doing so. As the early history of central banking in the United States has shown, the political backlash against central bankers in these circumstances can be lethal.

BOX 4.3 HEALTHY OR CONVENIENT? THE ECB’S DISTRUST OF THE EFFICIENT MARKET HYPOTHESIS

In an efficient financial market, asset prices always reflect the true fundamentals, as all economic agents are rational and take all publicly available information into account. In such a market there can be no asset price bubbles and there can be no underpricing of financial assets. In other words, efficient financial markets have no room for distortions, nor do they have room for ideas such as Minsky’s financial instability hypothesis, in which risk is underpriced during good times. Although the EMH has been the dominant paradigm in finance theory since Eugene Fama introduced it some five decades ago (Fama 1970), notwithstanding its many critics (see Malkiel 2003), policy-​makers, including the ECB, have shown through their actions since the crisis that they place little faith in it. In fact, the economic rationale that has systematically been provided by the ECB to explain non-​standard measures rests on notions of financial markets that are far from being efficient. Indeed, the language that the ECB has used suggests, if anything, that the Governing Council had little, if any, trust in financial markets during the crisis. At the onset of the crisis the ECB described its actions as necessary to “keep financial markets functioning”. This was the stage at which the 3. Recent research by ECB economists (Ampudia et  al. 2018) has suggested that the APP reduced income inequality through its indirect effects on employment. That is to say, by reducing the unemployment rate, the APP benefited low-​income households. Such research may not be entirely convincing, however, in that it does not pass the test of independence. 63

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interbank market dried up in autumn 2008 and banks could no longer rely on each other for their funding. In a press release, issued on 10 May 2010, the ECB explained that its non-​standard measures, including the SMP and long-​term refinancing operations, were designed to “address severe tensions in certain market segments which are hampering the monetary policy transmission mechanism” (European Central Bank 2010). During 2012, when sovereign yields were becoming increasingly divergent in the euro area, the ECB talked about “severe distortions in government bond markets”, which originated from “unfounded fears … of the reversibility if the euro”. This was the economic rationale for introducing the OMT, which it describes as a “powerful circuit breaker against self-​ enforcing fears in sovereign bond markets”. In the third phase of the crisis the ECB addressed the onset of a credit crunch and the risk of deflation. The APP was aimed at putting downward pressure on the term structure of interest rates –​in other words, to reduce long-​term interest rates more than short-​term ones. The programme was very transparent, so that market participants could understand what the ECB was trying to do, and this was meant to make it, in a certain sense, neutral. Nevertheless, it was clearly intended to affect asset prices in ways that increased confidence and stimulated investment and aggregate demand. By itself, the ECB’s decision to introduce quantitative easing, with all the political controversy that surrounded it, confirms that, on balance, the Governing Council has a healthy distrust of the EMH.

Concluding remarks The ECB, together with euro area central banks, took many decisive actions during the crisis, and the fact that the euro area has not only remained intact but has also grown, notwithstanding the crisis, is a testament to the success of these actions. The ECB did well in terms of providing the economic rationale for its non-​standard monetary policy measures during the three phases of the crisis. It emphasized malfunctioning financial markets (see Box 4.3), including distortions, and can be congratulated for having had the courage to distance itself from the notion of efficient markets. It also described market fears about the political commitment to the euro as “unfounded”, which could arguably be seen as a political statement, notwithstanding the irrevocability 64

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of the monetary union. There is no doubt that the euro could well have unravelled without drastic action from the ECB. Often these were emergency measures that provided invaluable time for politicians to find solutions to the unprecedented problems. It is also evident that the actions withstood the test of the law, when challenged in German and European courts. If anything, court rulings vindicated the legality of the ECB actions, having taken into account the substantive economic factors behind them –​the severity of the crisis and the risk of deflation. Legitimacy questions still loom large over many central banks, however, including the ECB, not least because of the perceived distributional consequences of QE. Moreover, at this time of growing populism the ECB may have to face even more controversial questions relating to how far it is prepared to go to preserve the euro –​which, after all, is a political project. Although the ECB may have got it technically right in its crisis management, the transparency and accountability of some of its actions left something to be desired. One glaring weakness has been the communication and defending of actions relating to ELA provision and the ECB’s role in bailout negotiations, both of which were, for a considerable period of time, shrouded in secrecy. It is precisely this lack of transparency that allowed narratives about ECB blackmails to be generated. Beyond communication, however, there remain questions of legitimacy: should the ECB be taking part in bailout negotiations? And, as supervisory judgements about systemic banks are now made by the ECB, shouldn’t ELA decisions become the sole responsibility of the Governing Council? This would certainly enhance the coherence and accountability of the Eurosystem and help protect the NCBs  –​ the frontline troops who defended the euro. We will return to these decisions in the concluding chapter.

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5

Whatever it takes

The euro in troubled waters The fate of the monetary union at the beginning of the summer of 2012 was far from certain. The Greek crisis had exposed much more than just Greece’s structural problems. It had also exposed the incomplete architecture of the euro, including the absence of an effective crisis management mechanism. All of a sudden access to financial markets became much more important than previously thought, as market participants realized that there was no automatic bailout mechanism in place. Countries that appeared to be lacking fiscal discipline came in for considerable battering by their peers, as politicians responded to the lack of appetite on the part of electorates for bailing out other countries. Markets had clearly underestimated the deep distaste of public opinion in Germany towards fiscal profligacy and the extent to which it could influence the German government’s willingness to take part in the Greek bailout. Moreover, the disconnect between monetary policy, which was conducted at the Eurozone level, and fiscal policy, which remained in the hands of member states, made any country with a high sovereign debt vulnerable to a bank run, since the provision of bank liquidity was the ECB’s prerogative. Cash in hand became much safer than bank deposits, especially in countries at risk of leaving the euro. Greek depositors demonstrated this abundantly: deposits in Greek banks declined from almost €280 billion before the crisis to just over €150 billion at the peak of the crisis in 2015 (see Figure 5.1). This was another design peculiarity to the euro area that was beginning to create new strains. With deposits fleeing Greece’s banks, the ECB’s function as lender of last resort was itself becoming another source of vulnerability. Like any other central bank, the ECB could supply liquidity to Greek 67

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Figure 5.1  Bank deposits in Greece Source: Bank of Greece.

banks only as long as these banks were solvent. The bank’s solvency was dependent on the sovereign’s solvency, however, not least because Greek banks were holding a disproportionate amount of Greek government bonds (GGBs) –​a pattern repeated in most other euro area countries, including heavily indebted Italy. Thus, the supply of liquidity to Greek banks became completely dependent on the political decisions to bail out Greece taken by euro area governments at Eurogroup. The “doom loop” between the sovereign and the banks was at the heart of the survival or failure of the euro area. If the ECB was unable to supply liquidity, banks would close and could reopen only under a new national currency regime. The ECB became inadvertently politicized. As if that was not enough, the ECB was also a member of the “troika” –​which oversaw all programme countries at technical level. Thus, it became part of the enforcement mechanism for unpopular fiscal reforms, including austerity –​which made it even more political. In Greece, the election of 6 May 2012 delivered a hung parliament. A new election was set for 20 June, with SYRIZA, a Euro-​sceptic leftist party very much on the ascendancy, likely to win. SYRIZA was playing openly with the idea of taking Greece out of the eurozone. In a surreal telephone conversation with one of their advisors, I realized that if they were elected the likelihood of Grexit would be very high. They 68

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knew that what they were pledging was not going to be acceptable to the European Union. They knew that this meant likely financial meltdown, as, without a government committed to deliver on what had been agreed with Europe, the ECB would be forced to cut off liquidity from Greek banks. Greek citizens were withdrawing their euros as if there was no tomorrow. And, although Grexit risk subsided markedly on 20 June 2012, when the results of the Greek election showed a clear victory for New Democracy, the centre-​right party led by Antonis Samaras, it was no longer the only vulnerable country. Pandora’s box had been opened for other countries with a high debt burden: countries with potentially unsustainable public finances could not expect an automatic bailout. It wasn’t just those in the euro’s periphery that started becoming vulnerable. And, as bailouts were accompanied by unpopular fiscal policies, the political commitment to adhere to the euro, in light of such conditionality, finally came under scrutiny by the markets. Bond yields in the euro area in mid-​2012 started diverging at an alarming pace (see Figure  5.2). Portugal, Spain, Ireland and even France were showing heightened risk, suggesting that the core of the euro area was itself at risk. Higher borrowing costs were also adding pressure on the sustainability of debt burdens. The euro’s unravelling appeared almost 8 7 6 Price

5 4 3 2 1 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Year

Figure 5.2  Ten-​year government bond yields, 2007–​2018

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inevitable. It was only a matter of time before one of the euro’s weakest links would break. The only question was which one? In Greece, the respite was only temporary. It was obvious neither that Samaras would be able to steer Greece on the straight and narrow path demanded by the European Union and the IMF, nor that that path would deliver a sustainable debt burden at the end. Moreover, given the delicate political balance, it was only a matter of time before SYRIZA, with its charismatic leader Alexis Tsipras, would come to power –​as indeed happened in January 2015. But, even before the risk of Grexit began to subside in late June 2012, Cyprus was starting to show significant signs of strain. Part of the problem was that its banks had suffered losses amounting to over 25 per cent of GDP from the Greek debt restructuring. As Cyprus’s two major banks were bloated with Russian money and their balance sheets exceeding 400 per cent of GDP, the country’s inability to bail them out understandably began to occupy rating agencies, which, based on the Greek experience, could no longer assume the existence of automatic bailouts. Conditionality in the case of Cyprus appeared even more politically toxic, in light of the country’s significant ties with Russia. To many independent observers, the euro look almost certain to unravel. The Outright Monetary Transactions programme Against the background of the euro’s likely unravelling, Draghi made a speech in July 2012 in which he pledged that the ECB would do “whatever it takes to preserve the euro” (see Box 5.1). Arguably, it was this speech that helped save the euro; yields began to subside shortly after it was delivered. At its first meeting following Draghi’s London speech, held in Frankfurt on 2 August 2012, the Governing Council signalled its backing for “whatever it takes” by announcing that it might undertake “outright open market operations of a size adequate to reach its objective” (European Central Bank 2012a, emphasis added; see Box 5.2 for further details). Details of the OMT programme were not announced until 6 September 2012, however. Two paragraphs of the introductory statement were devoted to the new policy, explaining both the rationale and the modalities. A separate press release provided further details. 70

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BOX 5.1 THREE WORDS THAT SAVED THE EURO

Against the backdrop of the euro apparently beginning to unravel, Mario Draghi bemused participants at an event at Lancaster House in London on 26 July 2012, when he described the euro as a bumblebee that managed to fly contrary to the laws of physics. According to the former Bank of England governor, Mervyn King, who was one of the other luminaries on a morning panel brought together to discuss challenges to the global economy, the event was not planned to be one of great significance. According to those present, Draghi appeared relaxed and understated during his talk, rarely referring to his notes (Randow & Speciale 2018). Six and a half minutes into his talk, however, he paused, looked down, took a breath, folded his hands and stated in Italian-​accented English: “But there is another message I want to tell you. Within our mandate, within our mandate, the ECB is ready to do whatever it takes to preserve the euro.” He then paused again and added, “Believe me, it will be enough.” “Whatever it takes” were the three words that stuck, and in all likelihood they will prove to be the legacy of Mario Draghi at the ECB. Draghi was applauded by the movers and shakers who were present, including Christine Lagarde, managing director of the IMF, who reportedly stated that, with this pronouncement, Draghi may have just saved the euro. Draghi himself seemed less convinced. He was clearly anxious to convince his strongest critic, Jens Weidmann, president of the Bundesbank, who was one of the first people he called after the speech. Weidmann’s reaction was lukewarm. Later on, when the plan to buy government bonds became apparent, Weidmann’s opposition to “whatever it takes” hardened. Nonetheless, political reaction from the German government appeared positive. In a joint statement the following day, the German chancellor, Angela Merkel, and the French president, François Hollande, echoed Draghi’s pledge: “France and Germany are fundamentally tied to the integrity of the euro area … They are determined to do everything to protect it.” From that point onwards “whatever it takes” framed ECB policy and, according to many economic and political commentators, turned Draghi into the guardian of the single currency, although it also attracted critics from more conservative circles, especially from within Germany, who saw his easy monetary policy as irresponsible bankrolling of the euro’s southern periphery.

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The introductory statement explained that OMTs were designed to address “severe distortions in government bond markets which originate from, in particular, unfounded fears … of the reversibility of the euro” (European Central Bank 2012b). OMTs were highly conditional on governments taking appropriate actions, however, such as pushing ahead “with great determination with fiscal consolidation, structural reforms to enhance competitiveness and European institution-​building”. It also made clear that “strict and effective conditionality attached to an appropriate European Financial Stability Facility/​European Stability Mechanism (EFSF/​ESM) programme” was essential. Although OMTs were available to countries in trouble, they first had to go through the rigours of an economic adjustment programme agreed at technical level with the European Commission, the ECB and the IMF. One could, therefore, legitimately ask why the fears were unfounded, if politicians had little appetite for economic adjustment programmes. Governments in countries that had them, including Greece, Ireland and Portugal, found themselves quickly becoming unpopular. In fact, some of the questions asked by journalists at the press conference went to the heart of this tension. The first question raised the issue of legitimacy. What gave the ECB the democratic legitimacy even to say that the euro was irreversible? Surely that was not explicitly stated in the TFEU. Draghi repeated what he had said in London, that “we will do whatever it takes, within our mandate [putting emphasis on the phrase “within our mandate”, by repeating it], to have a single monetary policy in the euro area and to preserve the euro. And we say that the euro is irreversible. So unfounded fears of reversibility are just what they are: unfounded fears. And we think this falls squarely within our mandate.” He proffered a raison d’être for the ECB. The monetary union was, after all, meant to be irreversible. The ECB was the central bank of the monetary union. With unfounded fears of reversibility, there could not be a single monetary policy. Without a single monetary policy, the ECB had no reason to exist. It was as simple as that. Like a good politician, however, Draghi, avoided addressing this question: what if the fears were not unfounded? What if some countries actually wanted to exit? But, in September 2012, Draghi was not pressed any further on this. He was, nevertheless, relentlessly attacked 72

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by German journalists for “lira-​ization” of the euro and for violating Article 123 of the TFEU with the intention of financing governments through the back door. Draghi was clearly treading a very fine line. On the one hand, he had to assure markets that OMTs were sufficient to address “unfounded fears” of reversibility; and, on the other, he had to defend the ECB from criticism that it was financing, albeit indirectly, fiscally profligate governments. The reality of OMTs, however, was that conditionality was stringent. A fiscally profligate government would not qualify, as it would not pass the debt sustainability tests carried out by the IMF. In fact, the real problem was whether governments would be willing to accept unpopular austerity in order to qualify for OMTs. A more valid criticism of OMTs were that they did in fact create moral hazard for governments. By convincing the markets, which paid little attention to its stringent conditionality, that the ECB would do whatever it took, they quickly reduced borrowing costs for countries that were reluctant to apply for an EFSF/​ESM programme, such as Italy and Spain. The policy, therefore, allowed governments to postpone or avoid altogether fiscal consolidation and structural reform. OMTs were, in fact, never used. It was a case in which the ECB, by flexing its muscles, convinced markets that the euro was irreversible. In so doing, however, the ECB became a victim of its own success. Without those reforms the risks to the euro are once again rising.

BOX 5.2 THE BIRTH OF OUTRIGHT MONETARY TRANSACTIONS

Mario Draghi’s “whatever it takes” talk in London on 26 July 2012 caught the ECB Governing Council by surprise. On arrival at the Euro Tower, on 1 August 2012, many of us wondered what he had in mind. During the informal discussions it became obvious that neither Draghi nor ECB staff had a concrete plan. There was hardly even a set of ideas for discussion. The brainstorming that followed during our evening informal session on the same day was highly productive, however. This was a bunch of central bankers at their most inventive, with a common conviction to save the monetary union, which we silently understood as something much more sacred than any economic arrangement; it felt as if we were working to save project peace in Europe. A late night shift was required. 73

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No one complained, although some of us had had to fly in that day from much further afield. By midnight we had reached a consensus on what was needed. The world’s media were focused on the monetary policy decision of 2 August. Was the Governing Council going to back Draghi and, more importantly, was it going to provide some flesh to “whatever it takes”? Anyone expecting a cut in policy rates were certainly disappointed. Key ECB rates remained unchanged; they had already been lowered by 25 basis points in July. But what was really needed to calm markets down wasn’t conventional monetary policy. Markets were looking at what the ECB could do to bring down bond yields to sustainable levels. The introductory statement contained three completely new paragraphs, compared to previous statements. This did look like a major shift: the ECB was finally flexing its muscles, if not showing the big bazooka. Often ECB watchers had had to rely on very small nuances, such as changes in emphasis or the use of a new word, in order to detect a slight change in policy. The first new paragraph acknowledged the previous night’s lengthy deliberations, alluding to the Governing Council’s “extensive” discussions of “policy options to address the severe malfunctioning in the price formation process in the bond markets of euro area countries” (European Central Bank 2012a). It also added: “Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible.” The second paragraph explained that the euro could not be saved by the ECB alone. It called on policy-​makers to “push ahead with fiscal consolidation, structural reform and European institution-​building with great determination”. It also acknowledged that institution-​building takes time and called on governments to “activate the European Financial Stability Facility (EFSF)/​European Stability Mechanism (ESM) in the bond market when exceptional financial market circumstances and risks to financial stability exist –​with strict and effective conditionality in line with the established guidelines”. It was important to convey the message that not everything depended on the ECB. What the ECB would do was left for the third and final (new) paragraph. In fact, it was just one sentence, which nevertheless summed up succinctly the consensus that had been reached the previous night: “The Governing Council, within its mandate to maintain price stability over the

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medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective” (European Central Bank 2012a, emphasis added). The paragraph ended by explaining that the “appropriate modalities for such policy measures” would be designed over the coming weeks. The programme that would save the euro –​the Outright Monetary Transaction programme –​was conceived there and then. It would only be born a month later, however, after a lot of work on the detail by various technical committees at the ECB. The announcement of 2 August, even though it provided little detail, did enough to calm the markets –​at least until September. It also indicated –​albeit subtly and implicitly –​that Draghi’s “whatever it takes” was more a statement of intent than a fully worked-​out plan of what needed to be done.

OMTs: conditionality and technical features Technical aspects of OMTs include the “strict and effective conditionality” required in the form of an appropriate European Financial Stability Facility/​ European Stability Mechanism macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), as long as it included the possibility of EFSF/​ESM primary market purchases (see European Central Bank 2012c). The involvement of the IMF in the design and monitoring of such a programme, implicit in any such programme, was made explicit. OMT conditionality also required the country benefiting from OMTs to be compliant with the conditionality of the EFSF/​ESM programme. As if that was not enough, the press release stated that the Governing Council would decide on the start, continuation and suspension of OMTs, following a “thorough assessment”, and that they would be terminated in case there was non-​compliance with the macroeconomic adjustment or precautionary programme. The coverage of the programme made it clear that it was primarily intended for future cases of EFSF/​ESM programmes. Countries that were already under a macroeconomic adjustment programme –​such as Ireland, Portugal and Greece –​could be considered only when they had regained bond market access. Bonds targeted would be at the short 75

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end of the yield curve, with maturity of between one and three years, and no quantitative limits would be set on the size of the programme. Other technical features of OMTs included (a) the pari passu treatment of the Eurosystem in purchasing government bonds –​i.e. in case of default euro area central banks would not have preferential treatment over private investors; (b) sterilization of liquidity created by OMTs: any liquidity created from the purchase of OMTs was to be absorbed, therefore OMTs were designed to be neutral on the money stock; and (c) aggregate OMT holdings and money values were to be published weekly. The technical features of OMTs also included a decision to terminate the Securities Market Programme, as the liquidity injected through that programme would be absorbed, as in the past. In all, the “Technical features of Outright Monetary Transactions” press release (European Central Bank 2012c) provided strong defence against critics from within Germany who were already attacking the ECB for exceeding its mandate.1 The programme was from its inception limited in scope and had very strict conditionality. The only country that could have used it at the time was Spain. Ireland’s case was much weaker, as it was already in an economic adjustment programme. Whether it was “regaining” bond market access remained in doubt. The technical features of the OMT programme –​its limited scope and conditionality  –​were somehow glossed over by market participants, however, who preferred to focus on the unlimited firepower of the ECB. The ECB succeeded in stabilizing bond markets without as much as spending one cent on buying government bonds through OMTs. Concluding remarks The summer of 2012 was probably the most critical period for the euro. Markets began to price its demise as they realized there was no automatic bailout clause that would protect fiscally profligate countries and that the political willingness for unpopular austerity programmes could not be taken for granted. The ECB responded to this through Draghi’s 1. Such dissent was also known to have existed within the Governing Council, as Jens Weidmann, the Bundesbank president, publicly stated his disagreement with the programme. Draghi acknowledged that in the press conference on 6 September 2012. 76

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bold statement that it would do whatever it took to preserve the euro. This reassured markets in the short run, but it was clearly not sufficient. The ECB had to put in place a policy that could convince market participants that it would indeed deliver on that promise. That policy was the OMT programme. It seemed to provide what was needed  –​ although markets glossed over the conditionality. The fact that the OMT programme was never tested, however, had more to do with the fact that politicians engaged in other reforms that began to convince markets that the political commitment to preserve the euro was in fact a strong one. One such reform was the creation of the banking union.

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6

Banking union

Origins and overview The banking union involves a number of initiatives to create a safer banking system, including a single rulebook for all EU banks and a single supervisory mechanism, aimed at enhancing the safety and soundness of the banking system. It also includes a single resolution mechanism, which is aimed at the orderly restructuring of banks that are failing or are likely to fail. Together with the single rulebook, the SSM is intended to minimize the number of bank failures, while the SRM is intended to minimize the harm to the real economy from banks that are failing or are about to fail. Between them, the first two pillars are expected to put an end to “too big to fail” –​a distortion that is widely believed to have led to excessive risk taking by large banks prior to the global financial crisis. The idea of creating a banking union in Europe was first placed on the policy agenda by IMF managing director Christine Lagarde on 17 April 2012.1 Lagarde explained that the monetary union needed to be supported by stronger financial integration, in the form of unified supervision, a single bank resolution authority and a single deposit insurance fund. Europe quickly welcomed Lagarde’s proposals, with Mario Draghi first echoing them in a speech to the European Parliament on 25 April 2012, followed a month later by French president François Hollande, the Italian prime minister Mario Monti and the European Commission president José Manuel Barroso. By the end of June 2012 there was political agreement at the European Council for the creation of the SSM under the ECB’s authority. Political agreement for the creation of the 1. The idea of creating a “banking union” in Europe was first floated by Bruegel scholar Nicolas Véron in December of the previous year (Véron 2011). 79

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SRM was achieved in December 2012. By 4 November 2014 SSM was not only established but also fully functional as it assumed authority for banking supervision in respect of all banks in the euro area. SRM was established in 2014 and assumed its authority in 2016. The third and final pillar for a fully fledged banking union, which remains incomplete, is the creation of a European deposit insurance scheme (EDIS). The EDIS is intended to provide more uniform insurance cover for all retail deposits in the euro area. It is the subject of deep disagreement at the political level, however, as it is seen by some quarters, especially in Germany, as the back door to a permanent transfer union. The SSM and SRM are already in place. At the time of writing EDIS remains in a state of limbo, due to a deadlock in the policy discussions, notwithstanding a proposal adopted by the European Commission in November 2015 (see the relevant section in this chapter for more details). The banking union project arose out of the realization that banks in euro area member states operated under regulatory environments that were very different. These differences impacted adversely on the transmission mechanism of monetary policy. Reducing policy rates had an uneven impact on borrowing costs across member states. Some banking systems were plagued by a high amount of non-​performing loans (NPLs) while, in others, the banking system was the main provider of finance for the government, amplifying the doom loop between banks and public finances that led to the crisis. Even more worryingly, in small member states with large banking systems political pressure on bank supervisors meant that they could adopt lax regulatory standards, which sooner or later might lead to a crisis.2 It was therefore important to have the same regulatory framework for banks across member states and to make sure that this was enforced consistently, effectively and fairly. Moreover, it was also important to introduce an effective framework to deal with banks that were failing and to ensure that depositors have the same level of protection across Europe. These initiatives, which will be reviewed in the rest of this chapter, expanded the scope of ECB and ESCB activities and created new challenges for central bank independence in Europe. The banking union project was, of course, not just a response to growing redenomination risk in the euro area. It was a response to 2. A good example of this is Cyprus; see Demetriades (2017b). 80

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a broader range of challenges that had surfaced during the financial crisis, exposing the vulnerabilities in the architecture of banking regulation not only in the euro area but also in the rest of the European Union. As such, the single rulebook applies to all 28 member states. Similarly, although SSM and SRM apply to countries in the euro area alone, provisions for non-​euro area countries have been made so that they can also join in the future, if they so wish. The project to set up the banking union was led by the European Commission, which worked closely with the ECB, however, and liaised with all EU member states and the European Parliament. The blueprint for the banking union arose from work carried out by expert committees from member state central banks and finance ministries. The speed with which the banking union was created is no doubt a remarkable achievement in European cooperation, not least because the process required unanimity by the governments of all EU 28 member states, as well as majority ratification in the European Parliament. In this chapter I take a closer look at what has been put in place and evaluate the extent to which it has lived up to expectations. A lot, if not all, of the discussion in Europe on what is missing has focused on the disagreements in setting up the EDIS. Although I do not dispute that the EDIS is important for a fully fledged banking union, it is equally important to ask whether the first two pillars, which are already in place, have delivered what was expected of them. This question has received little, if any, attention in the policy debate about the banking union, although, as explained in the rest of this chapter, it is inextricably linked to the setbacks to central bank independence in the euro area. The single rulebook and the Basel Accord The single rulebook is the foundation for the banking union. It aims to create a unified regulatory framework for the EU financial sector that will help complete the single market in financial services. It comprises a single set of harmonized prudential rules that banks throughout the European Union must adhere, with the intention of closing regulatory loopholes and ensuring the uniform application of “Basel III” in all member states.

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The Basel Committee on Banking Supervision (BCBS) was formed by the G-​10 in 1974 under the auspices of the Bank for International Settlements, with a view to harmonizing the regulatory treatment of internationally active banks. In 1988 the BCBS published a set of minimum capital requirements for banks, which became known as the Basel Accord. The accord stipulated that internationally active banks should hold capital equal to 8 per cent of risk-​weighted assets (RWAs). It also defined five categories of credit risk, against which banks were expected to hold capital. Risk weights ranged from 0 per cent, for government bonds, to 100 per cent, for corporate exposures. Residential mortgages and municipal bonds carried a risk weight of 50 per cent, while securitized assets with a triple A rating carried a risk weight of 20 per cent. The Basel Accord was eventually adopted by over 100 countries, although enforcement of its provisions varied considerably across countries. Although it was an important step in the direction of harmonizing banking regulation across countries, its treatment of banking risks was neither comprehensive nor sufficiently refined. Banks could easily move into riskier assets within the same category without being required to hold more capital  –​a process known as regulatory arbitrage. For example, they could switch from low-​risk sovereign bonds to high-​risk ones without being required to hold more capital, given the zero risk weight attached to bonds from all Organisation for Economic Co-​operation and Development countries. Basel II, published in June 2004, started being adopted prior to the global financial crisis and was an attempt to address the weaknesses in the original accord by introducing additional categories of risk, such as trading and operational risks, as well as a more refined treatment of credit risk. The latter included additional risk categories for banks using the standardized approach to measure risk. Importantly, however, it also allowed banks with more sophisticated risk management processes  –​typically the larger banks  –​more leeway in calculating risk weights by using an “internal ratings-​based approach”. Basel II introduced the concept of three pillars regulation, with minimum capital requirements, which evolved from Basel I, being the first pillar. Pillars II and III comprised the supervisory review process and market discipline, respectively, and were meant to supplement minimum capital requirements through oversight of banks’ risk management by 82

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supervisors and disclosure requirements that assist financial markets in “disciplining” banks that are seen to take excessive risk. Although Basel II is often criticized for allowing banks to take on excessive risks, it is not obvious that this is a fair criticism, given that the risks that led to the crisis were already accumulating even before it was fully adopted. Basel II, in fact, was never fully implemented, as many developed countries moved straight to Basel III in response to the global financial crisis. Basel III was very much a response to the deficiencies exposed by the crisis. It was agreed by BCBS in 2010 and started being implemented in 2013. It aims to strengthen the capital buffers of banks through increased emphasis on loss absorbency and common equity. Additionally, it introduces a macro-​prudential overlay intended to address systemic risk, which includes a new counter-​cyclical capital buffer, higher capital buffers for global systemically important financial institutions (G-​ SIFIs), a new leverage ratio and new liquidity requirements. Although the original Basel Accord stipulated that banks should hold capital equal to 8 per cent of risk-​weighted assets, the definition of capital was such that banks could hold a half of that in what was known as “tier II” capital, consisting of undisclosed reserves, revaluation reserves, loan loss reserves, hybrid capital instruments and subordinated debt. Moreover, only half the tier I capital needed to be common equity, which meant that banks could satisfy the minimum capital requirements with just 2 per cent common equity (this was also true in Basel II). The rest could be retained earnings or preferred stock. By contrast, Basel III introduces a common equity tier 1 (CET1) ratio of 4.5 per cent, while the minimum tier I capital requirement is increased from 4 per cent in Basel II to 6 per cent. In addition, as of 2019, a new capital conservation buffer equivalent to 2.5 per cent of risk-​weighted assets is introduced, increasing the CET1 ratio to 7 per cent and the tier I requirement to 8.5 per cent. A discretionary counter-​cyclical buffer of up to 2.5 per cent can also be introduced to counter high credit growth. Large banks can also be required to hold an additional 3.5 per cent of capital against risk-​weighted assets. Basel III introduces new liquidity requirements, known as the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). The former is intended to enable a bank to withstand 30 days of liquidity stress, while the latter aims to ensure that a bank has sufficient stable funding sources to cope with a one-​year period of extended stress. 83

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The single rulebook consists of the Capital Requirements Regulation (CRR), the Capital Requirements Directive (CRD IV), the Bank Recovery and Resolution Directive (BRRD), the Deposit Guarantee Schemes Directive (DGSD) and a revised Payments Services Directive (PSD2).3 The CRR, which is directly applicable to firms across the European Union, lays down uniform rules concerning general prudential requirements that supervised institutions should comply with, including capital and liquidity requirements relating to various banking risks, large exposures and their requirements in relation to reporting and disclosure. CRD IV, which is implemented through national law, is intended to implement the Basel III agreement in the European Union. As such, it includes enhanced requirements for the quantity and quality of capital, provisions for new liquidity and leverage requirements, rules for counterparty risk and other macro-​prudential standards, such as the counter-​cyclical capital buffer and additional capital buffers for systemic banks. In addition, CRD IV includes new rules on corporate governance and remuneration and introduces standardized regulatory reporting. The BRRD was adopted in spring 2014 and is intended to provide comprehensive and effective arrangements to deal with failing banks at the national level, as well as cooperation agreements to tackle cross-​ border bank failures. The directive requires banks to prepare recovery plans to overcome financial distress. It also grants resolution authorities powers to ensure the effective winding down of failing banks with minimal costs for taxpayers. Importantly, it includes new resolution tools, such as the “bail-​in” mechanism, which is aimed at ensuring that banks’ shareholders and creditors pay their share of costs. The DGSD was adopted in 2014 and requires EU member states to introduce at least one deposit guarantee scheme (DGS) in their jurisdiction to provide protection for depositors in order to reduce the risk of bank runs and to safeguard the stability of the EU banking system as a whole. Deposits are covered per depositor per bank to a limit of €100,000. For joint accounts, such as those belonging to a couple, the 3. EU regulations have binding legal force throughout every member state while directives lay down certain results that must be achieved but member states are free to decide how to transpose them into national laws. 84

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€100,000 limit applies to each depositor. DGSs protect all deposits held by individuals and companies, whatever their size, but do not cover deposits of financial institutions and authorities (except for small local authorities). Deposits in non-​EU currencies are also covered, as this is important for small and medium-​sized enterprises (SMEs) active in several countries. The directive stipulates repayment deadlines that have to be adhered to; the goal is that by 2024 repayment deadlines will be reduced from 20 working days to 7 working days. The directive confirms that DGSs should be financed by contributions from banks, with riskier banks paying more. By 2024 DGSs are expected to reach a target level of 0.8 per cent of covered deposits. The PSD2 was adopted in 2015 and sets requirements for firms that provide payments services, including banks, building societies, payments institutions, e-​money institutions and their customers. The directive aims at making payments safer and more secure, as well as driving down the cost of providing payments services by enhancing competition. Single supervisory mechanism The SSM is the first pillar of the banking union. It was established on 15 October 2013 through a European Council regulation that conferred specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions. The SSM comprises a central body, which is part of the ECB, and the national supervisors of participating countries –​initially the euro area member states.4 It aims to ensure the safety and soundness of the European banking system, increase financial integration, enhance financial stability and ensure consistent supervision. The SSM’s creation was expected to establish a common approach to banking supervision across participating countries, including a harmonized approach in taking supervisory actions and corrective measures, as well as ensuring a consistent application of regulations and supervisory policies. The SSM supervises directly 117 “significant” banks of the participating countries, which hold 82 per cent of the banking assets in the euro 4. Eleven of the 19 national supervisors are, in fact, the euro area central banks. 85

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area. It also supervises, albeit indirectly, all the remaining banks in the euro area, which are deemed as “less significant”. A team of supervisors is attached to each significant bank, known as a Joint Supervision Team (JST), as it comprises staff of the ECB and the national supervisors. Banking supervision involves conducting supervisory reviews, including bank stress tests, on-​site examinations and investigations that are aimed at ensuring compliance with EU prudential rules (CRR and CRD IV). The SSM has the power to grant or withdraw banking licences and assess the acquisition and disposal of “qualified holdings” –​ participations that represent more than 10 per cent of the shares and/​or voting rights in a bank. In addition, it has the power to impose a wide range of corrective measures and sanctions, including the imposition of fines or withdrawing a banking licence. Day-​to-​day supervision by the SSM involves constant oversight of the activities of supervised banks, as part of the Supervisory Review and Evaluation Process (SREP), which involves using a common set of methodologies and standards to assess banking risks, governance arrangements and capital and liquidity positions. The SSM is governed by a supervisory board, which meets twice a month to discuss, plan and carry out the ECB’s supervisory tasks. The board comprises a chair, who is appointed independently for a term of five years and is not a member of the ECB Governing Council; a vice chair, who is chosen from among the members of the ECB’s executive board; four ECB representatives; and 19 representatives of national supervisors. The supervisory board is an internal body of the ECB. Its role is to prepare the draft adopted by the Governing Council of the ECB under the non-​objection procedure. If the Governing Council does not object within a defined period of time, the decision is deemed adopted. This seemingly complex decision-​making process is intended to prevent conflicts of interest between monetary policy and supervisory responsibilities; it is aimed at ensuring a separation of objectives, decision-​ making processes and tasks. The SSM’s creation was intended to rebuild trust in the European banking system, which had been eroded during the global financial crisis and, subsequently, the crisis in the euro area. Much of the political discussion at the time the banking union was conceived as an idea emphasized the need to break the bank–​sovereign doom loop, 86

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whereby banks in each member state invested disproportionately in their sovereign’s bonds. That was how a sovereign debt crisis almost automatically led to a banking crisis, and vice versa.

BOX 6.1 INSIGHTS FROM A RECENT BANK FAILURE

On 19 June 2018 the European Commission broke the news of the failure of the Cyprus Cooperative Bank (CCB) by announcing that it had approved state aid for financing its “orderly market exit”, involving the sale of its good assets and deposits to another Cypriot bank. The bank –​the second largest credit institution in Cyprus –​had been under government control since February 2014, as it had then been bailed out with public money –​on the back of a restructuring plan that aimed at returning it to viability. The Commission’s announcement stated that the bank had “failed to recover much money from its very significant portfolio of non-​performing loans, partly because of CCB’s own governance failures and partly because of obstacles created by the Cypriot legal framework to work out non-​performing loans”. It also explained that the CCB had initiated a sale process on 19 March 2018, which had not resulted in any bids at a positive price, however. The cost of winding down the cooperative bank to entice a buyer was €3.5 billion –​an amount equivalent to around 20 per cent of Cyprus GDP. On top of that, the government offered guarantees to the buyer and took over the management of bad assets comprising €6 billion of NPLs –​representing a contingent liability for the taxpayer amounting to an additional 33 per cent of GDP. This was a massive failure, with significant political ramifications. Earlier in the year, in February, Nicos Anastasiades had been re-​elected for a second five-​year term, on the back of a campaign that had emphasized his successful management of the economy during his first term. Among his alleged achievements were the stabilization of the banking system and the turning around of the Cyprus Cooperative Bank. During the pre-​election period the government had dismissed claims that the CCB was in trouble. Anastasiades’ second term started on 1 March 2018. On 6 March 2019 an 800-​page report containing the findings of a judicial enquiry into the failure of the CCB, led by former Supreme 87

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Court judge George Arestis, was made public.5 The report ascribed much of the responsibility for the Cyprus Cooperative Bank’s failure to the government’s mishandling of the bank. It apportioned much of the blame to the finance minister, Harris Georghiades, and President Anastasiades for ignoring supervisory warnings regarding the inadequacy of the bank’s senior management. One of the most revealing insights from the enquiry was a letter from the governor of the Central Bank of Cyprus to President Anastasiades, dated 23 October 2017 (p. 544), which states the following [my translation from Greek]: “ The Central Bank of Cyprus, with coordinated efforts towards the direction of the ECB, has managed, for the time being, to prevent early intervention measures [by the SSM], using primarily the actions that have been undertaken [by the CCB] to attract investors …” Had the SSM taken early intervention measures in 2017, the CCB might have been saved, or perhaps the cost of failure would have been smaller. As this was in the middle of the pre-​election period, however, it would probably have had an impact on the outcome of the election. This clear case of regulatory forbearance indicates that the SSM is not immune from political pressure from national supervisors, who –​not surprisingly –​are under political pressure at the national level.

An even bigger concern, albeit rarely acknowledged, was the lack of de facto independence on the part of national supervisors, which often led to supervisory forbearance. This was a problem particularly relevant in small countries with large banking systems, in which dominant banks commanded political clout through which they could exert political pressure on national supervisors. By assigning supervisory powers to the ECB, large banks could no longer capture the supervisory process by capturing their national supervisor. The extent to which this has succeeded remains to be seen. Early signs suggest that the national supervisors continue to exercise disproportionate influence on the process and that they often act to block or delay SSM decisions affecting banks in their respective countries; see Box 6.1 for a recent example from Cyprus. 5. The report, which is available only in Greek, can be downloaded from www. pio.gov.cy/​ assets/ ​ p df/ ​ newsroom/ ​ 2 019/ ​ 0 3/ ​ E KTHESI%20EREYNITIKIS%20 EPITROPIS%20GIA%20SYNERGATISMO.pdf.

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Single resolution mechanism The single resolution mechanism is the second pillar of the banking union. It was established in 2014 by a regulation and applies to all banks in EU countries that participate in the banking union. Its aim is the orderly restructuring of banks that are failing or are likely to fail without harming the real economy. Specifically, resolution is intended to put an end to the “too big to fail” doctrine, by minimizing the use of public money when dealing with systemic banks and ensuring that their winding down does not cause financial instability (see Box 6.2). At the heart of the SRM there is the Single Resolution Board (SRB), which is a fully independent EU agency, based in Brussels, that acts as the single resolution authority within the banking union. In addition to the SRB, the SRM comprises the national resolution authorities (NRAs) of participating member states. One of the tasks of the SRB is the resolution planning for all banks under the direct supervision of the SSM, which is intended to ensure that all systemic banks are resolvable and that any obstacles to resolution are removed. The SRB’s other tasks include triggering resolution (jointly with the ECB) as and when appropriate, adopting resolution decisions and choosing which resolution tools to apply. Resolution tools available to the SRM include the sale of business tool, the bridge institution tool, the asset separation tool and the bail-​in tool. The tools are implemented by the NRAs. In addition, the SRB’s tasks include setting minimum requirements for its own funds and eligible liabilities that can be used to shore up a bank’s capital buffers during resolution (known as MREL) and cooperating with and giving instructions to NRAs. Besides cooperation with NRAs, the SRB also cooperates with resolution authorities of EU member states and third countries in relation to resolution planning in connection with cross-​border banks. The SRM is complemented by a Single Resolution Fund (SRF), which can be used to ensure the efficient application of resolution tools, as a last resort. For example, it can be used to guarantee the assets or liabilities of the institution under resolution, to make loans or purchase assets of the institution under resolution, to make contributions to a bridge institution or an asset management vehicle or pay compensation to shareholders or creditors who incurred greater losses than under normal insolvency proceedings. 89

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The SRF is financed by contributions from the banking sector and aims to reach 1 per cent of covered deposits by 2023. Small institutions (49 per cent of the total), with assets below €1 billion, pay a lump sum contribution, while large institutions (21 per cent of the total) are subject to a risk-​based contribution and pay 96 per cent of the total bill. The rest (those with assets above €1 billion but below €3 billion) have a special calculation method that depends on their business model. In all, the SRF aims to ensure that the banking industry contributes to the stabilization of the financial system, which should help to address public criticism.

BOX 6.2 THE END OF “TOO BIG TO FAIL”?

Bank resolution is the process by which systemically important banks that are failing can be wound down in an orderly manner, with minimal cost to the taxpayer and little disruption to the financial system. During the global financial crisis such banks were bailed out with public money, since the only available method for winding them down –​liquidation –​ was believed to be inappropriate. Although small banks can be liquidated using standard insolvency procedures, the liquidation of large banks would almost certainly have resulted in economic and financial meltdown, because of their size and large number of connections with the rest of the financial system. Large-​ scale fire sales of assets would have destroyed value and could also have caused a collapse of asset prices, triggering defaults of numerous other financial and non-​ financial institutions, causing massive disruption. Bailing out banks that were deemed too big to fail could exacerbate moral hazard in the future, however. The advent of resolution is meant to put an end to such moral hazard, which leads big banks to take on excessive risk in the knowledge that, should things go wrong, they will be bailed out by the taxpayer. Unlike liquidation, an appropriate resolution framework protects value by preventing fire sales of financial assets and also allows a bank that is being resolved to continue operating its critical functions, thereby minimizing any disruption to the rest of the financial system. An appropriate resolution regime enables the resolution authority to ring-​fence critical functions while carving out and disposing problem 90

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assets, using appropriate resolution tools, such as the sale of business tool. Moreover, the bail-​in tool allows the resolution authority to write down shareholders’ equity and other claims by investors, which helps to ensure fair burden-​sharing. An appropriate resolution regime includes putting together resolution plans –​known as “living wills” –​for each and every systemic bank. Resolution is, therefore, expected to put an end to the distortions associated with “too big to fail”, which contributed to the build-​up of systemic risks prior to the financial crisis. Nevertheless, the extent to which resolution planning can put an end to “too big to fail”, in practice, can be gauged only after the next financial crisis. Resolution planning, by its very nature, aims to put one failing bank on its deathbed without public money. It remains to be seen if it will work when several systemic banks are failing at the same time. Specifically, one of the most important resolution tools –​sale of the business –​implicitly assumes that there will always be buyers of distressed financial assets. Although this is plausible in normal times, it is a very different proposition during a major financial crisis. Even during “normal” times, when one or two banks fail, the application of the bail-​in tool is fraught with many difficulties, as investors who lose money are bound to use all the political and legal levers at their disposal to evade losses.

European deposit insurance scheme The European deposit insurance scheme is the third and final pillar of the banking union, but it remains missing (or “incomplete”), however, because of continuing political disagreement. It is intended to protect depositors in the same way, irrespective of where they are, by pooling resources across countries so as to increase shock absorbency. It is expected to enhance the capability of national member states to deal with systemic crises. Because it will reduce the contingent liabilities of governments in their banking systems, it is also expected to weaken the link between sovereign risk and banking risk, as banks would depend less on public money during crises. On 24 November 2015 the European Commission published its proposal for an EDIS that could be introduced in stages, with the aim of building a deposit fund at the EU level that reaches 0.8 per cent of covered 91

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deposits. The EDIS will be built on the existing system, composed of national DGSs set up in line with European rules, offering the same level of protection (€100,000 per depositor per bank). It is intended to be cost-​neutral for the banking sector; the contributions that banks make to the EDIS will be deducted from their national contributions to the DGSs. They will be risk-​weighted, with riskier banks paying higher contributions than safer banks. Strict safeguards will accompany the EDIS, in that it will insure only those national DGSs that are compliant with EU rules. The introduction of the EDIS is envisaged to be accompanied by measures to reduce risks, such as proposals to reduce bank exposures to their sovereigns. The EDIS will be mandatory for banks supervised by the SSM but it will also be open to EU member states that want to join the banking union. The Commission’s proposal starts with a reinsurance phase that would last until 2020, during which a national DGS would access EDIS funds only once it had first exhausted all its own resources. In this phase EDIS funds would provide a “top-​up” but only up to a certain level. In phase 2 there will be co-​insurance, by making EDIS a progressively mutualized system. This means that a national scheme will not need to be depleted before using EDIS funds, although such funds would still be subject to strict limits and safeguards against abuse. The share contributed by the EDIS will start at a low level of 20 per cent. In phase 3 there will be full insurance of national DGSs, by 2024. By that time the SRF will be fully funded, and the expectation, therefore, is that recourse to the EDIS will be limited. By that stage the Deposit Insurance Fund (DIF) available at the EU level is expected to reach €43 billion, or 0.8 per cent of covered deposits. Alongside the EDIS, the Commission is proposing a series of risk reduction measures that would harmonize the application of prudential rules and increase the loss-​absorbing capacity by banks, so that adequate resources are available to deal with banks that are failing.

BOX 6.3 SPAIN VS ITALY (NOT A FOOTBALL GAME)

On 6 June 2017 the ECB declared Banco Popular, a medium-​sized bank in Spain supervised by the SSM, to be “failing or likely to fail” (FLTF) on account of its stressed liquidity situation, and notified the SRB. It was the

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first case of a bank failure to be dealt with by the SRM under the new resolution framework in the euro area. It was, therefore, very much a test case. The SRB and the Spanish national resolution authority (FROB) took swift action. By 7 June they had already transferred all the shares of Banco Popular to Santander Bank, which they had sold for €1 using the sale of business tool. The swift action by the SRM protected all depositors at Banco Popular and protected the bank’s critical functions. In addition, as no public money was used, the resolution actions protected the Spanish taxpayer. Banco Popular was a model resolution, hailed as a success by the European Commission and many independent commentators; everything was done exactly as prescribed by the single rulebook. All the conditions for resolution were met: (a) the bank was FLTF because of its rapidly deteriorating liquidity condition, which suggested that the bank would be unable to pay its debts as they fell due; (b) there was no reasonable prospect that any alternative private sector measures or supervisory action would prevent its failure within a reasonable time frame; and (c) resolution action would be necessary in the public interest. Specifically, resolution action would ensure the continuity of the bank’s critical functions, including deposit-​taking from households and small and medium-​sized enterprises, lending to SMEs and payment and cash services. Moreover, resolution was needed to avoid adverse effects on financial stability. On 23 June 2017 Banca Popolare di Vicenza and Veneto Banca –​two medium-​sized Italian banks based in the Veneto region –​were also declared as FLTF by the ECB. The SRB decided that resolution action by it was not warranted for these banks. The SRB justified its decision not to take resolution action by stating that neither of these banks provided critical functions and their failure was not expected to have a significant impact on financial stability. As a result, the banks were wound up under normal Italian insolvency proceedings. Treating them in that way enabled the Italian government to effectively bail out bondholders in the two banks by offering another Italian bank –​Milan-​based Intensa Sanpaolo –​state aid of up to €17 billion to take on some of the assets of the two banks without hurting its capital ratios. The actions protected financial stability in Italy but raised many eyebrows among financial commentators, not least because of the contrasting treatment of bondholders in the two countries (bondholders in Spain were bailed in) and the different application of the single rulebook across the two countries at the same point in time. It did not help that the Italian government had made it clear that 93

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it did not wish to apply bail-​in, because of the impending election, and campaigned vigorously in Brussels to use national law to deal with the troubled lenders.

Weaknesses, gaps and challenges for central bank independence Much of the policy debate around the banking union project so far has focused on the missing third pillar  –​the EDIS. Proposals have been put forward aiming to break the continuing political deadlock by leading European economists and think tanks, although the European Commission’s proposals have been backed by ECB research (Carmassi et al. 2018). A recommendation by Daniel Gros (2015) retains a permanent autonomous role for national DGSs in a reinsurance system, while Isabel Schnabel and Nicolas Véron (2018) propose an EDIS design that is institutionally integrated but financed in a way that is differentiated across countries. Moreover, Schnabel and Véron (2018) embed their EDIS proposal in a wider set of euro area reforms proposed by a group of Franco-​German economists (Bénassy-​Quéré et al. 2018), covering financial, fiscal and institutional reforms. The policy debate has, perhaps inadvertently, missed the equally important question of how well the existing two pillars of the banking union are performing. Although it is perhaps too early to carry out a comprehensive assessment, the evidence that has emerged in the short time that the two pillars have been in existence is not as encouraging as would have been expected at the outset. The first weakness of the banking union architecture is the fact that the SSM has not been given powers relating to the supervision of anti-​ money-​laundering (AML) and combating the financing of terrorism (CFT) programmes. A series of recent money-​laundering scandals have exposed a glaring gap in the supervisory architecture, suggesting that, in fact, a fourth pillar may be needed to deal with AML/​CFT. Proposals by the European Commission to give more powers to the European Banking Authority are a step in the right direction, but it remains to be seen if and when they will be enacted. Even if they are, they arguably do not go far enough, as considerable discretion will remain in the hands 94

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of national regulators. Experience has shown that national AML/​CFT regulators can be captured or weakened by special interest groups; this weakness is particularly relevant in small countries with large banking systems (see Chapter 8). The second weakness relates to supervisory independence. The set-​ up of the SSM is such that the supervisory board’s independence in practice can now be questioned, in light of the events described in Box 6.1 –​a case study of a failing bank where proposed SSM early intervention measures were deferred through “coordinated action” by a national supervisor acting to protect political interests during a pre-​election period. This is a classic case of regulatory forbearance during an electoral cycle that the SSM could and should have prevented. Ignazio Angeloni (2019) explains that supervisory independence is more difficult to put in practice than monetary policy independence. One concrete example provided by him relates to the challenge by the European Parliament to the ECB’s power to set provisioning calendars for deteriorated exposures. Although Article 16 of the SSM regulation states that the ECB can require banks to apply specific provisioning policies, the European Parliament made a challenge on the grounds that calendars, being akin to rules, invade the prerogatives of legislators. Clearly, this is a case in which interpretation of the law limits supervisory independence and can impinge on progress in cleaning up bank balance sheets from non-​performing loans. Part of the difficulty with supervisory independence relative to monetary policy is the vagueness with which supervisory targets are defined. Although an inflation target of 2 per cent per annum is easy to understand, the objective of “safety and soundness” is impossible to define precisely. Because of this, the accountability of supervision becomes a big challenge by itself. In turn, without sufficient accountability, it is almost inevitable that supervisory independence will suffer from political manoeuvring. The SSM is in fact accountable to national parliaments for its actions, but so far this has scarcely been evident. In fact, in the case of the failure of the Cyprus Cooperative Bank, the SSM declined to appear in front of the committee of enquiry set up by Cyprus’s attorney general, although it did in the end agree to provide written answers to the committee’s questions. A similar point can also be made in relation to the independence of the SRM. The differential treatment of banks in Italy and Spain in June 95

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2017 (Box 6.3) was largely the result of campaigning by the Italian government, which wanted to avoid the application of bail-​in to “retail investors” months before an election. In fact, all the evidence we have so far from the application of the bail-​in tool in various European countries, including Cyprus, Slovenia and Spain, suggests that investors who lose money will use all possible political and legal levers at their disposal to avoid losses. It is likely, therefore, that both pillars will come under severe political pressure every time there is a bank failure, let alone a full-​blown crisis. A broader weakness of the first two pillars is the lack of explicit fit and proper criteria for the boards of national supervisors and national resolution authorities –​which more often than not are the Eurosystem central banks. There have been instances when governments appointed former bankers of failed banks or those involved in money-​laundering scandals to the boards of Eurosystem central banks. In an era in which integrity in politics is becoming a scarce commodity, uniform rules for such appointments would protect against the gradual erosion of the competence and independence of national supervisors. Last but not least, the existing pillars of the banking union –​supervision and resolution –​may be separate at the European level but often coincide at the national level. As shown in Table 6.1, 11 euro area central banks are the national competent authorities for banking supervision, while nine of them are, in addition, the national resolution authority; this is so in Belgium, Cyprus, Greece, Ireland, Italy, Lithuania, the Netherlands, Portugal and Slovenia. The Bank of Spain has both supervision and resolution responsibilities, although the latter are shared with another two agencies. Moreover, even in member states where banking supervision is not the responsibility of the central bank, resolution and supervision are, more often than not, under the same institution; this is the case in Austria, Estonia, France, Germany, Latvia, Luxembourg and Malta. The only euro area country in which monetary policy, banking supervision and bank resolution are delegated to three different institutions is Finland. Although it is easy to understand the concentration of powers in one institution in small countries, where resources are limited, it is much harder to do so in large countries such as Italy, for example, where the explanation must lie in the institution’s own appetite and/​or aversion towards institutional rivals. But, even in small countries, concentrating

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Table 6.1  Supervision and resolution authorities in euro area member states Supervisor

Resolution authority

Austria Belgium Cyprus Estonia Finland

Financial Market Authority National Bank of Belgium Central Bank of Cyprus Financial Supervision Authority Financial Supervisory Authority

France

Prudential Supervision and Resolution Authority Federal Financial Supervisory Authority Bank of Greece Central Bank of Ireland Bank of Italy Financial and Capital Market Commission Bank of Lithuania Commission for the Supervision of the Financial Sector Malta Financial Services Authority The Netherlands Bank Bank of Portugal Bank of Slovakia Bank of Slovenia Bank of Spain

Financial Market Authority National Bank of Belgium Central Bank of Cyprus Financial Supervision Authority Finnish Financial Stability Authority Prudential Supervision and Resolution Authority Federal Financial Supervisory Authority Bank of Greece Central Bank of Ireland Bank of Italy Financial and Capital Market Commission Bank of Lithuania Commission for the Supervision of the Financial Sector

Germany Greece Ireland Italy Latvia Lithuania Luxembourg

Malta Netherlands Portugal Slovakia Slovenia Spain

Malta Financial Services Authority The Netherlands Bank Bank of Portugal Resolution Council Bank of Slovenia FROB, Bank of Spain and National Securities Markets Commission

so much power in one institution can raise questions of legitimacy that can unleash a backlash from politicians, which has the potential, sooner or later, to erode the independence of the central bank. Important examples in this regard are Cyprus and Slovenia, which are discussed elsewhere in the book. It is, in fact, the application of bail-​in in both cases that had an adverse impact on the independence of the countries’ central banks, not least because of the political power of the affected elites.

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Concluding remarks The creation of the banking union, with all its gaps and weaknesses, remains a remarkable achievement for Europe, and particularly the eurozone, not least because of the speed with which it has been put together. It has made banking systems more resilient and better able to withstand future crises. Its success is also its most important weakness, however. The European Central Bank has assumed supervisory powers while many Eurosystem central banks now have resolution as well as supervision powers. As such, the banking union has created new legitimacy concerns and challenges for central bank independence.

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7

Small countries and why they matter

Why small countries are systemic At the peak of the Cypriot crisis the German finance minister, Wolfgang Schaüble, was reported as saying in Eurogroup discussions that Cyprus was not systemic. That was code for the idea that Cyprus could be forced out of the euro area without any significant consequences for other countries. Schaüble was not bluffing. He behaved in a similar fashion in July 2015, when Greece came even closer to leaving the euro. He publicly stated that Greece was better off exiting the euro “temporarily” and returning when it was ready. On both occasions Schaüble was in a small minority, with support from only a handful of finance ministers. In the case of Cyprus, it was pointed out to him that a disorderly sovereign default in Cyprus would send financial shock waves through to Greece, as Cypriot banks owned 11 per cent of Greek bank assets and liabilities. More generally, if any country left the euro, no matter how small, it would create an important precedent. If the euro is not an irrevocable monetary union, markets would constantly be looking for the next weak link. The monetary union is, in effect, as strong as its weakest link at any point in time. It would unravel very quickly if the political commitment to keep it irrevocable was seen as waning. In fact, the Cypriot and Greek crises were intimately linked. Cypriot banks’ exposure to Greece was massive. The banks’ loan portfolio in Greece represented an amount equivalent to 140 per cent of Cyprus’s GDP. In addition, the two largest Cypriot banks –​Bank of Cyprus and Laiki Bank –​had very large investments in Greek government bonds. When the Greek debt restructuring –​widely known as Private Sector

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Involvement (PSI)1 –​was agreed in 2011, the two largest Cypriot banks made losses amounting to 25 per cent of Cyprus GDP. These losses meant that they had to raise fresh capital in order to pass the subsequent stress tests conducted by the European Banking Authority. Their failure to do so by June 2012 was what triggered the Cyprus crisis and forced the Cypriot government to apply for financial assistance from Europe and the IMF. Without that, the ECB could not have continued to supply liquidity to Cypriot banks that had lost significant deposits in Greece because of Grexit risk. Small countries, such as Cyprus and Greece, were correctly viewed as systemic in terms of the irreversibility of the euro, and this explains why governments of euro area countries, in reality, were never persuaded by Schaüble’s arguments –​which were probably a reflection of bailout fatigue. And, although we have no counterfactual for this, we do have a counterfactual for the systemic nature of small countries when it comes to the erosion of central bank independence, to which the rest of this chapter is devoted. There is little doubt that the erosion of CBI in the euro area started in Cyprus in 2013/​14. The Economist at the time described the resignation of the governor in March 2014 as a “worrying precedent” for the euro, although it pondered whether Cyprus was just a “special case” (The Economist 2014). What happened afterwards confirmed that Cyprus was a precedent and not a special case. The events in Slovenia that eventually led to the resignation of the central bank governor there had striking similarities with the events in Cyprus. Investors who made losses from the resolution actions of the Slovenian central bank claimed that the banks’ losses had been exaggerated and that the governor was responsible for that. The same allegations had also been made in Cyprus. In both countries there were death threats against the central bank governors and their families. In both countries governments appointed bankers from banks that had failed and had to be bailed out to the board of the central bank afterwards. All these events reflect the fact that ruling elites have little respect for central bank independence, if that means significant financial losses. Both central banks had supervision and resolution powers,

1. The PSI was an initiative designed specifically for the Greek crisis. It was unique.

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which is what enabled ruling elites to put the blame on the central bank for the bank failures. There are fewer similarities with the erosion of CBI in Latvia, although the common characteristic was the use of national law to help push the central bank governor from office. If anything, Latvia took even more drastic action, by, in effect, removing the central bank governor from office over a weekend, without following due process. The allegations in Latvia were much more serious, however: it was claimed that the governor was seeking bribes. The evidence was not deemed sufficient by the European Court of Justice to take such drastic action, however. This points, if anything, to the possible misuse of national law to circumvent the provisions of the Treaty on the Functioning of the European Union. Another similarity was that there was a bank failure in Latvia at the same time as the central bank governor was removed from office. The bank that had failed –​ABLV Bank –​did so because of action by the US authorities, who deemed the bank to be “of primary money laundering concern” and removed it from the list of eligible counterparties that US banks could transact with. Before the failure of ABLV the Latvian central bank was providing ELA to it to help it with deposit outflows, as a result of the US sanctions. Although details are still emerging, what is clear is that the Latvian authorities, in fact, managed to remove a long-​ standing central bank governor from office without due process. One can postulate that they did so after having studied the previous two cases, in which the European Commission did little to uphold the independence of the governors. Would they have acted the same way had the Commission been more forceful in defending central bank independence in Cyprus and Slovenia? The rest of this chapter provides insights into how CBI was eroded in Cyprus, drawing on Demetriades (2017a; 2017b), following the central bank’s actions during the crisis. It explains that, although these actions were taken in agreement with the European Commission, the ECB and the IMF, and more often than not the Cypriot government, the crisis was so severe that the toxic fallout that was created settled upon the central bank, as politicians were looking to find a convenient scapegoat. This was, not least, because the same politicians were attempting to deflect attention from the real causes of the crisis: the influx of dubious Russian and Ukrainian money, which benefited Cyprus’s ruling elite. 101

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The true causes of the Cyprus banking crisis Although the Cypriot banking crisis was triggered by losses from the two largest banks’ investments in Greek government bonds (GGBs), this was not the root cause of the crisis. The investments in GGBs were a “gamble for resurrection”, as the banks’ interest income from their lending operations had dwindled because of rapidly growing non-​ performing loans (NPLs), which peaked at over 50 per cent of total loans. Such record NPL ratios were largely the result of imprudent lending practices, and were exacerbated by the bursting of the real estate bubble in 2008/​9 following the onset of the global financial crisis. Lax lending standards, which contributed to the formation of the property bubble in the first place, reflected lax corporate governance within banks, which, in turn, was symptomatic of more general weaknesses in prudential regulation that allowed banks to conceal NPLs. But what happened to the asset side of bank balance sheets provides only a partial picture of the crisis and fails to explain its root causes, which are to be found behind the inflows of foreign capital that led to a doubling of banking sector assets between 2005 and 2011. Relative to the size of the economy, total banking sector assets peaked in 2010 at 9.5 times GDP. Domestic banking sector assets, which are more representative of the contingent liability for the taxpayer, peaked at over six times GDP, and, as such, were the highest in the European Union. Two-​thirds of these assets were accounted for by the two largest banks:  Bank of Cyprus and Laiki Bank. The former had a balance sheet size of 2.1 times GDP while the latter’s size was 1.9 times GDP; relative to GDP, they were the two biggest banks not just in Cyprus but in the entire European Union. Not surprisingly, perhaps, these two banks and the power elite closely connected to them were able to exert considerable influence on the political process and the media, which shielded them from effective scrutiny by the regulators. It was the abundant liquidity generated by capital inflows –​which created fertile ground for excessively risky lending, resulting in financial fragility –​that eventually led to the crisis in Cyprus. The large volume of capital inflows, in turn, had its root causes in the “business model” adopted by the ruling elite, which specifically targeted capital flows from the Russian Federation and other former Soviet republics. The central role in this model was played by politically connected law firms, which 102

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acted as “introducers” of wealthy clients from former Soviet republics looking for a tax-​efficient safe haven for their wealth. The business model included the banks (especially the larger ones), law and accountancy firms and politicians; many leading law firms were, in fact, politically connected, often to successive governments or to parliament. The wider business community, including real estate developers, despite not being a part of the “business model”, benefited through access to easy credit. Easy credit to households facilitated home ownership as well as the acquisition of holiday homes and luxury cars and other consumer durables. Capital inflows helped to further fuel aggregate demand and the property bubble. This unprecedented upswing in the financial cycle was accompanied by large increases in GDP and a seemingly healthy fiscal balance, which reflected increased government revenue receipts from indirect taxation and taxes on property sales. There was a growing current account deficit, however, reflecting a deteriorating trade balance due to excessive consumption of imported goods and services. Nonetheless, the ruling elite congratulated itself for the “economic miracle” it had created, and the finance minister in charge of the economy during this unsustainable boom was credited with the (artificial) improvement in public finances. Such rapid expansion of financial assets resulted in hidden financial fragility, since banking risks were underestimated or altogether ignored –​in line with Minsky’s (1992) financial instability hypothesis. There were, even so, some warnings, but these were readily dismissed. The two big banks had marketing and advertising budgets that were commensurate with their grossly inflated balance sheets. Because of this, they were able to exert considerable influence over the media. Media owners showed no appetite for criticizing banks; critical journalists were silenced or dismissed. Media capture went hand in hand with the capture of nearly the entire political system; in any event, key parts of the political system were central in the business model (the politically connected law firms were, in fact, responsible for the influx of foreign capital). Financial regulation was and remained lax; for example, the definition of NPLs and loan loss provisioning fell well below international standards, and independent directors on bank boards were a small minority. The authority responsible for banking regulation and 103

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supervision was the national central bank. Although it was independent, the Central Bank of Cyprus was accountable to the national parliament. Interestingly, however, the CBC was hardly, if ever, scrutinized in parliament for its lax supervision of excessive risk-​taking by banks, even when the credit rating agencies started downgrading the sovereign for the large contingent liability represented by overblown balance sheets. That regulation was and remained lax was no coincidence: it was an endogenous equilibrium that suited the needs of the ruling elite; as such, it was not disturbed. Afterwards, however, the ruling elite blamed the CBC for its lax supervision and took actions to reduce the central bank’s independence. Such populist actions appeared to be justified, although they failed to acknowledge that the root cause of the problem was not so much excessive independence but inadequate accountability, for which parliament (in which the interest group behind the business model was more than adequately represented) was solely responsible. When the crisis hit, it took the ruling elite by surprise:  “financial development” and the “economic miracle”, which emanated from foreign inflows, turned into financial fragility and a full-​blown banking crisis within a space of a few months. Deposit flight started from Laiki Bank in the autumn of 2011, and the bank resorted to the Eurosystem for emergency liquidity assistance. In June 2012, when the two big banks were judged to have failed to address their capital shortfalls, Cyprus was forced to apply for an IMF/​EU economic adjustment programme, not least because the ECB might otherwise cease to continue supplying liquidity to the banking system. It took several months to negotiate the bailout agreement, however, with the outgoing left-​wing government refusing to accept labour market reforms and the privatization of state-​owned enterprises (mainly utilities and the port authority). The formation of a new right-​wing government, in early 2013, following the election of President Anastasiades created the expectation that the banks would be bailed out at the expense of taxpayers (whom no political party appeared keen to represent). The bankers themselves expected to be spared of the consequences of their actions, as the new government was much closer to the “business model” than was the case with the previous government. The first attempt to spread the burden of saving the big banks to small savers –​including insured depositors –​was initially made by the new government. When confronted with the IMF’s debt sustainability 104

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analysis, which showed that the two big banks were simply too big to save, the newly elected government proposed a 9.9 per cent levy on uninsured deposits and a 6.75 per cent levy on insured deposits to generate the funds to shore up the capital buffers of the two biggest banks. This was presented as an attempt to spread the burden of saving the banks evenly but it was, in essence, a disguised attempt to protect the “business model” by limiting the impact on foreign (mainly Russian) depositors. This attempt failed, as the proposed levy was turned down by parliament, albeit perhaps for all the wrong reasons. When the government realized that this “deposit haircut” was politically damaging, it distanced itself from it by claiming that it had been forced to accept it by the ECB, which had allegedly threatened to cut off liquidity from Cypriot banks. As a result, the proposal to tax deposits was perceived –​erroneously –​ as the result of ECB “blackmail” by the ECB, and was turned down on the expectation that the European Union and the IMF would somehow change their mind and accept a more traditional bailout, with the burden of saving the banks falling on taxpayers. As that alternative had already been considered and rejected by the IMF, however, on the grounds of public debt unsustainability, the only remaining solution was to bail in junior creditors and uninsured depositors at the two banks. This was eventually accepted by the government, since the only alternative was sovereign bankruptcy and exit from the eurozone. The unintended consequences of the bail-​in The bail-​in resulted in the wiping out of shareholders and bondholders and an unprecedented conversion of uninsured deposits into equity in the restructured Bank of Cyprus, which also absorbed the “good” part of Laiki Bank, consisting of all Cyprus-​booked assets, guaranteed deposits and the ELA liability to the central bank. There were at least two unintended (and under-​researched), albeit interrelated, political consequences of the application of bail-​in to resolve the Cypriot crisis in 2013, which proved more toxic than could ever have been imagined (see Demetriades 2018). Specifically, what is only gradually becoming recognized is that the bail-​in of uninsured depositors resulted in unpredictable switches in ownership in the resolved institution. The new owners may not want to own a bank and 105

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may also not even be fit and proper to do so. This was the first unintended consequence of the application of the bail-​in tool in Cyprus. The ten largest new shareholders who emerged after the bail-​in was implemented turned out to be politically exposed persons (Russian and Ukrainian oligarchs). One of them, who eventually became the bank’s vice president, Vladimir Strzhalkovsky, was a former KGB agent and was described by the Financial Times as a close ally of Russian president Vladimir Putin. Strzhalkovsky, who served as chief executive of Russian mining group Norilsk Nickel  –​the world’s largest producer of nickel and palladium –​had received a $100 million “golden parachute” pay-​off, the largest in Russia’s corporate history, for his part in bringing to an end a $1.4 billion dispute between two Russian oligarchs (Oleg Deripaska and Vladimir Potanin) over Norilsk rights. In yet another uncanny coincidence, all the Cypriot law firms representing rich Russian and Ukrainian depositors belonged to families of Cypriot politically exposed persons (PEPs). In fact, the one that represented Strzhalkovsky belonged to the family of the Cypriot president, Nicos Anastasiades (Demetriades 2017a). As about 50 per cent of the money that was converted into equity belonged to rich Russians –​with the largest ones being PEPs –​this in fact confirmed that the Cypriot crisis was inextricably linked to the influx of dubious money flows from Russia and Ukraine. What was surprising, however, was that they were all represented by the top Cypriot law firms –​all of which happened to be politically connected within Cyprus. Not surprisingly, perhaps, the fitness and probity checks, which are normally quiet, behind-​the-​scenes supervisory affairs, turned out to be beyond surreal public events. They became headline news in local media and generated a toxic political climate against the central bank and its governor. This was in addition to the political pressures on the central bank, which aimed to reduce the bail-​in percentage and therefore minimize the losses for rich depositors. Had they been heeded, these pressures would have resulted in an undercapitalized bank, with unimaginable consequences. The erosion of the independence of the central bank that followed these political attacks was the second unintended consequence of the bail-​in. It included legislative amendments to the governance structure of the central bank, which undermined its decision-​making powers, and changes to the resolution legislation, which shifted 106

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powers from the central bank to the government. These amendments were voted in by parliament, notwithstanding ECB legal opinions warning against their enactment. The way in which these direct political attacks on the central bank’s independence took place is outlined in the next section. The erosion of the central bank’s independence Even before the bailout was agreed at Eurogroup in March 2013, Cyprus’s ruling elite proceeded to create scapegoats and launched an unprecedented campaign of misinformation against the Central Bank of Cyprus, through political parties that were close to the main beneficiaries from the “business model” –​politically connected law firms, bankers and real estate developers. The first serious attack occurred two weeks after the bailout agreement. On 9 April 2013 the newly elected president, Nicos Anastasiades, decided to “annul” the appointment of the CBC’s deputy governor, Spyros Stavrinakis. Stavrinakis had been appointed a few months earlier by the previous president, Demetris Christofias. Neither the ECB nor the European Commission reacted to this “annulment” action; deputy governors are not protected by the Treaty on the Functioning of the European Union. Although the government found a constitutional pretext for dismissing Stavrinakis, this was a massive blow to the independence of the institution. It took just one letter and no notice to dismiss the deputy governor of a central bank. Within hours he was out of the central bank; he did not even have time to pack his belongings. A week later the rest of the board, with one exception, resigned; some indicated that they feared the consequences of standing up to the government and decided that this was not a battle they were prepared to fight. The board’s departure left the door open for the government to appoint cronies and government sympathizers to the board at one stroke. All of a sudden the government could capture the entire central bank board –​ which up to that time had consisted of non-​executive directors. That was just the beginning of the erosion of the central bank’s independence, however. In May 2013 the ruling party (Democratic Rally, or DISY, which belongs to the European People’s Party coalition) tabled legislative amendments in parliament that would deliver the final 107

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blow to the central bank’s independence. The proposals included the creation of two new executive director posts, without clear responsibilities, who were to report to the central bank board instead of the governor. Although the ECB issued a legal opinion advising against these amendments, as they would erode the central bank’s independence and decision-​making processes, the Cypriot parliament ignored the ECB’s warnings and proceeded to enact them. The two main political parties that voted in favour of these proposals (DISY and DIKO, the Democratic Party) appointed one executive director each from their ranks. Within months of their appointment, in late summer 2013, the position of the central bank governor became untenable. The arrival of two new executive directors at the central bank –​who, as board members, had more authority than the central bank’s most senior and long-​standing directors –​created divided loyalties and confusion among central bank staff. As they had no clear duties and no clear reporting lines, other than to the board, they could undermine any decisions made by the governor.2 Non-​executive board members were, at the same time, given a massive (17.6 times) pay rise and an audit committee was created (it transpired later that its main intention was to audit the governor). The changes made decision-​making within the central bank nearly impossible, unless the governor viewed his or her role as ornamental. As that was not the case, and with the central bank board more or less under the government’s control, President Anastasiades launched a public attack on the governor. The board’s mission was to make the governor’s daily life difficult and the work environment hostile. This was a board that was prepared to manufacture evidence that could be used against the governor in dismissal proceedings that the president declared he wanted to initiate. The board’s control of the central bank budget was to be used to “ground the governor” –​the analogy being that of a pilot who is in complete control of an aircraft in the air but is grounded because the company does not approve the budget to fuel it. What would they do if they can no longer fly? It was only a matter of time before the governor was “grounded” (see Box 7.1). 2. The situation was reminiscent of Communist Party commissars in the Red Army (although the government in Cyprus was pro-​Russian, it was more interested in serving oligarchs than workers’ rights). 108

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BOX 7.1 CENTRAL BANK INDEPENDENCE: A PERSONAL STORY

Within three days of my assuming office at the CBC on 6 May 2012, Laiki Bank, the second largest bank, asked for state aid. Bank of Cyprus –​the largest bank –​followed Laiki a few weeks later. Less than two years later I resigned from the governorship and returned to a more quiet life as an academic. Few at the time believed that what happened in Cyprus could be setting a precedent for the rest of the euro area. True, there had been informal discussions at the ECB’s Governing Council during which this concern was expressed. One wise voice put it bluntly: “ What is happening to Panicos now could happen to any of us in the future.” Such voices were a minority, however. For many in Europe, Cyprus was a minor irritation: they had more important problems to work on, and the support of governments, including those from small countries, was necessary to pass the much-​needed reforms through the European Council. On the ground in Cyprus there was a war of attrition raging. The odds were stuck against me and against central bank independence. Fighting to the bitter end did not make any sense, whatever the precedent for CBI, not least because that may have meant expensive legal battles. In theory, a central bank governor is meant to be financially independent. I certainly never felt like that. I was financially worse off being a central bank governor than a senior professor at a British university, even before taking into account potential legal fees to defend my actions during the crisis. The central bank board –​which was loyal to the government that wanted to remove me –​made it clear that I could not use the central bank’s resources to defend the dismissal of the deputy governor, let alone myself, against the Cypriot government. They were determined to have a good relationship with the government and they felt strongly the central bank shouldn’t have any legal battles with the government. After all, they were all appointed by the same government, which had, coincidentally, just discovered that non-​executives on the board were grossly underpaid; they decided to offer them an increase in their annual fee from €1,700 to €30,000 to bring their remuneration in line with their responsibilities. By stepping down, I could look forward to the end of the relentless attacks that the government had declared on the central bank and me personally. It wasn’t just the public statements that Anastasiades had made about me that were downright offensive or the media campaign 109

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that made me look like an “enemy of the state”, in the eyes of many ordinary people who believed the fake news. It was also that I could clearly see that the safeguards of central bank independence were illusory. I could have withstood the personal attacks by the government if I had thought that the independence safeguards were real and would have been upheld.

Concluding remarks Contagion is not always financial. It can also be political. The erosion of central bank independence in any country, no matter how small, through systematic political interventions and machinations can be emulated elsewhere. What happened in Cyprus in 2013/​14, as a result of the management of the crisis by the central bank and the use of bail-​in, seems to have influenced developments in Slovenia, which eventually led to the resignation of Bostjan Jazbec. They also seem to have influenced and encouraged attacks against Yiannis Stournaras in Greece, as media reports in Greece suggested that the Greek government was trying to follow the example set by Cyprus. Such examples can change behaviours. In March 2019 Slovakia’s central bank governor, Jozef Makuch, stepped down nearly two years before the end of his term in order to avoid conflict with the new government;3 the new governor of Slovakia’s central bank is the former finance minister.

3. Even though there is very little in the international press about the resignation of Jozef Makuch, this is well known in central banking circles. 110

8

Political money-​laundering

A new form of illicit finance Political money-​laundering is a relatively new form of money-​laundering that refers to the use of “dark money”1 to subvert or destabilize democracy. As such, it differs from ordinary money-​laundering, which is the process by which criminals disguise the origins of the proceeds from criminal activity and make them appear as legitimate. Ordinary money-​ laundering is associated with crime, corruption and tax evasion. As such, it is known to have adverse economic and social consequences. Political money-​laundering, on the other hand, can have deleterious consequences for democracy, in addition to any social and economic consequences. Not only can it affect election or referendum outcomes but it can also sponsor political extremism and divisive rhetoric, thereby undermining the functioning of democracies. The rise of “populist” parties and politicians in western Europe and the United States is now widely believed to have been associated with political money-​laundering (e.g., see Barnett & Sloan 2018). In the case of Europe, such parties and politicians have used anti-​European rhetoric. Their growing popularity represents a significant threat to the future of the euro. This chapter explains how the vulnerabilities in regulation have allowed political money-​laundering to flourish and makes recommendations for how these weaknesses can be addressed. From illicit financial flows to the financing of terrorism and subversion Illicit financial flows are usually defined as the transfer of financial capital out of a country in contravention of national or international laws. 1. Money whose origins are unknown or suspicious. 111

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Such flows generally arise from illegal or corrupt practices, but that is not always the case. The source of funds can be legal but the transfer itself may be illegal, as is the case, for example, with tax evasion. The use of funds could also be legal (e.g. private consumption), or illegal (e.g. terrorist financing, fraud or bribery). Illicit financial flows often involve highly complex schemes or criminal networks that establish multi-​ layered, multi-​jurisdictional structures that hide the ultimate ownership of the funds. At the opposite end of the spectrum, they can be simple private transfers of funds to offshore accounts intended to evade taxes. Illicit financial flows deprive economies of much-​needed resources for investment and growth. Moreover, they breed corruption, distort resource allocation and allow the looting of entire countries by kleptocratic regimes (e.g. Ferdinand Marcos in the Philippines). Such regimes move their fortunes out of the country and into safe havens, out of fear of regime change, which could lead to fund seizure or criminal conviction. Often the transfer of funds occurs through commercial banks, which “launder” the funds in order to disguise their origins. Illicit financial flows have traditionally been perceived as a problem affecting mostly developing countries  –​which explains why, until recently, the topic was of little interest to policy-​makers in developed countries or, more generally, to macroeconomics. The spread of terrorism into the United States and western Europe since the horrific 9/​11 attacks, however, has meant that illicit financial flows can no longer be viewed as a problem that concerns developing countries alone. In addition, more recently there have been growing concerns that dark money flows are being used to subvert western democracies by Russia. These include, among other alleged malign activities, a suspected attempt to influence the US presidential election of 2016. These concerns were so serious that, on 6 April 2018, the United States Treasury announced sanctions against seven Russian oligarchs and their companies, 17 senior Russian government officials and a state-​owned Russian weapons-​trading company and its subsidiary, a Russian bank. The announcement contained some very strong language, as follows: “The Russian government operates for the disproportionate benefit of oligarchs and government elites,” said Treasury Secretary Steven T.  Mnuchin. “The Russian government engages in a range of malign activity around the globe, 112

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including continuing to occupy Crimea and instigate violence in eastern Ukraine, supplying the Assad regime with material and weaponry as they bomb their own civilians, attempting to subvert Western democracies, and malicious cyber activities. Russian oligarchs and elites who profit from this corrupt system will no longer be insulated from the consequences of their government’s destabilizing activities.” (Department of the Treasury 2018) Money-​laundering: how it’s done and how it can be deterred There are three stages involved in money laundering:  (a) placement; (b) layering; and (c) integration. In the placement stage the proceeds of the criminal activity are introduced into the financial system through financial institutions, casinos, shops, exchange bureaus or other legitimate businesses that are known to handle large amounts of cash without raising suspicions (e.g. restaurants or taxi companies). The second stage –​layering –​is a substantive stage in which the funds are “washed” and their ownership and source disguised. It often involves converting cash into financial instruments or real assets that are then sold on, making the proceeds appear legitimate. Layering makes it more difficult to detect and uncover a money-​laundering activity. The final stage  –​integration  –​involves reintroducing laundered funds into the legitimate economy. It often involves the movement of previously laundered money through banks in different jurisdictions, making such funds appear to be normal business earnings. Known methods include using shell companies to buy and sell properties, providing false loans or false import/​export invoices and using complicit banks in jurisdictions where anti-​money-​laundering and combating the financing of terrorism oversight or enforcement is weak. Once laundered money has moved through several banks in different jurisdictions, it becomes much more difficult to trace its origin. As such, it appears legitimate and can be used for whatever purpose is required. AML and CFT rules normally require regulated financial institutions to enquire about the origins of large amounts of cash that are being placed and to report any suspicious transactions to the authorities. 113

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Know your customer (KYC) rules are also intended to prevent money-​ laundering: by knowing their customers, banks are in a good position to determine if a transaction appears suspicious and should therefore be reported. Banks are sometimes negligent or complicit in applying these rules, however. The role of AML regulators is to ensure that banks have effective AML compliance procedures. Bank employees and other individuals involved at some stage of the money-​laundering process may not be aware that by assisting criminals to make a profit out of a crime they may also be committing a criminal offence. Training is, therefore, an essential part of compliance so that bank employees recognize the risks to themselves of turning a blind eye and know exactly what they should do when they encounter a suspicious transaction. Euro area weaknesses AML/​CFT regulatory frameworks and their supervision are important tools to prevent illicit financial flows. In the euro area these remain in the hands of national member states, although all other aspects of banking supervision have been transferred to the SSM. As such, the supervision of AML/​CFT activities represents an important gap in the architecture of the banking union. Recent events in Cyprus, Estonia, Latvia, Malta and the Netherlands indicate that the risks from illicit money flows may be growing and that smaller countries may be particularly vulnerable to dirty money flows, particularly from Russia, possibly because their defences are relatively weak but also because of possible political pressure on AML regulators. As AML regulators are often the national central banks, the erosion of central bank independence in the periphery can have unintended consequences that go well beyond what the architects of the monetary union could have foreseen in the 1970s. Thus, the erosion of CBI in the periphery creates additional systemic risks for the monetary union. Once dirty money enters the euro area  –​or the single EU market  –​it creates risks for all EU member states. The risks are wide-​ranging. They include reputational costs to the ESCB and ECB and also possible financial instability, since, as we shall see below, illicit financial flows can also result in bank failures. In addition, there are also political risks emanating from “malign activity” to 114

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“subvert Western democracies”, which are potentially much more serious. Some of these cases –​and lessons that can be learnt from them –​ are analysed below. In 2018 the European Banking Authority announced that it had found “general and systematic shortcomings” in Malta’s application of anti-​money-​laundering rules, exposing yet another weakness in the euro area’s financial architecture. In Latvia, ABLV Bank, the third largest in the country, failed because of actions taken by the US Treasury arising out of money-​laundering “concerns”. Danièle Nouy, chair of the SSM, admitted that the ABLV affair was “embarrassing” for the ECB and was quick to call for EU-​level authorities to be given AML powers. Reputational considerations are of course very important, and more so for relatively young central banks such as the ECB, on whose reputation the future of the euro rests. But the Latvian case demonstrated several deeper flaws in the euro’s financial architecture. First, Europe cannot rely on the United States for actions against money-​laundering, not just because US intelligence may not always get it right but also because such actions may reflect US political biases. Second, AML failures can have implications for financial stability, banking supervision and bank resolution –​all of which are key elements of the banking union. Combine the two together, and it’s like handing over financial stability in the euro area to the United States. Last but not least, the Latvian case has demonstrated that even the national security objection to centralizing AML may be seriously flawed, especially if the biggest security threats to the euro area are common. Indeed, the ABLV affair suggests they might be, as the money-​ laundering “concerns” were linked to Russian deposits. Assuming the US Treasury “concerns” about ABLV Bank were valid, they suggest that the Latvian AML supervisor failed, even though Latvia is a country that is acutely aware of the security threat from the East. Regulators in small member states with large banking systems are, in fact, vulnerable to capture by powerful financial interests, as are the media and the political process. The story of the Cyprus crisis is a case in point, and it is also linked to the same threat from the East. From 2005 to 2011 the Cypriot banking system doubled in size, largely because of the influx of Russian and Ukrainian deposits, facilitated by politically connected law firms. The abundant liquidity in Cypriot banks resulted in a credit boom and a real estate bubble, as well as reckless investments 115

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outside Cyprus (e.g. the purchase of Greek government bonds and a top-​ten retail bank in Russia). Part of the problem was that the “ruling elite” of Cyprus became dependent on Russian and Ukrainian money and resisted any attempt at tightening regulation. When the banks suffered massive losses from their bond and loan portfolio, Cyprus was forced to apply for financial assistance from Europe and the IMF. As part of that, the country undertook, albeit reluctantly, a major restructuring of its banking system. The restructuring programme nominally addressed the regulatory failings that led to the crisis and included an apparent tightening of the AML/​CFT framework and supervision. But the programme has not addressed the deeper cause of the crisis: state capture by a ruling elite content to accumulate wealth by continuing to serve the needs of Russia and its oligarchs. The restructuring, in fact, resulted in toxic political fallout that eroded the central bank’s independence. In the second half of 2013, notwithstanding an ECB legal opinion advising to the contrary, legislative changes were enacted that shifted powers away from the governor, whose independence is protected by the TFEU, to the board of directors, which can be subject to political influence. Russian influence on Cyprus, has, if anything, increased since 2014, and the effectiveness of AML supervision remains doubtful. Why this can be problematic for Europe –​and, indeed, the rest of the world –​ is illustrated by what is perhaps the most infamous case of money-​ laundering to date:  that of Paul Manafort, former campaign manager of Donald Trump, who used Laiki Bank, the second largest bank in Cyprus, and a politically connected Cypriot law firm to launder millions of dollars from his work advising Ukraine’s former pro-​Russian president, Viktor Yanukovych (see Box 8.1 for more details).

BOX 8.1 PAUL MANAFORT AND THE CYPRUS CONNECTION

Paul Manafort was the Republican lobbyist who helped run Donald Trump’s presidential election campaign in 2016. Two years later, in 2018, Manafort was found guilty by a court in the United States for financial fraud, money-​laundering and violating a federal lobbying disclosure law. The charges, which arose out of an investigation into possible Russian influence in the American presidential election, related to Manafort’s work for Ukraine’s pro-​Russian former president, Viktor Yanukovych, who 116

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fled to Russia following a popular uprising in 2014. The Party of Regions –​ a pro-​Russia political party in Ukraine –​retained Manafort in 2006. Manafort was generating tens of millions of dollars of income from his political activities in Ukraine and avoided paying taxes by disguising his income as “loans”. In the process he was using “nominee offshore corporate entities” and “foreign accounts”. Twelve out of the 15 foreign entities that Manafort used were incorporated in Cyprus and were set up between August 2007 and March 2012, using the services of a politically connected Cypriot law firm that belonged to a former minister of justice –​named in the trial as “Dr K”. Two of the foreign entities that he used were created in Saint Vincent and the Grenadines, in August 2011, and the United Kingdom, in April 2013, respectively. The third one was also an entity based in Saint Vincent and the Grenadines, with an unknown creation date. The indictment lists hundreds of wires from Cyprus to various vendors in the United States, starting in 2008. Vendors included home improvement companies, antique and clothing stores, car dealers, art galleries, contractors and real estate companies. Wires from Saint Vincent and the Grenadines and the United Kingdom started in 2013, which coincided with Manafort’s Cyprus bank account being closed because of suspected money-​laundering. Somewhat surprisingly, however, the indictment also includes evidence of two wires from Cyprus in 2014 and 2015, amounting to $0.9 million and $1.0 million, respectively, which were disguised as loans. Cyprus can, of course, proudly point to the fact that its authorities cooperated fully with the Mueller investigation, thereby helping to convict Paul Manafort by providing the evidence of his money-​ laundering activities. Nevertheless, questions over the effectiveness of its AML framework remain, notwithstanding the strengthening that was initiated during 2013. This is because of the two “loan” transactions from Cyprus in 2014 and 2015, totalling $1.9 million. It is very hard to explain how such large transactions could go under the AML radar of a well-​supervised  bank.

Concluding remarks and a new proposal While AML supervision remains in the hands of national member states the euro area remains vulnerable to threats from the East and 117

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erratic behaviour from the West. Small states with large banking systems, such as Cyprus, Malta, and Latvia, are particularly vulnerable, as they are susceptible to state capture by powerful financial interests. The European Central Bank cannot rely on the effectiveness of national supervisors to safeguard the integrity, stability and reputation of the euro area from these threats. It is not surprising, therefore, that proposals have already emerged to address this glaring gap in the euro’s financial supervisory architecture. Specifically, in response to the various money-​laundering scandals that erupted in 2018, the European Commission president, Jean-​Claude Juncker, in his State of the Union address on 12 September 2018, announced measures to provide new powers to the European Banking Authority to help fight money-​laundering and terrorist-​financing as part of a wider push towards a European “security union”. The proposals recognize that, although the European Union has strong anti-​money-​laundering rules, these are not always effectively enforced across the Union, which creates risks for the integrity and reputation of the European financial sector. Moreover, it is also recognized that the status quo entails financial stability risks. The proposals involve amending the regulation on the EBA in order to strengthen the EBA’s role and give it the necessary tools and resources to ensure effective cooperation and a convergence of supervisory standards. More specifically, the measures include a revision of the AML directive to encourage better cooperation and exchange of information between anti-​money-​ laundering officials, prudential supervisors and the ECB and a more explicit and comprehensive AML mandate, accompanied by greater powers and resources, for the EBA. In effect, the proposals recognize that the current state of affairs, in which national supervisors are responsible for the compliance of supervised institutions with EU rules, is unsatisfactory. Moreover, they also implicitly recognize the unsatisfactory nature of the architecture of supervision at EU level. Besides the SSM, which oversees euro area banks and does not have a clear mandate on AML, the EBA, the European Securities Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA) have the mandate to ensure that the European Union’s AML rules are applied consistently, efficiently and effectively.

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The proposed amendments to the EBA regulation will ensure that the breaches of AML rules are consistently investigated: the EBA will have powers to request national supervisors to investigate and impose sanctions. They also include powers to intervene directly, as a last resort, when national authorities do not act, and institute periodic reviews of national supervisory authorities. Although the proposals are certainly a step in the right direction, it is not at all obvious that they will be adopted. Already certain countries, including the Netherlands, have expressed reservations. Even if they are adopted, it will take some time before the EBA’s resources and capacity are sufficient to carry out the envisaged improvements. Even then there will remain considerable reliance on national supervisors, whose limited independence exposes them to national political interests. In small countries with large financial sectors, where the benefits from illicit finance accrue to politically connected actors, the proposed reforms can prove too little and too late. The new chairperson of the EBA, José Manuel Campa, has, in fact, lowered expectations in relation to what the EBA can achieve, given its limited resources and mandate, which he described as “not significant enough to expect a revolution in AML supervision”. He stressed that “AML remains implemented at national level under the imperfect legal framework of the AML Directive” (Campa 2019). A much more effective, efficient and timely way to address the current shortcomings in Europe would be to assign AML/​CFT oversight powers to the Single Supervisory Mechanism, which already oversees all other aspects of banking supervision in the euro area and has much greater capacity than the EBA. By doing so, AML/​CFT supervision can be strengthened without the inevitable delay from setting up a completely new organization. The SSM is already in place and has substantial supervisory resources; it can immediately allocate some of its resources to high-​ risk AML jurisdictions/​banks. The SSM can also recruit new supervisors in a timely fashion, to cope with its additional responsibilities. Importantly, there are significant economies of scope, as well as synergies, between normal bank supervision and AML/​CFT supervision. A bank supervisor normally needs to assess the adequacy of a bank’s risk management framework and governance, as well as the adequacy of its capital buffers. Including AML/​CFT risks and a bank’s AML/​CFT

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compliance framework will provide a more comprehensive assessment of a bank’s risk management and governance framework. As such, it can be considered an integral part of normal bank supervision. The supervision of AML/​CFT compliance entails significant synergies with bank licensing (this includes the withdrawal of a licence). The possibility of withdrawing a licence is, in fact one of the most effective threats a supervisor has. Related to licensing, there is also the process of carrying out fit and proper checks for major shareholders, bank directors and senior executives. Both licensing and fit and proper checks can and should be informed by AML/​CFT conduct and record. This can be an effective deterrent that will help ensure that bankers and banks take their AML/​CFT responsibilities seriously. Negligence or non-​compliance in the application of AML/​CFT rules could become an explicit component of bank licensing and fit and proper checks. The only issue that needs to be addressed if the SSM acquires AML/​ CFT powers is what will happen to countries in the European Union that do not belong to the euro area. This is, indeed, the only weakness that I can see in the above proposal. Dirty money may, in fact, enter the single financial market through non-​euro area member states and end up in the euro area. There is no reason why the European Commission’s proposals to strengthen the EBA cannot go ahead at the same time as assigning the oversight of AML/​CFT supervision to the SSM. This will have the additional advantage that the EBA’s limited resources could more easily cope with nine (or eight) countries than with EU28 (27).2

2. See also Kirschenbaum and Véron (2018) for a detailed analysis of alternative solutions, including a new European anti-​money-​laundering authority. 120

9

Can the erosion of central bank independence be reversed?

The unintended consequences of “whatever it takes” The European Central Bank certainly did “whatever it takes” to preserve the euro during Mario Draghi’s presidency. “Whatever it takes” is often interpreted as equivalent to the Outright Monetary Transactions programme, announced soon after Draghi’s London speech of 26 July 2012, to address markets’ fear of the breakup of the euro, which the ECB considered unfounded. The reality, however, is that the OMT, despite its high profile and the calming impact its announcement had on markets, was never used. Perhaps it was never needed, because it was only one of many measures introduced after the onset of the crisis to save the euro. Others included a range of Eurosystem actions targeted at addressing market liquidity, including the relaxation of collateral rules, the provision of emergency liquidity assistance by national central banks and the introduction of non-​standard measures aimed at redenomination fears and the subsequent risk of deflation. In addition, the ECB played an active part in the creation of the first two pillars of the banking union –​the Single Supervisory Mechanism and the Single Resolution Mechanism. Although Draghi is widely credited with “whatever it takes” –​and there is no doubt that it was he who coined that term in his famous London speech  –​the policy of doing everything possible to save the euro actually started under the presidency of Jean-​Claude Trichet, albeit more opaquely, with the introduction of the Securities Market Programme (SMP) in May 2010. The programme involved buying sovereign bonds of crisis-​stricken countries  –​Greece, Ireland, Portugal, Spain and Italy –​in secondary markets. The SMP was successful in terms of reassuring markets and reducing yields but was highly controversial, not least because it was lacking in transparency; the ECB 121

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never announced details of the amounts purchased nor the targeted securities when the programme was active. It was also widely seen as uncomfortably close to breaching the monetary financing prohibition, as it eased pressure on governments to reduce deficits. Criticism of the SMP by former ECB chief economist Otmar Issing goes even further: he suggests that the ECB was breaching its own independence by helping to bail out countries such as Greece, Ireland and Portugal (Issing 2018). Doing “whatever it takes”, has, inevitably perhaps, made the ECB more political and more politicized. Some politicians felt that the ECB could and should do more to manage the crisis, while others felt that it was already doing too much, including helping some governments avoid or postpone much-​needed fiscal and/​or structural reforms. In programme countries it was widely perceived as part of the coercion mechanism that forced governments to take unpopular measures, including austerity or bail-​in. Taking all this into account, the erosion of central bank independence in the euro area that we have witnessed since the onset of the crisis is not at all surprising. It is, in fact, directly linked to the actions the ECB took or the actions politicians felt it should have taken but never did. But politicians hit first where independence was most vulnerable: Cyprus and Slovenia –​two countries with little tradition of respecting central bank independence, in which crisis management actions –​specifically, bank resolution –​hurt special interest groups or elites. From that point onwards the erosion of CBI started spreading –​not least because the European Commission failed to take decisive action that could have deterred others from emulating. Latvia was the next case in point: unsubstantiated corruption allegations were sufficient to remove the governor from office in 2017. The Commission’s reluctance to take effective legal action to protect the independence of central banks has been one cause of the problem, but not the only reason. The ECB, during Draghi’s term, interpreted its own independence very narrowly, as focusing on price stability. That clearly makes the ECB more transparent and accountable but leaves a big question mark over all the crisis management functions. It wasn’t just non-​standard monetary policy that saved the euro; it was also all the crisis management actions, and increased responsibilities of the Eurosystem  –​i.e. supervision, resolution and the provision of emergency liquidity assistance. The Treaty on the Functioning of the European Union, in fact, protects the independence of all the tasks and 122

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duties conferred upon the ECB and the NCBs by the treaties and the statute of the ESCB. Although it is, admittedly, much harder to define accountability for tasks and duties other than monetary policy, that does not mean that the ECB should not have done more to protect the independence of those NCBs attacked by politicians in member states for taking or participating in actions that helped to save the euro. High-​profile resignations –​or removals from office –​of central bank governors are just one symptom of the erosion of central bank independence in the euro area. The other, which can be equally deleterious, is the gradual capture of central bank boards through the appointment of political cronies or commissars. This is not always obvious but it is certainly worthy of academic research. My conjecture is that any sensible measure of the competence/​independence of central bank boards will show that board independence has been significantly eroded. High-​ profile appointments in Italy and the United States help to illustrate the point. We can, therefore, no longer take it for granted that central bank boards will be fit for purpose. And we cannot rely on central bank governors alone to do the job. Other than take part in monetary policy decisions, governors can do little without the consent of central bank boards. Bank supervision and bank resolution is in the hands of central banks in more than half the euro area. The same is true for the supervision of anti-​money-​laundering and combating the financing of terrorism programmes. One can only imagine the negative consequences of central bank budgets and policies in all these areas being controlled by incompetent or unfit boards, consisting of cronies or commissars appointed by populists governments. The way forward: six policy recommendations The erosion of central bank independence in the euro area can be reversed if prompt and effective action is taken to (a) strengthen the governance of Eurosystem central banks, by introducing uniform fit and proper rules for their boards; (b) Europeanize the supervision of AML/​CFT; (c) Europeanize the provision of ELA; (d) separate out the SSM from the ECB and/​or enhance the independence and accountability of the SSM; (e)  reduce the concentration of powers in NCBs by creating separate resolution authorities in each member state; and 123

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(f) increase the visibility and activity of the ECB in member states. The rest of this chapter is devoted to explaining these recommendations. (a) Introduce harmonized fit and proper rules for Eurosystem central bank boards The competence and independence of central bank boards should become one of the first priorities to strengthen the Eurosystem’s governance. If these boards can be captured either by political parties or governments –​or, indeed, special interest groups or local elites –​central bank governors will be fighting a losing battle. To this end, the process of appointing board members and safeguarding their independence needs to be reviewed with a view to introducing uniform fit and proper criteria for members of euro area central bank boards (including, of course, governors and deputy governors). Such criteria should be at least as stringent as those for commercial bank boards. They should rule out not only membership of political parties but also conflicts of interest; although individuals from the financial services industry should not be ruled out altogether from central bank boards, they can be only a small minority and can qualify only if they, or their immediate families, have no financial relationships with supervised institutions. A good way to protect board independence is to have a minimum of two “external” board members –​citizens of other member states drawn from a pool of suitably qualified individuals, proposed, perhaps, by the European Commission and the European Banking Authority. An even stronger safeguard would be to assign veto power to the ECB Governing Council, to prevent governments from appointing members with political affiliations or aspirations. (b) Europeanize the supervision of AML/​CFT Currently, responsibility for AML/​CFT supervision remains in the hands of national member states. The large number and scale of money-​laundering scandals emerging since 2017 suggest that the current system is failing and has been particularly vulnerable in small countries with large banking systems that have links with Russia, such as Latvia, Cyprus, Malta and Estonia. The European Union urgently needs a pan-​EU AML/​CFT supervisor, not least because powerful 124

Can the erosion of CBI be reversed?

interest groups that benefit from Russian money and politicians who represent them can often lean on national supervisors, who are especially vulnerable in small member states, to turn a blind eye. One way in which this can happen in practice is if Eurosystem central bank boards decide to under-​resource AML/​CFT supervision. Europeanizing the supervision of AML/​CFT will also address problems arising from a lack of exchange of information between national supervisors. Such information exchange is vital, because, by its very nature, money-​ laundering involves dirty money being “cleaned” by passing through numerous jurisdictions, so that by the time it reaches its final destination its origins are no longer known. The exchange of information will become a non-​issue if there is a pan-​EU AML authority to which national supervisors report. The SSM could take over AML/​CFT supervision in the euro area without undue delay. If the SSM does acquire AML/​CFT supervision powers, however, an open question is which institution should have authority over banks in non-​euro area member states. A possible solution to this conundrum could be a joint supervisor, involving the EBA in conjunction with the SSM. (c) Europeanize the provision of ELA Currently arrangements about the provision of ELA are problematic, as both the ECB Governing Council and the NCBs have responsibility for deciding whether to provide it, which makes accountability for the decision blurred. In addition, a supervisory judgement needs also to be made about the solvency of the institution applying to receive ELA. This should clearly be in the hands of the SSM by now but it may also rely on updated assessments made by the national supervisor. Governors in national central banks that have responsibility for supervision may come under political pressure to provide ELA to institutions whose solvency may be doubtful. The converse may also happen; politicians can engineer takeovers that benefit their favoured banks by exerting pressure on governors not to provide ELA to institutions facing temporary liquidity difficulties. Political pressure on NCBs can be lifted if the decision to provide ELA rests solely with the ECB Governing Council and is based on solvency assessments by the SSM. That will also make accountability for ELA decisions more clear than is at present. 125

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(d) Take steps to separate out the SSM from the ECB and/​ or strengthen the independence safeguards and accountability of the SSM To address genuine democratic legitimacy considerations in connection with concentrating too much power within the ECB and Eurosystem central banks, a TFEU amendment may be needed so that the SSM is established as a separate legal entity. Geographically and operationally, there is already a separation in place. All that is needed is a legal separation, although it must ensure that the SSM has strong independence safeguards, which should go hand in hand with increased transparency and accountability. A legal reform can also help enhance the independence of the SSM, which is no less important than the independence of monetary policy decision-​makers. Regulatory forbearance and financial instability are no less costly than inflation or deflation. What may, of course, be needed is a better definition of the “safety and soundness” of the financial system, a metric by which bank supervisors can be held accountable. This is a very worthwhile topic for future research. In any case, even if a treaty change is not possible, the independence of the SSM needs to be enhanced, together with its transparency and accountability. For example, regular reporting by senior SSM officials to national parliaments, as well as the European Parliament, should help address concerns about democratic legitimacy and prevent the creation of fake Euro-​sceptic narratives. (e) Reduce the concentration of powers in NCBs by creating separate resolution authorities in each member state Ten out of 19 NCBs have both supervisory and resolution responsibilities. Although there may be good reasons for this  –​usually central banks have competent staff and are more independent than other institutions  –​legitimacy concerns arising from the concentration of power, possible conflicts of interest and experience from the toxic fallout from bank resolutions in Cyprus and Slovenia suggest that central banks should avoid having resolution responsibilities. Having both bank supervision and bank resolution in the same institution can create serious conflicts; supervisors can defer declaring a bank likely to fail if there is concern that its resolution will create toxic fallout for the central 126

Can the erosion of CBI be reversed?

bank. Conversely, supervisors can be seen as favouring some banks at the expense of others by colluding with resolution colleagues to dictate mergers and acquisitions. Even if there is internal separation at departmental level, the governor and, in some instances, the central bank board are responsible for both. They can therefore come under political pressure either to exercise forbearance or to engineer bank mergers that favour interest groups. Alternatively, they can be incorrectly blamed for imposing losses on investors, resulting in the erosion of their credibility and independence, as was the case in Cyprus and Slovenia. Even if resolution actions are now guided by clear rules in the Bank Recovery and Resolution Directive, there remains considerable discretion that national resolution authorities may need to exercise, which can result in toxic political fallout. (f)

The ECB should become more visible and more active in national member states, in order to enhance its accountability and transparency to citizens in all 19 euro area member states

The ECB, unlike the European Commission, has no representative offices in member states. As such, its voice is not heard other than through NCBs –​which have their own mandates and often do not wish to be seen as defenders of ECB actions. Representative offices would also show the commitment of the ECB to euro area citizens wherever they are. They could engage not only with local media but also with local schools and universities to ensure that future generations are well informed about the benefits of the euro, as well as the challenges and risks ahead. Related to this is the frequency of ECB Governing Council meetings held in cities other than Frankfurt. Currently only two meetings per year are held in other member states. With 18 member states other than Germany, this means that there is a meeting of the Governing Council in each member state every eight and a half years. Although there are, clearly, numerous practical challenges that will need to be overcome to increase the frequency of meetings outside Frankfurt, there is no doubt that, from the point of view of making the ECB a more European institution, the benefits would outweigh the costs. At the EU level, the SSM should ideally be separated from the ECB. A change in the TFEU during the crisis may have been a very daunting 127

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prospect. We are now out of the crisis, however, and this is the right time to carry out reforms that can strengthen the foundations of the euro. Separating banking supervision from monetary policy will not only help to address questions of legitimacy and concentration of power but can, ultimately, safeguard the independence of both functions.

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134

Index

ABLV Bank, 101 accountability of banking supervision, 95 and central bank independence, 33 of Central Bank of Cyprus, 104 of ECB in member states, 127 of ECB in troika, 46 of ELA decisions, 125 to European Parliament, 17 and goal independence, 27 of SSM, 123, 126 for tasks and duties other than monetary policy, 123 under inflation targeting, 27 Adenauer, Konrad, 16 AML. See anti-​money laundering Anastasiades, Nicos attacks on central bank independence, 107–08 and Cyprus banks, 44 and Cyprus Co-​operative bank failure, 87 and Cyprus ruling elite, 45 and levy on insured deposits, 44 and Russian oligarchs, 106 anti-​money laundering (AML), 113 and EBA, 119 and euro area weakness, 114 European Commission proposals, 118, 119 in small states, 117 Arestis, George, 88 Asmussen, Jorg, 52 asset purchase programme, 10, 58, 60

Australia, 5, 26 Austria, 18, 96, 97 bail-​in, 105, 106 in BRRD, 84 and central bank independence, 97, 122 in Cyprus, 44, 105–07 difficulties, 91 in Italy, 94 and retail investors, 96 as a resolution tool in SRM, 89, 91 in Slovenia, 36, 110 in Spain, 93 Banca Popolare di Vicenza, 93 Banco Popular, 93 Bank for International Settlements, 17, 40, 82 Bank of England, 1, 2, 5, 6, 7, 8, 26, 41, 43, 49, 56, 71, 84, 127 Bank Recovery and Resolution Directive (BRRD), 84 Banque de France, 2 Barroso, Jose Manuel, 79 Basel Accord, 81, 82, 83 Basel Committee on Banking Supervision, 33, 82 Basel III, 81, 83, 84 Belgium, 18, 96, 97 Bini Smaghi, Lorenzo, 35 Blair, Tony, 5, 26 BRRD. See Bank Recovery and Resolution Directive Bundesbank, 5, 10, 16, 24, 28, 71, 76 135

Index

Capital Requirements Directive (CRD IV), 84 Capital Requirements Regulation (CRR), 84 Central Bank of Cyprus, 44, 54, 88, 97, 104, 107 Central Bank of Ireland, 52 CRD IV. See Capital Requirements Directive credit crunch, 41, 51, 54, 64 CRR. See Capital Requirements Regulation Cyprus, 18, 47, 54 application of bail-​in tool, 96 banking crisis 2012-​13, 102–05 and fake narratives, 44 and illict financial flows, 11 and perceived ECB blackmails, 52 and Russian influence, 11 violations of central bank independence, 35, 37 deflation, 65, 121, 126, 132 debt, 42 and the Great Depression, 59 risk, 8, 49, 57–60, 62 trap, 42 Delors, Jacques, 17 depression, 3 Deripaska, Oleg, 106 Draghi, Mario 26 July 2012 London speech, 71 and the banking union, 79 and fiscal instrument, 12 as a politician, 72 and “whatever it takes”, 9 EDIS. See European Deposit Insurance Scheme ELA. See emergency liquidity assistance ELA rules, 54 emergency liquidity assistance (ELA), 9, 51, 52, 121 during Cyprus crisis, 104 in Europe, 51–54 136

Estonia, 18, 96, 97, 114, 124 and illicit financial flows, 11 European Banking Authority, 33, 94, 100, 115, 118, 124 European Court of Justice, 11, 36, 60 European Deposit Insurance Scheme (EDIS), 91–92 failing or likely to fail (FLTF), 92 Federal Reserve, 1, 3, 5, 8, 41, 43, 129 financial instability hypothesis, 39, 40, 59, 63, 103, 133 Finland, 18, 96, 97 fiscal policy, 8, 67 FLTF. See failing or likely to fail France, 18, 69, 96 FROB. See Spanish National Resolution Authority Georghiades, Harris, 88 Germany, 10, 16, 18, 80, 96 Federal Constitutional Court, 60 Global Financial Crisis, 7, 8, 47, 50, 59, 79, 82, 83, 86, 90 Great Depression, 3, 43, 59 Greece, 6, 8, 47 and perceived ECB blackmails, 52 Greek government bonds, 68, 99, 102, 116 Grexit, 8, 68, 69, 70, 100 Hollande, François, 71, 79 Hungary, 19, 35 violations of central bank independence, 35 hyperinflation, 2 Iceland, 39 inflation bias, 15, 20, 22, 23 inflation target, 5, 6, 26, 27, 95 inflation targeting, 1, 5, 6, 7, 39 Intensa Sanpaolo, 93 Ireland, 9, 18, 46, 47, 54, 55, 56, 69, 72, 96, 97, 121 and emergency liquidity assistance, 52

Index

and OMTs, 76 and perceived ECB blackmails, 51–52 Italy, 6, 9, 18, 24, 55, 68, 73, 96, 97, 121, 123 bank bailouts under BRRD, 93, 95 Jazbec, Bostjan, x, 36, 110 Juncker, Jean-​Claude,  118 Keynes, John Maynard, 16, 40 King, Mervyn, 6 Lagarde, Christine, 71, 79 Lamfalussy, Alexandre, 17 Latvia, 18, 124 and illicit financial flows, 11 anti-​money laundering failures, 115 violations of central bank independence, 35 Lenihan, Brian, 51 Lithuania, 18 Lucas critique, 4, 21 Luxembourg, 18, 96, 97 Major, John, 26 Makuch, Josef, x, 110 Malta, 18, 96, 114, 124 and application of AML rules, 115 and illicit financial flows, 11 Manafort, Paul, 116, 117 Merkel, Angela, 71 Mersch, Yves interpetation of ECB independence, 33 Minsky, Hyman P., 39, 40, 59, 63, 103, 133 monetary financing, 23 prohibition, 28, 29, 35, 52, 54, 57, 60, 122 monetary policy and central bank independence, 23 conventional, 12, 41 credibility, 16 disconnect with fiscal policy, 67

ECB decision of August 2012, 74 and ECB independence, 10 and eligible collateral, 51 and eligible counterparties, 52 and financial independence, 30 and goal independence, 27 and instrument independence, 26 mandate, 47 non-​standard,  64 and personal independence, 30–31 separation from ECB supervisory functions, 32 standard, 50 and supervisory independence, 95 and systemic risk, 7 transmission mechanism, 9, 49, 64, 80 UK decisions prior to 1997, 6 unconventional, 9, 12 under inflation targeting, 6 monetary targeting, 4 Monti, Mario, 79 Netherlands, 18, 24, 30, 96, 97, 114, 119 New Democracy, 69 New Labour, 5, 26 New Zealand, 5, 20, 24, 26 Nouy, Daniele, 115 OMTs. See Outright Monetary Transactions Outright Monetary Transactions (OMTs), 13, 46, 56, 70–76 Phillips curve, 4, 15, 20, 21, 22, 23 Portugal, 9, 18, 46, 47, 54, 55, 56, 69, 72, 75, 96, 97, 121 Potanin, Vladimir, 106 Putin, Vladimir, 106 quantitative easing, 8, 59, 64, 133 rational expectations, 4, 20, 21, 22, 23, 59 137

Index

Rimšēvičs, Ilmārs, 36 risk-​weighted assets (RWA), 82, 83 ruling elite, 45, 101, 102, 103, 104, 107, 116 Russia, 11, 70, 106, 112, 114, 116, 117, 124 RWA. See risk-​weighted  assets Samaras, Antonis, 69, 70 Santander Bank, 93 Schaüble, Wolfgang, 99, 100 Securities Market Programme (SMP), 9, 55, 76, 121 Single Resolution Board (SRB), 89 Single Resolution Mechanism (SRM), 9, 121 Single Supervisory Mechanism (SSM), 9, 31, 119, 121 Slovakia, 18 Slovenia, 11, 18, 19, 96, 97, 100, 101, 110, 122, 126, 127 application of bail-​in tool, 96 violations of central bank independence, 35 SMP. See Securities Market Programme Soviet Republics, 11, 102 Spain, 9, 11, 18, 24, 55, 56, 69, 73, 96, 97, 121 application of bail-​in tool, 92, 95, 96 and OMTs, 76 Spanish National Resolution Authority (FROB), 93

138

SRB. See Single Resolution Board SRM. See Single Resolution Mechanism SSM. See Single Supervisory Mechanism stagflation, 4, 20 Stark, Jürgen, 10 Stournaras, Yiannis, 11 Strzhalkovsky, Vladimir, 106 Supervisory Board, 32, 33, 86, 95 Sweden, 5, 26 SYRIZA, 52, 68, 70 systemic risk, 7, 83 Thatcher, Margaret, 7 Trichet, Jean Claude, 51, 52, 121 troika, 45, 46, 52, 68 Tsipras, Alexis, 70 Ukraine, 106, 113, 116, 117 Varoufakis, Yanis, 52 Vekselberg, Viktor, 12 Veneto Banca, 93 Weber, Axel, 10 Weidmann, Jens, 71, 76 Yanukovych, Victor, 116 zero lower bound, 8, 50