News in Charts: Banking and Sovereign Debt Reforms Essential to the Euro Area’s Future

There have been considerable improvements in the euro area’s governance framework since 2011, but the bloc remains vulnerable to future sovereign and banking crises. The ‘doom loop’ between sovereign and banking risk has been weakened, but remains intact. In his first New Year’s address, Emmanuel Macron vowed to “reinvigorate European ambitions” while appealing to the French public not to be swayed by “nationalists” or “sceptics”. Since his election, President Macron has placed considerable focus on greater European integration.  A key part of Mr Macron’s vision focuses on the capacity of the European Stability Mechanism (ESM), or a new alternative body acting as a European Monetary Fund (EMF) to enhance the euro area’s resilience to future shocks. Fathom expects the ESM’s responsibilities to be expanded to help manage cases of sovereign insolvency and to complete some of the missing elements of banking union. Achievement of these reforms would be likely to increase confidence in the long-term viability of the euro area’s framework.

The ESM was formed in October 2012 as a permanent successor to the hastily established European Financial Stability Facility. The Spanish government was the first beneficiary of ESM funds, and since then Cyprus and Greece have both received ESM funding. Equipped with a war chest of €500 billion, the ESM was given responsibility for supporting sovereigns with liquidity issues. The fund’s operations were designed with the limits of EU law in mind: Article 125 of the Treaty on the Functioning of the European Union demands that any financial assistance to a member state is temporary and accompanied by conditions which prompt a “sound budgetary policy”. Since its establishment, the ESM has played a crucial role in ensuring states with liquidity issues can quickly source official funding support. This has been reinforced by the ECB’s Outright Monetary Transactions programme, with the result being a marked decline in peripheral sovereign spreads. However, the euro area’s framework crucially still lacks the capability to manage a sovereign that is insolvent, given the requirement for any financial assistance to be temporary.

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President Macron would like to see the European Stability Mechanism, or a newly established alternative, filling in these gaps, hammering away the remaining links in the sovereign-banking nexus and enhancing the level of integration in the euro area. Financial integration in the euro area declined markedly during the crisis and has yet to return to anywhere near its pre-crisis peak.

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In order to further reduce the interlinkages between sovereign and banking sector risk, reforms are focused on managing any future sovereign insolvencies and creating a shared backstop for the euro area banking system. Euro area politicians are keen to avoid any repeat of publicly-funded bailouts of private sector investors. However, proposed reforms to euro area sovereign debt restructuring arrangements will require that euro area banks reduce their holdings of ‘home’ sovereign debt. Meanwhile, momentum is building towards the completion of banking union, with attention focused upon a European Deposit Insurance Scheme (EDIS). Common deposit insurance would represent true risk sharing across the currency union, but is likely to be conditional on a further reduction in the stock of non-performing loans.

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German support for President Macron’s reforms is essential and the results of exploratory talks on forming a new ‘grand coalition’ were encouraging in this regard. The 28-page preliminary agreement referred to a desire for the ESM to come under the European parliament’s control, as opposed to being an interstate body. This change to the ESM’s governance would simplify the decision-making process associated with support measures, while German support for this reform potentially suggests a move away from Angela Merkel’s inter-governmentalism towards a more integrationist position. With regard to timelines, the new Eurogroup President Mario Centeno has expressed his hope that an initial package of reforms to the ESM can be agreed by June.

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