From Saviour to Guarantor

Transcription

1 From Saviour to Guarantor

2 Roma Tre Business and Finance Collection The Roma Tre Business and Finance Collection is a programme of new, high quality and innovative finance and business books combining up to date research and academic rigor, with an international approach written by leading experts at Roma Tre University. The topics covered span both accounting and finance, and business and management disciplines. With specific coverage of issues in banking and finance, regulation, corporate finance, strategic planning, marketing, consumer behaviour and corporate social responsibility the collection provides executives, students, scholars and professionals worldwide with access to the most valuable information and critical new arguments and theories in the fields of business, management, accounting and finance. Titles include : Ornella Ricci CORPORATE GOVERNANCE IN THE EUROPEAN INSURANCE INDUSTRY Roma Tre Business and Finance Collection Series Standing Order ISBN: ( outside North America only) You can receive future titles in this series as they are published by placing a standing order. Please contact your bookseller or, in case of difficulty, write to us at the address below with your name and address, the title of the series and the ISBN quoted above. Customer Services Department, Macmillan Distribution Ltd, Houndmills, Basingstoke, Hampshire RG21 6XS, England

3 From Saviour to Guarantor EU Member States Economic Intervention during the Financial Crisis Fabio Bassan Professor of International Economic Law and European Law, University of Roma Tre, Italy and Carlo D. Mottura Professor of Financial Mathematics and Risk Management, University of Roma Tre, Italy

4 Fa bio Bassan and Carlo D. Mottura 2015 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6 10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act First published 2015 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number , of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin s Press LLC, 175 Fifth Avenue, New York, NY Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave and Macmillan are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN ISBN (ebook) DOI / This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress.

5 Contents List of Figures List of Tables Preface List of Abbreviations vii ix x xv Part I The EU s Institutional Action 1 1 The EU Action to Face the Crisis EU s actions in support of the Member States public debt EU s actions in support of the banking system Eurostat public contingent liabilities Differences between EU and US actions 11 2 State Guarantees and State Aid 13 Part II The Financial Valuation of a Guarantee Contract 17 3 The Defaultable Guarantee Contract The guarantee contract and credit derivatives market The relevant issues 20 4 Valuation under a Standard Model 22 Part IIIA The State Guarantees in the EU: State Guarantees for the Safeguard of the Euro 47 5 Guarantees in Favour of the ESM The financial scheme Main features of the guarantees 53 6 Effects of the Guarantees Valuation and model risk The lack of effective sanctioning instruments Different sovereignties for Eurozone Member States The ECB and the lever of Archimedes 65 v

6 vi Contents Part IIIB The State Guarantees in the EU: The State Guarantees for the Stability of the Banking System 67 7 The State Guarantees to Cover Bank Debt The financial scheme Main features of the guarantees 70 8 Effects of the Guarantees Legal guarantee fee and market price Moral hazard effects Distortions in banking competition Member State guarantees and EU coordination 81 Part IV Innovation and Crisis-Fighting Measures in the EU 83 9 The Instruments That Triggered the Crisis in The path of risk: from private individuals to banks The path of risk: from banks to markets The path of risk: from markets to States Cultural sustainability of innovation in anti-crisis public finance The ECB s Unconventional Measures Facing the Challenge of Markets and National Courts Characteristics of the main unconventional measures The scope of the measures as outlined by the ECB and by the case law Application of the constraints set by the BVerfG for OMTs to other unconventional measures 117 Conclusions 121 Notes 126 Bibliography 151 Index 157

7 List of Figures 1.1 Level of public contingent liabilities (% of GDP) Level of contingent liabilities in the euro area (EA18) and the EU28 (% of GDP) Dynamics of public interventions to financial institutions ( billion, $ billion) CDS sovereign spread and CDS implied default probabilities (average) CDS bank spread and CDS implied default probabilities (Germany) CDS bank spread and CDS implied default probabilities (France) CDS bank spread and CDS implied default probabilities (Spain) CDS bank spread and CDS implied default probabilities (Italy) Trend of the 1Y up-front value at inception of the guarantee (guaranteed liability 100, recovery rate 40%, Gaussian model, ) Trend of the 3Y up-front value at inception of the guarantee (guaranteed liability 100, recovery rate 40%, Gaussian model, ) Trend of the 5Y up-front value at inception of the guarantee (guaranteed liability 100, recovery rate 40%, Gaussian model, ) Trend of the 10Y up-front value at inception of the guarantee (guaranteed liability 100, recovery rate 40%, Gaussian model, ) Trend of the 30Y up-front value at inception of the guarantee (guaranteed liability 100, recovery rate 40%, Gaussian model, ) ESM financial scheme Y up-front value at inception of the guarantee: PD Debtor at 2% (guaranteed liability 100, recovery rate 60%, G and MO models, ) 60 vii

8 viii List of Figures Y up-front value at inception of the guarantee: PD Debtor at 6% (guaranteed liability 100, recovery rate 60%, G and MO models, ) Financial scheme of a State guarantee to cover bank bonds US real estate market trends (S&P/Case-Shiller Composite-10 Home Price Index) Prices of US mortgage-related securities (in $) Development of gross public debt for selected OECD economies ( ; % of GDP) 90

9 List of Tables 4.1 CDS sovereign spread and implied default probabilities (average) CDS bank spread (average) CDS bank implied default probabilities (average) Y up-front value at inception of the guarantee (guaranteed liability 100, recovery rate 40%, Gaussian model, ) Y up-front value at inception of the guarantee (guaranteed liability 100, recovery rate 40%, Gaussian model, ) Y up-front value at inception of the guarantee (guaranteed liability 100, recovery rate 40%, Gaussian model, ) Y up-front value at inception of the guarantee (guaranteed liability 100, recovery rate 40%, Gaussian model, ) Y up-front value at inception of the guarantee (guaranteed liability 100, recovery rate 40%, Gaussian model, ) Valuation cases for a 3Y inter-state guarantees (guaranteed liability 100, recovery rate 40%, Gaussian model, ) ESM s Member State Guarantee Amount ESM s Member State Rating Y up-front value at inception of the guarantee (guaranteed liability 100, recovery rate 60%, G and MO models, ) Government-guaranteed bank bonds issued in individual countries Guarantee fees to government (October ) Legal fee vs mark-to-model fee (Gaussian model, theoretical cases) 78 ix

10 Preface The US financial crisis originated in It infected the US banking system and was transmitted to an already institutionally weak Europe where it developed into a sovereign debt crisis that in turn infected the European financial system and, consequently, its banking system. In this framework, the Greek crisis became the symbol, if not the paradigm. The pattern above is the one used for reconstructing in brief the economic and financial events of the past seven years. According to this reconstruction, the European Union (EU) and its Member States have taken, in fast sequence, complex measures aimed at sterilising or at least curbing the effects of the crisis. In particular, the States margins of freedom in the use of economic policies were reduced, and strict conditions were created for allowing access to financial support. The EU established instruments first on a provisional basis (European Financial Stability Mechanism EFSM, and European Financial Stability Facility EFSF) and later on a final basis (European Stability Mechanism ESM); the EFSM was in compliance with EU Treaties (EU 407/2010 Regulation), the EFSF and ESM were in compliance with international agreements. 1 The strictness of the measures on sovereign debt was paralleled by a growing flexibility in terms of instruments created and of their use towards the banking system. These opposed and conflicting strategies to cope with the crisis had one and the same origin. The following is the chronological order of the steps taken by the EU to confront the sovereign debt crisis. First, the European Central Bank (ECB) intervened in the secondary market of public debt securities that were more exposed to speculation (Security Market Programme SMP) with increasingly unconventional instruments (Longer-Term Refinancing Operations LTRO) aimed at restoring the monetary chain. Second, the European Commission adopted communications aimed at enforcing the rules on Member State aid to the banking sector in a non-restrictive manner. Third, as mentioned, the recently established European regulatory system for the banking sector aimed at creating a European Banking Union (EBU) was transferred from the newborn independent European authority (EBA) to the ECB. However, while the latter s broader supervising function may be exercised with greater discretionary power, it is still limited to banks of European relevance. Therefore, the range of x

11 Preface xi action was broadened on the objective side but reduced on the subjective side (that of the entities being supervised). The fourth step was the introduction, first by means of EFSF and then confirmed with the ESM, of a specific measure of financial support for the recapitalisation of the banks. The fifth move was the strengthening at the European level of the Member States political economies through the golden rule of a balanced budget as a constitutional principle. The sixth step was the setting up of a EBU based on a Single Supervisory Mechanism (SSM) and a Single Resolution Mechanism (SRM), A third pillar, the Single Resolution Fund (SRF) is still on the agenda. The seventh step is the point of contact we address here. This aspect lays the basis not only for a connection but also for a possible short circuit that is related to the guarantees that the Member States give to themselves. These guarantees are varying, original, direct and indirect, but are also such as to almost never fall within the scope of public debt and might therefore be used in the belief that they cannot spread the contagion further, even when they are not part of a unitary intervention scheme. The eighth step is the ECB s further action taken by unconventional measures, aimed at restoring the monetary transmission chain (Outright Monetary Transactions OMT, September 2012, and Targeted Longer- Term Refinancing Operations TLTROs, June 2014), at stimulating growth and inflation through the direct purchase of covered bonds and asset-backed securities (Asset Backed Securities ABS Programme, September 2014) and also through the purchase of public bonds (Quantitative Easing QE, announced in January 2015). The ECB s actions have been at the very centre of the debate and often questioned and challenged. 2 It is quite surprising that the ECB s unconventional measures are the first steps and the last, so far. After seven years, European institutions and Member States have returned to the starting point. There is, of course, more than one explanation, and most of them give pieces of the truth. Several observers consider the Member States measures and the EU s institutional changes barely effective, or out-of-focus. Others genuinely believe that the evolution of the crisis in Europe was unpredictable. Actually, if one were to try and answer such fundamental questions, one would abandon the too big to fail superstition (when applied to States) and acknowledge the overall effects that the systemic crisis produced. The length and seriousness of the European economic and financial crisis depend most of all on the strategies and instruments

12 xii Preface chosen to fight the crisis. Hence, one should focus on the main instruments at hand and measure their feasibility and efficacy. With this goal, the study of Member State guarantees deserves an in-depth analysis for at least three main reasons. In the first place these guarantees are still scarcely addressed in the literature probably because of their technicality, notwithstanding their interesting and still unclear aspects that call for separate studies. In the second place, despite many multilevel interventions from international treaties to EU regulations, no need has been identified for specific regulation of these guarantees, as if they were merely the necessary relief valve of an otherwise closed control system. In the third place, because the guarantees, on closer view, seem to be the cornerstone of the EU s action, still absent are an EU government, shared financial measures (i.e., Eurobonds), a capital market and, at the very bottom, fiscal competence. Member State guarantees are state aids indeed, but the relaxing of competition rules during the crisis allowed the Member States to use them for consolidating the banking system and creating intergovernmental funds. The guarantees, again, are now a kind of panacea that Member States use for financing, among other things, small- and medium-sized enterprises (SME) and workers severance payments. In this book we review the guarantees in the Eurozone system used for the financial support to Member States and for the stability of the banking system through a new law and finance approach that provides a unique perspective. Our intention is to verify whether the instruments implemented so far by the Member States and by the EU are stable or whether the State guarantees themselves may represent, in the absence of specific regulatory interventions, another factor for instability in public international finance. We are confident that the answer to this question will help us in finding solutions. With the new law and finance methodology that we are implementing with this book, we place the tools adopted by European institutions and Member States in the EU s evolving institutional context and try to measure the effectiveness of the tools themselves as well as the new European institutional framework. The complexity of the matter within the EU calls for a review of the system of guarantees offered by Member States to the ESM and for national bank stability (see Part III). Further, a review is needed of the so-called unconventional instruments and measures developed and used at the EU level to manage and protect the European convergence process and to increase the sharing of sovereignty among Member States. Therefore,

13 Preface xiii we deal with the unconventional measures adopted by the ECB (in Part IV) that are relevant for the protection of the ECB s role as guarantor of last resort that is, a safeguard of Member State guarantees. We also deal with the scope of this safeguard which is defined and delimited in practice not only by the ECB but also by the EU and national Courts with all the limitations and risk that implies. The ECB s unconventional measures become relevant for their innovative character (at least from the viewpoint of international and EU law) and also because they protect the value of the Member State guarantees. In fact, from a technical standpoint they contribute to regulating the evaluation uncertainty that, in the EU s present situation, is typical of the guarantees reviewed in our research. These measures may also contribute to overcoming the possible conflict between the unifying effects of the guarantees in favour of the ESM and the disaggregating effects of Member State guarantees in favour of national banks (as these depend on the greater or lesser power of each guarantor State). Looking forward, the effects of unconventional measures may have an impact on the very definition of the players involved in public guarantee schemes. In these schemes, the guarantor may be the EU considered as a single body or as it is now as an aggregation of parts more or less independent from one another (individual Member States) whose sovereignty is only partially delegated and that therefore exposes their aggregation to the risk of disaggregation. The faster the EU achieves its institutional strengthening, the less external (or even internal) players will be able to affect the variables that are presently governing the uncertain nature of the EU s value and the undermining of its strength. In this respect, in the terminology of contingent liabilities adopted by Eurostat to qualify prospective public support of the financial system, unconventional measures may also be interpreted as instruments for harnessing counterparty risk (i.e., individual guarantor State risk) and, in the case of guarantees in favour of States, also of the risk of the underlying reference entity. The harnessing of the risk of the underlying assets of the Member State guarantees in favour of the lending system individual national banks is instead something different that relates to the process of gradual building the EBU, which is not covered by our research. In fact, the goal of the EBU is to identify new instruments to allow the banking system to guarantee a resolving intervention in case of defaults without any form of aid by the Member States, not even as guarantors. Besides, the statutory reforms passed recently are not linear. They are instead a layering of interventions implemented from time to time

14 xiv Preface to overcome the various stages of the crisis. We will therefore briefly explain these reforms to show how different approaches sometimes backward-looking to overcome existing criticalities, sometimes forwardlooking to prevent future ones have made it harder to achieve a unified approach. Notes 1. See F. Bassan, C. D. Mottura, Government guarantees and the European model of financial assistance to Member States, in Mercato, concorrenza, regole, 2013/3, pp See F. Bassan, The German Constitutional Court reviews the ECB nonconventional measures, in Rivista di Diritto Internazionale, 2014, pp For an analysis of the risk evolution in the financial markets shaken by the crisis that began in , see C. D. Mottura, Il ruolo del rischio nella recente crisi dei mercati finanziari, Gnosis, Rivista italiana di Intelligence, n. 4, 2010.

15 List of Abbreviations ABS ABSPP AT BE BoE BVerfG CB CBPP CCP CDS CY DE DK EA18 EBA EBU EC ECB ECJ EEA EFSF EFSI EFSM EIB EIOPA EL EUROSTAT ES ESCB ESM ESMA EU EU28 asset backed security ABS purchase programme Austria Belgium Bank of England German Constitutional Court covered bond covered bond purchase programme Central Clearing counterparty credit default swap Cyprus Germany Denmark euro area (Member States number) European Banking Authority European Banking Union European Commission European Central Bank European Court of Justice European Economic Area European Financial Stability Facility European Fund for Strategic Investments European Financial Stability Mechanism European Investment Bank European Insurance and Occupational Pensions Authority Greece European Statistics Spain European System of Central Banks and of the European Central Bank European Stability Mechanism European Securities and Markets Authority European Union European Union (Member States number) xv

16 xvi List of Abbreviations FFA Financial Assistance Facility Agreement FI Finland FR France G Gaussian model GDP Gross Domestic Product HQLA High-Quality Liquid Assets IE Ireland IMF International Monetary Fund IT Italy LTRO Longer-Term Refinancing Operations LU Luxembourg LV Latvia MO Marshall Olkin model MoU memorandum of understanding MRO Main Refinancing Operations NCB national central banks NL Netherlands OECD Organisation for Economic Co-operation and Development OMT Outright Monetary Transactions OTC Over The Counter PD probability of default PMP Primary Market Purchases PMSF Primary Market Support Facility PT Portugal QE Quantitative Easing SGP Stability and Growth Pact SME Small and Medium Enterprises SMP Security Market Programme/Purchases SRF Single Resolution Fund SRM Single Resolution Mechanism SSM Single Supervisory Mechanism TARP Troubled Asset Relief Program TEU Treaty on European Union TFEU Treaty on the Functioning of the European Union TLTRO Targeted Longer-Term Refinancing Operations TSCG Treaty on Stability, Coordination and Governance in the Economic and Monetary Union ( Fiscal Compact ) UK United Kingdom US United States of America