No Hope in a Storm: Why Europe Is Unprepared for the Next Banking Crisis

By Veron, Nicolas | The International Economy, Summer 2008 | Go to article overview

No Hope in a Storm: Why Europe Is Unprepared for the Next Banking Crisis


Veron, Nicolas, The International Economy


As shockwaves from America's subprime disaster continue to reverberate, there is growing doubt about Europe's ability to handle a financial crisis on a major scale. Severe lapses in bank regulation--in Germany, Britain, and perhaps France--have damaged the credibility of national systems of supervision. But this is only part of the problem. The European Union remains hopelessly ill-equipped to handle the crises that haven't yet happened: cross-border crises sparked by EU banks' increasing interdependence.

EU financial integration began in earnest in the 1980s, and the European Commission and European Council made great strides in financial-sector reform. Among the milestones were the decisions in 1986--88 to remove all restrictions on cross-border capital flows, and the launch in 1999 of a legislative action plan on financial services. The euro was introduced and quickly became the world's second currency, behind the dollar.

Perhaps less conspicuous, the European Union's decision to adopt International Financial Reporting Standards in 2000-02 triggered an extraordinary move toward the global harmonization of accounting rules. Meanwhile, the Commission's steadfast defense of competition in the banking sector--particularly in Portugal, Germany, Italy, and Poland--ended an era of protectionism in the guise of prudential control; this helped to spur cross-border financial integration to an extent unprecedented in developed economies.

These achievements came during a period of remarkable stability in Europe's financial markets. Even during the 1992-93 dark days of the European Monetary System, Europe looked like a safe haven in an unsettled financial world. Many countries outside the European Community suffered banking crises, including neighboring Norway, Sweden, Finland, and Turkey, as well as many East European nations during their transitions from communism.

By contrast, the most serious bank failures inside the European Community in the 1990s--including BCCI, Credit Lyonnais, and Barings--had only a limited fiscal cost and a negligible impact on growth. Later, corporate governance scandals in Asia and then in the United States, notably after the dot-corn bubble and the accounting debacles at Enron, WorldCom, and others, encouraged Europeans to think that the "old continent" had somehow preserved higher standards.

The subprime-induced storm ended that fair-weather complacency. From the point of view of public policy, three points can already be made in its wake.

First, the good news: the European Central Bank proved itself an efficient lender of last resort to Europe's financial system. When the crisis started in earnest in August 2007, the ECB reacted quickly and intervened as long as the inter-bank market needed support. Banks in the eurozone and beyond all benefited. By contrast, the Bank of England's reluctance to provide liquidity--because of concerns about "moral hazard"--was a poor choice.

Second, however, national banking supervision in Europe fell far short of requirements and its overall credibility is now in question. German authorities have been deplorably tolerant of commercial bank involvement in complex asset-backed securities investments, which were kept off their balance sheets via so-called "conduit" operations in Ireland. …

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