Tuesday, March 26, 2013

EU Stability and Growth Pact – Theory vs. Practice!

Habt euch vorher wohl präparirt, Paragraphos wohl einstudirt, damit ihr nachher besser seht, daß er nichts sagt, als was im Buche steht.”
After studying the law, you will realize that it only says what is written.”
(Johann Wolfgang von Goethe, Faust)

When it comes to legal affairs, theory and practice don’t always match. The EU stability and growth pact is a good example here.

The subject-matter of the pact is to monitor budgetary positions, to avoid excessive government deficits, and to coordinate economic policies. The final goal is to

  • safeguard price stability;
  • develop strong growth;
  • create employment;
  • guarantee a sustainable exchange rate stability.

Reference values and medium terms objectives

At the heart of the regulation are the following reference values that the EU member states commit to respect

  • Government deficit of maximum 3 % of GDP
  • Government debt to GDP ratio of maximum 60 %

To reach the above objectives, the EU member states adhere to reach tailor-made medium term objectives of budgetary positions situated between – 1 % of GDP and a balanced or surplus budget.

Each EU member state engages to build and publish programs showing how they intend to reach the above objectives. Such program is called “stability program” in case of an EU member state of the Eurozone and “convergence program” for any other EU member state.

Stability program

Contents of a stability program:

  • Expected path of the government budget, debt ratio, expenditure, revenue, and capital formation
  • Main assumptions about expected economic developments and variables
  • Scenario analysis for those assumptions
  • Quantitative assessment of budgetary and other economic policy measures
  • Reasons for a deviation from the required adjustment path towards the medium term budgetary objectives

Stability programs shall be submitted and published annually by April 30 at the latest.

Deviations from the medium term objectives are possible

  • to implement long-term structural reforms;
  • to carry out pension reforms;
  • in case of an unusual event outside the control of the member state concerned and which has a major impact on the financial situation of the government;
  • in case of a severe economic downturn (The reference point for such downturn is an annual fall of at least 0.75 % of real GDP.) in the Eurozone or EU.

However, these exceptions can only be granted temporarily.

Convergence program

Contents and publication details of convergence programs as well as exceptions from medium term objectives are almost identical with the regime of stability programs. It’s just the packaging that changes.

The regulation distinguishes between EU member states which have adopted the Euro and those which have chosen to keep their domestic currencies.

The above material rules are secured by very detailed procedural rules including submissions by the member states and reports and sanctions by the European Commission.

The Stability and Growth Pact in Practice

Government Deficit

In the above data set, you can see that

  • ,between 2002 and 2011, the number of EU countries which don’t meet the 3 % reference value has increased from 14 to 18.
  • Greece and Portugal have never met the government deficit floor since 2002. Italy and Hungary have only succeeded once, in 2007 and 2011 respectively.
  • ,on average, the highest budgetary deficits can be found in Greece (8.08 %) and Ireland (5.95 %).
  • only northern European countries has average surplus budget levels: Denmark (1.4 %), Estonia (0.65 %), Luxembourg (0.79 %), Finland (2.05 %), Sweden (0.86 %), and Norway (13.3 %).

Government Debt

I extract five main conclusions from the above government debt data:

  • In 2002, six countries had reached a debt level beyond 60 % of GDP. By 2011, this number has more than doubled (15 countries).
  • Between 2002 and 2011, five countries have never met the 60 % government debt cap: Belgium, Austria, Germany, Greece, and Italy.
  • The countries with the highest average debt levels are Greece (117 %), Italy (109 %), Belgium (94 %), and Portugal (74 %).
  • Italy’s debt level is among the highest in Europe and, even more interestingly, shows very low variation.
  • In northern Europe (Estonia, Latvia, Lithuania, Finland, Sweden, and Norway), debt levels are, by far, lower than in the southern part.


Wednesday, March 20, 2013

Banking Reform in France – “Nobody can hide behind barbaric shortcuts or blurry algorithms!”

The introduction to the Banking reform proposal does not lack strong language. France’s economic and finance minister, Pierre Moscovici, says:

D’aucuns s’abritent derrière ses acronymes barbares et ses algorithmes obscurs pour parer aux tentatives de régulation.”
Nobody can hide behind barbaric shortcuts or blurry algorithms!”

La finance au service de l’économie, et non au service d’elle-même”
Finance for the benefit of the economy, not for the benefit of itself”

Remettre la finance au service de l’économie réelle.”
Shift finance to the benefit of the real economy!”

Let’s put this language aside and have a look at the proposed regulation:

Separation and Regulation of Banking Activities in France

The French government intends to

  • guarantee the stability of financial institutions,
  • endorse the solvency of banks in the interest of depositors, and
  • ensure the financing of the economy.

The draft law provides for four prohibitions: A financial institution cannot

  • practice proprietary trading;
  • trade with hedge funds (whose characteristics are to be defined by the Regulator later on);
  • practice high frequency trading;
  • trade forward financial instruments, whose underlying is agricultural commodities.

Proprietary Trading

In principal, financial institutions will no more be allowed to negotiate financial instruments on their own balance sheet.

However, this constraint shall only apply if the trading business goes beyond thresholds to be defined by the French regulator later on.

In addition, specific market activities are still allowed if they are carried out in legally separated subsidiaries of the financial institution. Such activities include

  • Financial investment services for the benefit of clients
  • Set-off of financial instruments
  • Risk management for the financial institution
  • Market making activities (Acting as an intermediary, the financial institution provides simultaneously offer and demand quotations for financial securities to keep markets liquid, or it executes put or call orders from clients.)
  • Wise and prudent cash management activities
  • Intra-group transactions
  • Strategic long-term or intra-group investments of the financial institution

The subsidiaries who do the above activities cannot receive client deposits or supply payment services.

Trading with hedge funds

French financial institutions will only be allowed to trade with hedge funds if their operations are backed by legal securities.

Liquidation Regime for Financial Institutions

With its reform, the French government strives for

  • preserving the financial stability;
  • ensuring the continuity of activities, services, and operations of institutions which are crucial for the functioning of the economy;
  • protecting deposits;
  • avoiding or, at least, limiting, the exposure of taxpayers’ money in case of a crisis.

The main features of France’s new liquidation regime for financial institutions are twofold:

  • Elaboration of a prophylactic restructuring plan by the financial institution and communication of such plan to the regulator
  • Injunction of restructuring (namely nominate a temporary administrator, dismiss the management team, impose of spin-offs, call other financial institutions or the depository and liquidation fund for help, “expropriate” shareholder’s equity, reduce the balance sheet, inflict equity rights’ issues, and limit the distribution of dividends) on a failing financial institution.

When reading the draft legislation, it becomes clear that important questions such as thresholds for the application of the law have been put aside for now. The full picture has not yet been painted.


Monday, March 18, 2013

The Banking Reform in Germany – The Baby and the Bathwater

A few days ago, Germany’s finance minister, Dr. Wolfgang Schäuble, introduced Germany’s planned banking reform to the parliament:

Wir versuchen, Wege zu finden, wie wir Eigenhandel, Investmentbanking und die normalen Bankgeschäfte so voneinander abgrenzen können, dass Risiken in einem Bereich keine Ansteckungsgefahren für andere Bereiche bedeuten können.
We are trying to find ways to separate proprietary trading, investment banking and normal banking transactions to ensure that risk in one area does not entail a risk of contagion for other areas.

Ich glaube, es ist vernünftig, dass wir bei der Regulierung von Banken nicht das Kind mit dem Bade ausschütten, sondern immer daran denken, dass die Funktion und Leistungsfähigkeit unserer Banken in einem starken Maße vom Erfolg auf den Weltmärkten abhängt.
When it comes to banking regulation, I think it is reasonable not to spill out the baby together with the bathwater, but to keep in mind that the function and performance of our banks depends, to a great extent, on their success on the world markets.

The general goals of the German reform are to allow a winding-up of systemically relevant financial institutions without impairing public funds and counter effectively “too big to fail” situations.

It has three main pillars:

  • Restructuring and liquidation of financial institutions
  • Risk protection for financial institutions
  • Criminal liability of risk management executives

A. Restructuring and liquidation of financial institutions

Reorganization Plan

Systemically important financial institutions are bound to establish a reorganization plan.

The German regulator qualifies a financial institution as systemically important on the basis of qualitative and quantitative factors such as

  • size;
  • domestic and cross-border business activities;
  • interconnectedness with other financial institutions in the financial system;
  • (im)possibility to replace the financial institution as regards its financial services and infrastructures.

The reorganization plan

  • defines indicators to disclose a crisis early on;
  • describes stress scenarios;
  • analyzes the firm’s structure, business model, and main activities from a strategic point of view;
  • evaluates the possibility for the financial institution to be rescued;
  • reveals the firm’s options to restructure;
  • sets up a communication plan for a crisis scenario.

The German regulator can intervene if he feels that the implementation of the reorganization plan is compromised. He can, for example, order the financial institution to recapitalize or to revise its refinancing strategy.

If, nevertheless, the financial institution continues to lack a sufficient degree of operational security, the regulator might

  • ask to conclude service agreements;
  • put limits on the institution’s risk exposure;
  • entrench information rights;
  • order asset sales and spin-offs;
  • require to reduce the complexity of the firm’s structure.

Liquidation Plan

In case a financial institution is systemically relevant but not part of a financial group that is monitored by the German regulator, the administration will put a liquidation plan in place. Amongst other elements, the plan analyzes the institution’s business strategy and internal structure and illustrates if and how the business units can be isolated in a crisis situation. The liquidation plan will not necessarily be disclosed to the financial institution.

B. Risk protection for financial institutions

Germany's government intends to proscribe two types of activities:

  • Proprietary trading (= trading activities on the bank’s balance sheet as opposed to deals done on behalf of clients)
  • Granting of credit and guarantees to hedge funds and other comparable, highly leveraged institutions

By contrast, market-making activities are, as a general rule, permitted. Exceptionally, the regulator can prohibit them if they compromise the solvency of the financial institution. Market-making refers to activities which consist of

  • posting firm, simultaneous two-way quotes of comparable size and at competitive prices, with the result of providing liquidity on a regular and ongoing basis to the market;
  • fulfilling orders initiated by clients or in response to clients’ requests to trade;
  • hedging positions arising from the fulfillment of the tasks above.

In addition, the above restrictions only apply to financial institutions whose balance sheet outstrips, on a consolidated level, one of the following thresholds:

  • Available-for-sale financial assets exceed 100 BEUR.
  • Available-for-sale financial assets represent a minimum of 20 % of total assets and, over the past 3 financial periods, total assets were at least 90 BEUR.

Finally, the proposal expressly exempts asset liability management activities and long-term strategic participations in other companies. Also, a brokerage institution can still perform speculative activities if it is economically and legally separated from any financial institution. This independence namely means that the broker must refinance its balance sheet on a stand alone basis. The exception intends to leverage advantages linked to size and diversification of a financial conglomerate.


Tuesday, March 12, 2013

Are European banks shrinking?

If you trust my data on major European champions, the answer is yes. One caveat of the below data is, however, that it only includes national champions and ignores boutiques. Even though it is, therefore, necessarily incomplete, the trends are still interesting.

Total Assets and Net Income

Total assets of the above financial institutions differ in absolute figures and currencies. In any manner, the negative tendency since mid 2012 is observable for all European champions.

For almost any bank, the net income evolution in 2012 has been negative. Only banks from Northern Europe and BNP Paribas constitute exceptions.


If you are looking for a job in a European bank, which banks should you approach? The surprising answer leads us to Spanish banks which are the only banks in the dataset having increased their headcount in 2012. However, I must admit that even Banco Santander and BBVA have reduced their numbers of employees slightly over Q4 2012.

Headcount Banco Santander / BBVA

If you are interested, you can find the data here.

Wednesday, March 6, 2013

Universal Bank or Specialized Bank? Laptop or PC?

Is it wise to separate banking and investment banking? Does this question really matter?

To answer these questions, imagine you would like to buy a computer. Any computer consists of the following:

  • The hard disk contains exploration system and your data, even when you turn your computer off.
  • The memory stores the data that you actually need to work with when your computer is operating.
  • The processor calculates and makes your machine working.
  • The motherboard is the piece which connects the above 3 elements.
  • Accessoires such as mouse, keyboard, sound speaker, and screen allow communicating with your computer.

Going back to last week's debate about the separation of banking and investment banking,

  • the hard disk is the banks which collect and hold deposits;
  • the memory compares to any form of financial security (loan, bond, stock, and derivative);
  • the processor is the place where financial securities are exchanged and which is administered by securities firms;
  • the motherboard represents the financial system as a whole;
  • accessoires are things that represent the infrastructure of the financial system such as branches, websites, electronic trading platforms, etc..

Now, which type of computer do you buy (if ever you are still interested in buying a computer instead of an i-pad)?

  • Do you prefer buying a laptop which unifies all of the above elements? You might think that this is the most efficient tactic to buy, as professionals will make sure that all elements work together as efficiently as possible. On the other hand, you must be aware that you cannot easily change a piece of your laptop if it breaks – usually, you will be obliged to by a complete new laptop.
  • As an alternative, you could also buy a desktop computer and choose its components yourself. Here, you run the risk of buying some components that don't work 100% efficiently together. On the other hand, it's relatively easy to change a single component if one element breaks down.

So what do do? Obviously, you must make a trade-off between risk and efficiency. The safest, but also most expensive solution is to buy both a desktop and a laptop. At the other end, working only with a laptop is most efficient, but risky.

There are certainly plenty of incoherences in the above comparison. My principal goal is, however, to show three elements:

  • Banking and financial markets need each-other. They necessarily work together, no matter the shape of the participating firms' legal structure.
  • There is no right or wrong solution. It's a question of making a trade-off between efficiency of the financial system on the one hand and the costs for operating it on the other hand.
  • The most important thing to do is to monitor your system and to be prepared for a possible break-down.

In my view, the importance of a choice between separated and integrated financial institutions is probably less important than it seems at first glance.