How fragile remains the euro area?
Are the chances of an Italian default overblown ?
Casa das Garças May 21, 2019
Francesco Giavazzi Bocconi University
Reforms since the euro crisis (2011-12)
- Common banking supervision
- ESM backstop for banking resolution - European Stability Mechanism
- Outright Monetary Transactions
Euro Area Reform
partial progress, but some progress, though the area reamains fragile
• The area lacks a fiscal stabilization instrument that could step in when the ECB has reached its limits (as it has
today), e.g. some elements of a common unemployment insurance
• EDIS (European Deposit Insurance) remains taboo
• The area lacks an instrument to stop the emergence of
“bad equilibria” (OMT is subject to double conditionality) - for such an instrument to be credible its resources
should be in principle unbounded (in “normal”
jurisdictions this is the job of the central bank)
Fragilites
- Northern countries require Risk Reduction and the
possibility of Debt Restructuring before accepting Risk Sharing
- Thus: No EDIS, no serious macro stabilization function, no instrument to eliminate bad equilibria
- Risk reduction has a name: “Doom Loop”
A single stumbling block underlies the difficulty in
adressing the causes of fragility
“Worries about Italy have led some to reject any further risk-sharing in the Eurozone
Without cutting the cord between sovereigns and banks, the so-called sovereign-bank doom loop, completion of the banking union is impossible
A fiscal backstop for the single resolution fund, the EU’s rescue fund for failing lenders, and rules
covering non-performing loans are not sufficient To protect financial stability, the Eurozone should offer more risk-sharing through common deposit insurance. But it should also inject more market discipline through the regulation of sovereign exposures”
Isabel Schnabel, member of the German Council of Economic Experts
Risk Reduction and Risk Sharing: The Northern View
Source: Flossbach von Storch Research Institute
- Sovereign concentration charges
- ESBies (European Senior Bonds): a euro area safe asset without mutual guarantees
(Brunnermeier at al)
Safety achieved by some combination of diversification and seniority.
Banks would purchase a standardized diversified
portfolio of sovereign bonds and use it as collateral for a security issued in several tranches.
The subordination level (the size of the junior and
mezzanine tranches) would be calibrated so that the five-year expected loss of the most senior is about the same as that of a AAA-rated sovereign bond.
Doom Loop: solutions that work and solutions that do not work
- Debt Restructuring
The second stumbling block
Italy’s fragilities
- Productivity - Banks
- Debt
Italy
- Productivity - Banks
- Debt
-
Italy’s low productivity: it’s a composition problem !
Italy’s low productivity: it’s a composition problem !
Size Distribution of Firms
Source, Prometeia on OECD data
Italy
- Productivity - Banks
- Debt
-
NPLs ratio (weighted average by country)
Italy: Net NPLs (EUR bn and as % of total net loans)
Source: DBRS
Italy
- Productivity - Banks
- Debt
Bottom line: Underlying Euro area continuing fragility lies the Italian debt
Source: Banca d’Italia, Bollettino Economico, 2-2019
The Italian spread: default vs redenomination risk
Who holds the Italian debt ?
- by type of holder
- Foreigners 33
- Bank of Italy 19 - Italian banks 20
- Italian insurance cs 23 - Italian households 5
Country exposures to Italy (%GDP)
France 14,1 Spain 6,4 Germany 3,1
