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Eurobonds as a Possible EU Response to the Current Economic Crisis

Master's Thesis 2012 92 Pages

Economics - Finance

Excerpt

Table of Contents

Acknowledgement

Abstract

Table of Contents

1 Introduction
1.1 ProblemFormulation
1.2 Objective of the Master Thesis

2 Financial Systems
2.1 Key Concepts and Analytical Issues in the Financial System
2.2 Economic Foundations ofFinancial Intermediation
2.3 Structural Change in Financial Systems over the Last Years
2.4 Role ofMarkets and Institutions in a Financial System
2.5 Nature and Components of the Efficiency in the Financial System
2.6 The Pivotal Role of the Financial System and its Importance in an Economy
2.7 Summary

3 Current Economic Crisis
3.1 Nature, Causes and Origins of Crisis
3.2 Economics ofFinancial Innovation
3.3 Euro Area Economic Crisis and the Consequences for the EU
3.4 Current Developments in Economic and Financial Policy
3.5 Implications for Post-Crisis Business Strategies and Regulation of the Banking Sector

4 European Bond Market
4.1 Bond Markets - General Information
4.2 European Bond Market and European Government Bond Yields
4.3 The Creation of a Common European Bond Market

5 Eurobonds
5.1 Eurobond Proposals (main models and most discussed)
5.1.1 Depla / Weizsäcker ‘Eurobonds: The Blue Bond Concept and Its Implications’
5.1.2 European Commission ‘Feasibility ofIntroducing Stability Bonds’
5.1.3 German Council ofEconomic Experts ‘The European Redemption Pact’
5.1.4 The ELEC ‘Euro Treasury-Bill Fund’
5.2 Other Proposals, Alternatives, Similar and Complementary Instruments
5.2.1 Jones ‘The Eurobond: Proposals, Comments, and Speeches’
5.2.2 Euro-nomics ‘European Safe Bonds’ (ESBies)
5.2.3 FIRE for the Euro - A Strategy for Stabilizing Government Bond Markets
5.2.4 Synthetic Eurobonds
5.2.5 Suarez ‘A Three-Pillar Solution to the Eurozone Crisis’
5.2.6 Operations of the European Stability Mechanism (ESM)
5.2.7 Schulmeister ‘The European Monetary Fund’

6 Summary ofKey Findings
6.1 GeneralAspects
6.2 Results and Recommendation
6.3 What could be the Role ofEurobonds in Solving the Current Economic Crisis?
6.4 What could be the Role ofEurobonds within the Euro Area Financial System?
6.5 Could Eurobonds be a Durable and Equitable Solution for a Common European Bond Market?

7 Future Outlook

Bibliography

Acknowledgement

During my MBA studies, I have had the opportunity to dig into the knowledge and experience of a great number of individuals, who contributed to this thesis and my professional development as a management scholar in one way or another.

Now is the time to thank them.

First and foremost, I would like to thank my family and parents.

My honest appreciation goes to Professor Michael Hanke for his guidance and supervision.

A special thanks to my friends for their support during these exhausting but valuable moments.

Finally, I would like to thank Professor David T. Llewellyn and Franz Nauschnigg (OeNB) who both have shared their knowledge and experiences with me to make this work possible.

Abstract

“Everythingflows, nothing stands still ”
Heraclitus of Ephesus

The objectives of this Master’s thesis were to develop a better understanding of the current econom­ic crisis situation after the financial crisis of 2008/2009 and the subsequent sovereign debt crisis of 2010/2011 in order to provide a good solution as a possible EU response.

The theoretical part of this thesis focused on financial systems with a general overview and in special answering the question ‘Why is the efficiency of the financial system important for the economy as a whole’.

Furthermore with some ground information to the current economic crisis - a combination of sovereign debt crisis, the euro project fault-lines and fragility ofbanks - this work gave some insights to the present difficult European situation and consequences for the EU.

With a short overview of the current unsatisfactory situation at the European bond market and the debate on whether creating a common European bond market is useful brings the thesis into the main topic.

The empirical part focused on the eurobond proposals and the common issuance of euro area Member States sovereign bonds. The aim was to gather an in-depth understanding of the main models and most discussed proposals and to point out the reasons that govern such need in order to solve the current economic crisis.

In the summary ofkey findings these theories and proposals which were developed from different groups by presenting solutions in order to solve European problems were discussed. Based on these key findings (pros and cons) and in connection with my considerations the three main questions were answered: What could be the role of eurobonds in solving the current economic crisis? What could be the role of eurobonds within the euro area financial system? Could eurobonds be a durable and equitable solution for a common European bond market?

At the end of this thesis there was given a future outlook.

1 Introduction

“Current credit crisis is arguably the greatest crisis
in the history offìnance capitalism“

Lord Adair Turner, fsa Chairman

The 2007-2012 global financial crisis is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s. It resulted in the collapse oflarge financial institutions, the bailout ofbanks by national governments and downturns in stock markets around the world. Another analysis, different from the mainstream explanation, is that the financial crisis is merely a symptom of a deeper crisis, which is a systemic crisis of capitalism itself.(1 )

1.1 Problem Formulation

The current economic crisis has become increasingly larger and the intensification of the euro area sovereign debt crisis has triggered a debate on the feasibility of a common issuance of eurobonds, genuinely approaching a ‘risk-free asset’ concept within the euro area.

Some economic analysts, senior European Union officials, members of the European Parliament and financial market participants believe that issuing eurobonds would be a step which could help resolve the European region’s debt crisis, the current economic crisis, by expanding the euro area’s bailout fund.

The Economic and Monetary Union (EMU) - established in 1999 - is an umbrella term for the group of policies aimed converging the economies of members of the European Union (currently composed of17 Member States) in three stages so as to allow them to adopt a single currency, the euro. As such, it is largely synonymous with the ‘eurozone’ and ‘euro area’.

EMU was created without a formal collective political body at its centre and the euro has the European Central Bank (ECB) as a single monetary authority, but without any political equivalent. The euro is the official currency of the euro area, which consists of Austria, Belgium, Cyprus, Estonia, Finland,

France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain.

Despite the opposition of some European politicians the clamour of ‘eurobonds’ - concealing a multi­tude of variations as an instrument to stabilise the EMU and/or to boost economic growth as well as a measure which would strengthen financial discipline in euro area Member States - has not diminished. The concept of common issuance of sovereign bonds was first discussed in the late 1990s when the Giovannini Group published a report presenting a range of possible options for co-ordinating the issu­ance of euro area sovereign debt.

The debate on common issuance has evolved considerably since the launch of the euro in January 1999. Initially the focus was mainly on the benefits of enhanced market efficiency, but recently the focus has shifted towards crisis management and stability aspects.

The first proposal for the introduction of eurobonds has been made by Wim Boonstra in 2005.

In 2008 the interest in common issuance was revived through the European Primary Dealers Association (EPDA) and in 2010 Euro-group chairman Jean-Claude Juncker’s and Giulio Tremonti’s common European bond recommendation flared up the discussions again.

Is it decision time for the euro area now?

There are fears and threats, of course. Yannos Papantoniou, the former Economy and Finance Minister of Greece, thinks that such innovations like eurobonds could lead to a rise in countries domestic borrowing costs and to direct/indirect fiscal transfers. The danger exists of course, that they could also generate moral hazard by relieving over-indebted countries from pressure to put their public finances in order. I agree with Papantoniou that they could cite treaty-related and constitutional difficulties in establishing rules and procedures. They could infringe all European countries’ sovereignty. But on the other hand, refusing to accept the growing consensus that fiscal union is the key resolving the debt crisis exposes the euro area to serious risks. But for sure, sticking to half-measures exacerbates markets’ impatience and provokes increasingly determined speculative attacks. (2 )

Papantoniou pointed out in his comments that in the event of sovereign defaults, the cost ofbailing out the banks may far exceed the cost of issuing eurobonds. Investors need to be reassured that debt- service costs are under control, and that debt volumes and deficit limits are firmly monitored in order to minimize default risks and strengthen banks’ ability to lay the groundwork for sustainable growth. According to experts’ opinion weakening banking conditions are emerging as a major threat to the euro area’s recovery and stability.(2 )

Papantoniou wams that the emerging systemic risk concerning the sustainability of euro area produces a vicious circle. Moreover, viewed from a wider perspective, economic and social turbulence on Europe’s southern periphery will constitute a geopolitical risk.(2 )

Erik Jones (Professor ofEuropean Studies and Director ofBologna Institute for Policy Research at Johns Hopkins SAIS) illustrates in his paper that the introduction of eurobonds should lower the risk of default. In his opinion highly indebted countries are struggling because they cannot get access to private capital at affordable interest rates, and the more countries have to pay for their borrowing the more likely they are to be forced to write down the principal of their debts. Market speculators are betting on this effect and market speculation results in higher interest rates that in turn make some sort of default more likely.(3 )

In this sense I understand Jones’ argument that German’s opposition to the eurobond proposal is irrational from the perspective of eurobond-supporters because the introduction of eurobonds will increase fiscal discipline in highly indebted countries, shield Germany from losses on the borrowing, and weaken the influence of speculation in the marketplace.(3 )

Definitely, it should be guaranteed that the risks in the future will be marginal. But how could the uncertainty about risks be minimised? There must be answers to a number of open questions: How can we be sure that access to the eurobonds will be limited? What mechanism will be used? What will happen if investors stop refinancing the eurobonds?

By all means, the distinction between opponents and proponents is a fairly standard problem in behavioural economics. As demonstrated by Daniel Kahneman and Amos Tversky in their Nobel prize-winning research on ‘prospect theory’. The prospect theory says that people make decisions based on the potential value oflosses and gains, rather than the final outcome, and that people evaluate these losses and gains using heuristics. The other interesting insight from ‘prospect theory’ is that the emotions surrounding the fear of loss are stronger than those surrounding the prospect of gain.(3,4 )

So, today’s most discussed proposals have to turn this problem situation around:

Firstly. The Blue Bond proposal from Delpla and von Weizsäcker: Bruegel informed European Union policy with his research in May 2010in order to put forward the idea that euro area Member States should divide their sovereign debt into two parts. In this proposal separate ‘red’ and ‘blue’ bonds, under the plan, eurobonds - the senior ‘Blue’ tranche - would be issuedjointly and collectively up to the value of 60% of each euro area Member State’s gross domestic product (GDP). Borrowing beyond that level would require an individual Member State to issue ‘Red’ bonds without the collective guarantee and with the market likely to charge a higher yield to reflect the additional risk.

Secondly, the proposal ‘Feasibility of introducing Stability Bonds’ was presented by the European Commission President José Manuel Barroso on 23rd November 2011. This instrument with its three options should enhance financial stability in the euro area.

Thirdly. The German Council ofEconomic Experts proposed a ‘European Redemption Pact’ scheme, which creates ajoint debt vehicle for 25 years and its aim would be to ease down the current unsustainable levels while implementing credible fiscal policy reforms in all euro area Member States. It would combine joint and several liability with a strong individual commitment in refinancing the euro area Member States over the next years as well as provide a road map to each member country reaching a 60% debt-to-GDP ratio.

Fourthly. The ELEC temporary Euro T-Bill facility: A pan-EU panel of economic. market and legal experts has been drawn together by European League for Economic Cooperation (ELEC) to make a proposal for atemporary ‘Euro T-Bill Fund’ once the proposed ‘Treaty’ on fiscal discipline is signed. Their proposal is designed to provide a degree of mutual support that will be sufficient to allow adequate time to Member States that are themselves trying to restore their competitiveness and the sustainability of their public finances. They proposed a stabilisation tool that will assist Member States who are experiencing the difficulties ofhigher interest costs. rather than needing an immediate financial rescue that might involve the need for funds from external providers. These Treasury-Bills are eurobonds with a maximum maturity of 2 years.

Finally. some other proposals. alternatives. similar and complementary instruments will be introduced. Among others Professor Erik Jones showed in his paper also the evolution of the eurobond discussion over the last two years. Professor Brunnermeier proposed an alternative solution in form of ‘European Safe Bonds’. which are securities (not eurobonds) funded by currently outstanding government debt (up to 60% of GDP) that would constitute a large pool of safe assets. The authors argue that these ESBies would address both liquidity and solvency problems within the European banking system and help to distinguish between the two.

It will be of great interest for me to analyse the realistic possibilities adopting eurobonds. in which time horizon they could be launched and how successful they could be. Especially. because we know. there are. however. still some European politicians who say that a common euro area bond initiative creates a ‘free-rider’ situation where bigger economies are saddled with the liabilities of weaker Member States and face higher borrowing costs. The risk of moral hazard is of course one of the biggest problems in issuing common eurobonds. There are worries that a eurobond solution with its lower interest rate would be an invitation for southern Europe to splurge on debt, but that could be mitigated in part by charging higher rates for bonds issued by countries with higher debts and deficits.

The pros and cons of proposed solutions could be debated endlessly, but by giving some facts in this paper I hope to be able to give useful background information for further discussions. The political and legal problems may rather be the biggest sticking points.

The most important thing is that we have to keep in eye our objective by notjust finding temporary palliative but also long-term solutions. Therefore I believe that the creation of a common European fiscal policy could guarantee a long-term perspective for the euro and a fiscal union is both a necessary and a sufficient condition for the long-term survival of the currency. But the hardest issue would be the loss of sovereignty that national parliaments would confront if eurobonds were introduced related to the idea of a common European fiscal policy. To make the bonds work and to avoid excessive borrowing, it would be advisable to create a central authority responsible for reviewing national budgets and financing needs. In a way it could mean the setting up of a pan-euro area finance ministry or fiscal authority (a common fiscal policy for a pan-European financial system), although parliaments would still have the right to set taxes and decide how their budgets were spent.

The sovereign debt crisis that began in Greece and spread to other euro area Member States has served as a painful reminder of the risks associated with high public debt in a global financial system. In the article ofRoya Wolverson the threat of contagion to other European countries or even countries outside Europe has divided US experts’ opinion on what the impact will be on the economy of the USA and China. Some economists argue that the US economy will benefit from the euro area crisis, since the euro’s continued weakness will secure the US dollar’s status as a global reserve currency and the US Treasury bills as a ‘safe haven’. Others say the US debt problem will escalate ifbloated entitlement programs go unaddressed. Some analysts argue the greater impact of the crisis will be on USA’s as well as China’s growth, which relies on market confidence and exports to Europe. Wolverson summarized US experts’ significant opinions: CMC Markets’ Ashraf Laidi, Mesirow Financial’s Adolfo Laurenti, the National Bureau ofEconomic Research’s Carmen Reinhart and the American Enterprise Institute’s Vincent Reinhart agree that the crisis buys the US government time to tackle its debt. Of greater concern is the impact of the crisis onUS market confidence and growth, say the Carnegie Endowment's Uri Dadush and Invesco’s Ron Sloan. Finally, American University’s Anna Gelpern says the crisis heightens the need for strong financial reforms that can shield banks - and by extension the public - from government failure.(5 )

I am convinced that a common issuance of euro area Member States sovereign bonds (like eurobonds) could create a counterpart to the US government bonds. Economic experts mean that an acceptance of eurobonds already at a level of 40% of national GDP would create a bond market the size of the US Treasury market, which is generally considered as the world’s second most efficient financial market after foreign exchange. It would not only become impossible to speculate against individual Member States, the bond would bind them together. In this way euro area would also become a global economic superpower. Big countries, like China, are highly interested in buying ‘European’ bonds. The acceptance comes also from countries of the G8-group. I am quite sure, that as soon as ,European’ bonds would be accepted from the market, also countries like Switzerland could profit by them, because the pressure upon Swiss francs would decrease. And it is highly evident to realize that a higher demand would automatically decrease the interest rate of such eurobonds and secure a high rating.

The main significance of the eurobond proposals is political. A common bond would be regarded as the first step on a road towards a fiscal union. It would in some way or other co-ordinate important aspects of tax and budget policies, financial policies, and even employment policies. Its impact would be to ensure that the euro area has a sufficient number of mechanisms at its disposal to deal with crises.

1.2 Objective of the Master Thesis

The present Master’s thesis seeks to develop a better understanding of the current (economic) crisis in Europe and to demonstrate different possible solutions to overcome the crisis.

The matter is that the euro area is now in a deepening crisis. It is important to mention that this - mistakenly sometimes also called as ‘euro crisis’ - is not a crisis of the currency, but rather the outcome of policy errors and economic woes.

Professor Jones explains that the real problem in the euro area lies not in Greek indebtedness but in the wider structure of savings and investment across the euro area as a whole, or what economists refer to as macroeconomic imbalances.(6 )

Jones defines the standard objections in his paper concisely: European markets are not flexible enough, European business cycles are uncoordinated, and national economies are too vulnerable to asymmetries emanating from abroad. Worst of all, the countries ofEurope are unwilling to share their fiscal resources, they do not all belong in a single currency and they refuse to do anything about it.(6 )

Jones analyses the special situation in Greece as followed: The problem there is much simpler. A small country borrowed itself into trouble without any sanction from European authorities and with few, if any, penalties in the market. Moreover, it did so simply because it could, or rather, because not doing so would have been more difficult. Greek politicians wanted to borrow money rather than make difficult spending cuts or tax rises, and that money was freely available. The reason is that, beyond all the complicated arguments about nominal convergence as per the Maastricht Treaty (1992) or ‘optim­um currency areas’ in the debate among economists, a country thatjoins a monetary union no longer faces a balance-of-payments constraint. It does not have an own currency and so it can no longer be threatened with a currency crisis.(6 )

Jones refers to the Maastricht Treaty, which included only two bulwarks to hold back the threat of countries taking advantage of their relaxed current account constraints and strengthened credit-worthi­ness to run excessive deficits: One was the excessive deficit procedure, which was supposed to pre­vent countries from borrowing more than they could manage; the other was the ‘no bailout rule’, which was supposed to make it clear to Member States that they would each be responsible for clean­ing up their own mess.(6 )

Jones reminds us also that there was a solution, which would have been to reduce membership in Europe’s economic and monetary union to a core group oflike-minded countries. The problem was that only few countries actually qualified to participate in the single currency according to the Maastricht criteria. The first deadline to start the euro in 1997 was missed and the second deadline in 1999 allowed for no further delay. And faced with the choice between a very small single currency and a large one, the European Union leaders took the decision to start with 11 Member States. Of those countries that wanted tojoin, only Greece was held out of the initial project for failing to meet the Maastricht criteria. Nevertheless, it was able tojoin shortly before common notes and coins were issued.(6 )

We all know that Europe has now to co-ordinate its economy better in order to make it competitive. But this takes time, because different massive problems are arising one after another and the previous strategy, to solve the crisis only with bailout packages, failed.

Sometimes, the European policy looks like dealing only with symptoms instead of tackling problem at its roots. It is now about whether the euro area has the political will to do whatever it takes: to set up a mechanism of policy co-ordination, to accept fiscal transfers and ultimately move towards a fiscal union. History has told us that monetary unions that refuse to become political unions are destined to fail.

Jones argues that the current crisis has revealed the underlying tensions between integration at the global level and interdependence within Europe. Globalization encourages European countries to be different from one another, often in unpredictable ways. On the other hand interdependence ensures that the fates of these different countries are inextricably intertwined. He also mentions that in the past, European countries have usually responded to economic crisis with a constitutive politics - building new institutions to help address the problems of the past. The politics this time around is more distributive than constitutive in order to be more concerned with who pays and who benefits than with how the underlying causes for the crisis should be managed or addressed.(7 )

We need visions! How will Europe look like in five years? InlO years? How about our vision for the future of the euro? If we want to keep the currency, we have to take action and create a common economic and financial policy. In principle, this should have been clear already in the introduction of the euro that it is a community and needs a unified economic government.

Fritz Breuss (Jean Monnet Professor for Economic Aspects ofEuropean Integration) put it in a nutshell: Whether the political solution will be an ‘economic government’ orjust ‘economic governance’ may be not so important for the further development of the European economy, but it would be of great importance to start the three central initiatives:(8 )

- Installation of a permanent European Monetary System (ESM) in order to be better steeled for future crisis
- Stronger controlling (scrutiny) of the reported statistics (Stability and Growth Pact: In 1997 the Treaty of Amsterdam transformed the rules of the Treaty ofMaastricht - the 3%-deficit rule and the 6O%-debt rule for entering the monetary union - into permanent obligations)
- Elimination of the macroeconomic disequilibrium which has been escalating since 1999

Anyway, the route of an ‘economic government’ will probably come in small steps and I strongly agree with many experts that one such step could be the idea to create a common issuance of eurobonds for euro area Member States with limited drawing rights.

Originally, the idea of eurobonds was intended to strengthen fiscal discipline within the euro area by creating market incentives for highly indebted countries to decrease borrowing. Over time, it has developed to a candidate solution (there are various forms) for responding to Europe’s sovereign debt and to solve the current economic crisis.

At the very moment there are plenty of discussions about creating new common eurobonds or alternatives. Whether they would be called ‘Eurobonds’, ‘Blue Bonds’, ‘European Safe Bonds’, ‘European Redemption Fund Bonds’, ‘Euro Treasury-Bills’, ‘Stability Bonds’ or something else, the most important thing is to create rules in order to minimize moral hazard. A big problem is that rescue operations automatically create moral hazard, which is the incentive that people behave badly and get profit from their counterpart. The positive intention of rescue operations is to save banks, but it will encourage other banks to behave badly, therefore regulations have to stop moral hazard (ideally only with 85% coverage). The difficulty in finding the right solution is that moral hazard happens only after a contract is concluded.

The master thesis is structured in order to give an understanding to the current crisis situation and to offer possible answers. In this paper arguments will be given for finding the best eurobond proposal.

The starting point will be an overview to financial systems. I am also going to give an introduction to the current economic crisis and to illustrate the European bond market.

The main approach will be to present the different proposals for issuing eurobonds and similar instruments, which will be suggestions to help to overcome the current economic crisis.

The summary ofkev findings consists of a critical discussion about the role of eurobonds and similar instruments. There will be some analysis, conclusions and recommendations for the best suited solution according to the different pros and cons of various proposals. In order to meet these objectives the following three main questions have been defined:

- What could be the role of eurobonds in solving the current economic crisis?
- What could be the role of eurobonds within the euro area financial system?
- Could eurobonds be a durable and equitable solution for a common European bond market? Finally, there will be also a future outlook.

2 Financial Systems

“Euro areafinancial system needs
urgent overhaul, including bank regulator ”

Peter Praet, Member of 'the ECB’s Executive Board

In this chapter I am going to give first an overview of the analysis and theoretical basis of financial systems: Starting with key concepts and analytical issues in the financial system, going on with economic foundations of financial intermediation and structural change in financial systems over the last years as well as the role of markets and institutions in a financial system. After that I want to give a short explanation to the nature and components of the efficiency in the financial system. The main focus will be to explain the pivotal role of the financial system and its importance in an economy.

Generally seen, in finance the financial system is the system that allows the transfer of money between savers/investors and borrowers. A financial system can operate on a global, regional or firm specific level. The global financial system is the financial system consisting of institutions and regulators that act on the international level, as opposed to those that act on a national or regional level. The main players are the global institutions - such as International Monetary Fund (IMF) and Bank for International Settlements (BIS) - as well as national agencies and government departments (central banks and finance ministries), private institutions acting on the global scale (banks and hedge funds) and regional institutions.(9 )

2.1 Key Concepts and Analytical Issues in the Financial System ()

According to the analysis and theoretical basis of financial 10 systems there are some important key concepts and analytical issues to consider.

David T. Llewellyn (Professor at Loughborough University) defines following main key concepts: Information and asymmetric information, bounded rationality, moral hazard and adverse selection, risk versus uncertainty, risk transfer, probability versus impact, normal distribution and tail risks, expectations (rational/adaptive), risk aversion, disaster myopia, incentive compatible contracts, contracts (debt, equity and insurance), principal agent relationships, financial intermediation, network externalities and fallacy of composition.(10 )

Some ground facts about Information and Asymmetric Information: As we know, information is costly and we will always stay in the level of ‘not enough informed’. What do we know about the future? All transactions are related to future and we make assumptions ofhow the future will look like. Information is always asymmetric, because not everyone has the same information.

In 1970 George Akerlof published a ground breaking paper about the consequences of information asymmetry. In his paper he explained, that in markets where it is impossible to asses the quality of a product/service - where the seller of the product/service has more information than the buyer - the market will gradually deteriorate and maybe even eventually disappear altogether. The main issue is that quality is inaccessible beforehand, thus giving sellers’ incentives to present the product/service as being ofhigher quality than it actually is. The buyer, however, knows this and will take the average quality of the market into consideration. This will have as a result that high quality products/services will leave the market, since they will only sell goods for average market quality. Therefore the average market quality will deteriorate and the market will shrink.(11 )

What do we learn about this? The main problems with asymmetric information are uneven strength in contracts, moral hazard, market break-down and unfairness. Therefore adequate regulations and monitoring are very helpful.

Bounded Rationality means that we do not only have enough information, but we also cannot use all information we know. We handle with bounded rationality, ‘bounded’ because a rational decision has to be done with all information and a bounded decision uses only a part of information (mostly four to five pieces of information). It is therefore crucial, which one we use! There are some problems that may occur, if the excluded information was not used and would have been the most dominate according to the result.

Moral Hazard and Adverse Selection are both crucial key concepts: Moral hazard is the incentive that people behave badly and get profit of counterpart. A big problem is that rescue operations automatically create moral hazard. Therefore regulations have to stop moral hazard. Through rescue operations there should be only 85% coverage and not 100%, because this would create for sure moral hazard. It is important to keep in mind, that naturally an adverse selection occurs before, but moral hazard happens after a contract is concluded!

Risk versus Uncertainty: Because the future is unknown there are probabilities of risk. In case of a risk, you can put a risk premium, but if there is uncertainty we do not know how risky it is!

Problems arise if risks are transformed into uncertainty. Uncertainty dominates the risk! How can a bank handle with uncertainty? There is really an interesting theory ‘Credit Rationing in markets with imperfect information’ from Stiglitz and Weiss: The idea is that in a competitive equilibrium a loan market may be characterized by credit rationing and they suggest a mechanism where the interest rate a bank charges may itself affect the riskiness of a pool of loans by either adverse selection (by sorting potential borrowers) or moral hazard (affecting actions ofborrowers).(12 )

Risk Transfer: The central function of a financial system is to transform risk and to enable risk to be transformed. Transformation of risk happens through insurance companies (because they can diversify it more easily) or through financial markets. It is quite interesting, that we are also shifting risk, even if we know that the risk is equal zero. When is the best time to take insurance? The answer is, when risk occurs it is serious and you are already diversified. All (types of) insurance creates moral hazard and therefore we should always accept a risk.

Probability versus Impact: We have to look at the probability of occurrence and impact of risk. If the probability of occurrence and seriousness of occurrence are both low, it is ‘happy’ to take risk. If the probability of occurrence and seriousness of occurrence are both high, we should not take the risk. We can price the risk, if the probability of occurrence is high but seriousness of occurrence is low. There are crisis potential, if the probability of occurrence is low but seriousness of occurrence is high.

Normal Distribution and Tail Risks: The normal distribution is underestimating the probability of fat tails (as an explanation: fat tails are actually more common than normal distributions with thin tails).

In statistical models it is mostly irrelevant to look on data for a short time period, irrelevant periods or past periods. Some other fault line in this statistical model is that the correlation rises when the volatility is high.

Expectations (rational/adaptive): How do people form the future? They have certain expectations and you can never know their intentions. The future is unknown and therefore we have to make assumptions for the future. How do we come to our expectations? There are two ways: rational (view we take under clear mind) and adaptive expectations. At different time different expectation models do occur, because there are changes all the time. Both euphoric and dysphoric prices are bad at financial markets. In uncertain times the volatilities are high, therefore different expectation models are changing all the time.

Disaster Myopia: Large economic shocks occur so infrequently that we often underestimate shock probabilities. We talk about disaster myopia, when there is crisis potential. This means, that the probability of occurrence of risk is low but seriousness of occurrence is high. There are two forms of disaster myopia: availability heuristic and threshold heuristic.

Andrew G. Haldane (Executive Director for Financial Stability, Bank ofEngland) explained in his speech about risk-off, that in financial markets risk perceptions are as important as reality.

Behavioural economics tells us that financial crashes can leave lasting psychological scars on risk­taking. This means that perceptions of risk can be systematically over-stated - the fear of fear itself.(13 )

Psychologists know from experimental evidence that, faced with uncertainty, people base their judgements on simple rules of thumb or heuristics. One such rule of thumb is the ‘availability heuristic’. This states that agents base probabilistic assessments on the ease with which an event can be brought to mind: how recently it has occurred, how severe are its effects and how personal is the experience. Car crashes are the classic example. These often arise from disaster myopia, as drivers systematically under-estimate the probability of a pile-up and drive too fast. The longer the period since the last crash is the greater the risk-taking. After a lengthy stretch of clear motorway, risk appetite may become too healthy, and risk-taking too great, relative to the true probability of disaster. In other words, drivers are disaster-myopic. Should a crash occur, however, risk-taking incentives go into reverse gear. Their closeness to a disaster event causes drivers to move more slowly than might be justified by the underlying risk. The experience heuristic leads to an over-weighting of recent, severe, personal events. Risk appetite then switches from too high to too low relative to the true risk. The result is traffic congestion.(13 )

Financial crashes and car crashes have common psychological roots. One of the causes of the current economic crisis was an under-pricing of risk. That was rooted in disaster myopia - an under­estimation of risk during the so-called Great Moderation. Memories of financial disaster had faded, with the Great Depression in almost no-one’s experience sample. The upshot was an over-healthy appetite for risk-taking. The subsequent crash has turned these behaviours on their head. Memories of financial disaster are now fresh - as after the Great Depression - causing an over-estimation of the probability of a repeat disaster. In these situations, psychological scarring is likely to result in risk appetite and risk-taking being lower than reality might suggest. Risk will be over-priced. Today, the disaster myopia that caused the crisis may be retarding the recovery. Disaster myopia may be more potent in the markets than on the motorways. Asset prices are guesses about the future. Faced with uncertainty about the future, market participants form these guesses using their own.(13 )

Network Externalities: Managing only one’s own bank is nowadays not enough any more, because the network externalities are growing and growing. Network externalities are very important, but it is not so easy to know, how this is possible to monitor in order to get the full exposure! Some network externalities are: increased connectedness of markets and banks, reduced systemic diversity and the ‘small-world’ effect, where small shocks have big impacts. As an example, interbank lending is facing a big trouble these days, because of fear of network externalities.

Enhanced network externalities are one of the structural changes identified earlier as preceding the crisis, Professor Llewellyn explained us in our course. It was the increased power of network externalities associated with increased connectivity between different institutions as well as between banks and markets. This had the effect of spreading shocks in one market to other markets and institutions.(14 )

2.2 Economic Foundations ofFinancial Intermediation

A financial system in today’s world is perhaps the most important system among all the systems because all the economics of the world have become interlinked. It has also become a very complex system. One of the main function which financial system perform is the channelization of the savings of individuals and making it available for various borrowers like companies, which take loan in order to increase the production of goods and services. This in turn increases the overall growth of the economy. (15 )

Why are we so worried about financial crisis? One reason is that functions of the financial system are much too inefficient. Financial system covers everything: Financial institutions, financial markets, exchanges and auctions. There are important universal functions of the financial system, which should be regarded in order to increase efficiency.(10 )

Llewellyn defines the universal functions of the financial system as:(10 )

- Manage the payments and settlements system
- Provide mechanisms for saving and borrowing
- Creation of financial assets and liabilities
- Create financial instruments and contracts
- Mechanism for pooling of funds and financing large-scale individual projects
- Bridge different portfolio preferences of suppliers and demanders of funds
- Mechanism for transferring economic resources: time, agents, geography
- Allocation of funds to their most efficient use
- Manage uncertainty
- Price risk
- Enable risks to be transferred between different parties according to their ability and willingness to absorb them
- Offer facilities and markets enabling wealth-holders to change the structure of their portfolio of assets and liabilities
- Deal with asymmetric information problems: resolution of moral hazard and adverse selection
- Offer specialist services (insurance, fund management, etc.)

Here we can see that in order to create financial assets and liabilities we need to provide mechanism for saving and borrowing. The efficient use of a fund may be to get largest risk-adjusted return that means we have to look for both: risk and return!

Llewellyn explained in our course, that there are two things, which are necessary in a financial system in order to be efficient (with a high deal of outcome): the need of information and the need of price. We can only sign possibilities for that, because we cannot see and know what future brings. So we have to set a price, but we have to know that overpricing of risk is exactly as bad as underpricing of risk. The possibility to manage uncertainty is to build insurance contracts. In all financial transactions there will always be adverse selection and moral hazard, because both parties will never have the same amount of information and the same possibilities to use the information. (10 )

When comparing financial systems, the structure in the way they use the functions as well as the efficiency how they use them are reasons to act: a completely inefficient financial system has to be restructured.

2.3 Structural Change in Financial Systems over the Last Years

Financial systems have become larger than the economy. There were structural changes in the global financial system. There has been a sharp rise in the pace of financial innovation and especially in the use of credit derivates (e.g. Credit Default Swaps, so called CDSs).

We experience an increasing financialisation of economies. The financialisation means a “financial capitalism which developed over several decades leading up to the 2007-2012 financial crisis, and in which financial leverage tended to override capital (equity) and financial markets tended to dominate over the traditional industrial economy and agricultural economics“.(2 )

Llewellyn differences between financial systems, regarding to: the role of markets and institutions, the range of structure of institutions and markets, structure of corporate financing, ownership structures, corporate governance arrangements, links between banks and borrowers, portfolio preferences, range of financial assets and liabilities, regulation, role of the state, range of assets and liabilities.(10 )

Banks and markets became increasingly integrated. The interconnectedness has increased and globalisation of finance/financial markets takes place, therefore financial systems will be more crises prone in future.

2.4 Role ofMarkets and Institutions in a Financial System

In general, confidence of market has to be achieved, because markets are right either way. Who is governing whom? The markets? The politicians or vice versa? Governments and sovereigns have to make financial markets to work better, not to stop them.

Efficiency of financial system is better achieved, when there is no ‘taking the risk out’ of banking. There should be no ‘taking the risk out’ of the financial system, as well.

In order to emphasize the psychological impact and the way to control thinking and movements there is a way to reassure the public opinion national and even world-wide. Willibald Kranister, former Director of the Austrian Central Bank (OeNB), has been introducing a holistic system for central banks in order to improve the efficiency of monetary policy by offering an ‘information and communication strategy’. He points out that central banks could also promote stability with an effective information policy and public opinion strategy. In his opinion usual and proven instruments of monetary policy could be enhanced by new systems, which could be a real challenge for central bankers world-wide and a good approach to try to improve one’s efficiency. These instruments of monetary policy have very often tied to the psychological effects of the decisions and expectations in the economy of a country. Realizing a successful monetary policy the central banks have a decision making position with a high degree of responsibility for all parts of the economy of their country. We all do agree that the currency is only good and solid, if the own citizens and the international partners trust in it. There is no doubt that therefore a good interaction with the public is highly important.(16 )

2.5 Nature and Components of the Efficiency in the Financial System

David T. Llewellyn reports in his paper, that an efficient and robust financial system is an important prerequisite for an efficient and balanced economic development of a country. In our globalized world no country exits alone any more, so these facts are also related to the euro area as a whole and in a wider coherence even world-wide. He defines four immediate observations in order to set the current scene:(17 )

- There has been a shift in the balance of world economic power away from traditional economies
- Globalisation of financial markets, institutions and systems has steadily increased
- Liberalisation and deregulation in financial systems have progressed
- There has been major banking and financial crisis (followed a period of deregulation and liberalisation)

I agree with the argument ofLlewellyn, that the financial system has a major role in a country’s economic development and such development can be impeded if the financial system is not efficient and robust. In order to maximise efficiency of financial systems substantial liberalisation and a general policy of deregulation are leading to an increased role of markets. However, he argues, that a robust financial system also requires a proper decision-making and control, an efficient regulatory and supervisory regime for financial institutions and sound incentive structures.(17 )

In his paper he summarizes four key issues: Causes and implications of a steady globalisation of finance, policy actions are needed in order to create an efficient financial system, there are required conditions for the stability and robustness of a financial system and the optimum policy responses have to be found when crisis emerge.(17 )

2.6 The Pivotal Role of the Financial System and its Importance in an Economy

James Tobin (American economist, who in his lifetime served on the Council ofEconomic Advisors and the Board of Governors ofFederal Reserve System, and taught at Harvard and Yale Universities) meant 1984 that in his opinion efficiency of the financial system has several different meanings, whereas his fourth concept ‘functional efficiency’ relates more to the economic functions: pooling risks and their allocation to those most able to bear them, insurance function in the Arrow-Debreu spirit, facilitation of transactions and mobilization of saving for investments. In this functional efficiency financial industries perform services for the economy. In his conclusion he also recommend to consider what we can reasonable expect the financial system to achieve and at what social cost.(18 )

In 1984 Tobin already had fears that the immense power of computer will harnessing to that ‘paper economy’ in order not to do the same transactions more economically but to balloon quantity and variety of financial exchanges, which John Train already called as a ‘casino aspect of financial markets’. Tobin feared like John Maynard Keynes, that the advantages ofliquidity and negotiability of financial instruments come at the cost of facilitating speculation which for sure is short-sighted and inefficient.(18 )

Thorsten Beck from the World Bank’s research department expressed his view how the financial sector development fosters economic growth and reduces poverty by widening and broadening access to finance and allocating society’s savings more efficiently. In his opinion sound and efficient financial systems are built on macroeconomic stability and on effective and reliable contractual and informational framework.(19 )

Beck is convinced, that building a sound and effective financial system cannot be achieved overnight, but rather requires a mix of short-term policy measures, medium-term reform processes and long-term institution buildings.(19 )

I am with Llewellyn that a sound economic development requires an efficient and stable financial system, whereas a stable financial system is as important as a sound macro-economic management for the economic development of developing countries. In his opinion a well-developed financial sector contributes to growth by mobilising savings and then efficiently allocating these resources between competing investment projects and other demands for funds. The positive correlation between indicators of financial development and economic growth over the long-term reflects the importance of the financial sector. Also the financial debt, as measured by the ratio of money to GDP, displays a strong positive correlation with economic growth.(17 )

According to the opinion of Professor Llewellyn the financial system is so important because it is so pervasive in the way that it affects all aspects of the economy. The financial system is already a unique industry with a strong input throughout the economy and therefore its efficiency, its stability and robustness is a major issue and has a significant impact on economic development. This all amounts two basic requirements:(17 )

- A requirement to reduce the extent of macro shocks and macro instability
- A requirement to strengthen the ability of the financial system to cope with those macroeconomic shocks that do occur

I agree with Professor Llewellyn that effective (internal and external) regulation and supervision of banks and financial institutions has the potential to make a major contribution to the stability and robustness of a financial system.(17 )

Ross Levine (American economist, James & Merryl Tisch Professor ofEconomics at Brown University and Director of the William R. Rhodes Center for International Economics and Finance) points out, that financial systems support and spur economic growth. The financial system can either be an engine of economic prosperity or a destructive cause of economic decline. Therefore it is very import, which impact it has on the economy: how it mobilises and allocates savings, monitors the use of funds by firms and individuals, diversifies risk (including liquidity risk) and eases the exchange of goods/services. When financial systems perform well they tend to promote and boost productivity growth. On the other hand, if financial systems perform poorly they tend to hinder economic growth and curtail economic opportunities.(20 )

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Title: Eurobonds as a Possible EU Response to the Current Economic Crisis