Tuesday, 19 January 2010



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Monday, January 18, 2010


Effects of the Global Financial Crisis on Europe and the European Response

Some European countries156 initially viewed the financial crisis as a purely American phenomenon. That view changed as economic activity Europe declined at a fast pace over a short period of time. Making matters worse, global trade declined sharply, eroding prospects for European exports providing a safety valve for domestic industries that are cutting output.

In addition, public protests, sparked by rising rates of unemployment and concerns over the growing financial and economic turmoil, have increased the political stakes for European governments and their leaders. The global economic crisis is straining the ties that bind together the members of the European Union and has presented a significant challenge to the ideals of solidarity and common interests. In addition, the longer the economic downturn persists, the greater the prospects are that international pressure will mount against those governments that are perceived as not carrying their share of the responsibility for stimulating their economies to an extent that is commensurate with the size of their economy.

Since the start of the financial crisis, the European Union has taken a number of steps to improve supervision of financial markets. 

These actions include:
• Strengthened the Committee of European Securities Regulators. The Committee
is an advisory body without any regulatory authority within the European
Commission. The January 23, 2009 Directive strengthened the Committee’s
authority to mediate and coordinate securities regulations between EU members.
• Strengthened the Committee of European Banking Supervisors. The Committee
is an advisory body without any regulatory authority that coordinates on banking
supervision. The January 23, 2009 EU Directive broadened the role of the
Committee to include supervision of financial conglomerates.
• Strengthened the Committee of European Insurance and Occupational Pensions
Supervisors. The Committee is an advisory body without any regulatory authority
within the European Commission in the areas of insurance, reinsurance, and
occupational pensions fields. The January 23, 2009 Directive authorizes the
Committee to coordinate policies among EU members and between the EU and
other national governments and bodies.
• The European Parliament and the European Council approved on April 23, 2009,
new regulations on credit rating agencies that are expected to improve the quality
and transparency of the ratings agencies.
• Approved direct funding by the European Union to the International Accounting
Standards Committee Foundation, the European Financial Reporting Advisory
Group, and the Public Interest Oversight Body.
• The European Commission proposed a set of measures to register hedge fund
managers and managers of alternative investment funds and measures to regulate
executive compensation.
• Expressed support for a new European Systemic Risk Council and a European
System of Financial Supervisors.

European countries have been concerned over the impact the financial crisis and the economic
recession are having on the economies of East Europe and prospects for political instability157 as well as future prospects for market reforms. Worsening economic conditions in East European countries are compounding the current problems facing financial institutions in the EU. 

Although mutual necessity may eventually dictate a more unified position among EU members and increased efforts to aid East European economies, some observers are concerned these actions may come too late to forestall another blow to the European economies and to the United States.

Governments elsewhere in Europe, such as Iceland and Latvia, have collapsed as a result of
public protests over the way their governments have handled their economies during the crisis.

The crisis has underscored the growing interdependence between financial markets and between the U.S. and European economies. As such, the synchronized nature of the current economic downturn probably means that neither the United States nor Europe is likely to emerge from the financial crisis or the economic downturn alone. The United States and Europe share a mutual interest in developing a sound financial architecture to improve supervision and regulation of individual institutions and of international markets. This issue includes developing the organization and structures within national economies that can provide oversight of the different segments of the highly complex financial system. This oversight is viewed by many as critical to the future of the financial system because financial markets generally are considered to play an indispensable role in allocating capital and facilitating economic activity.

Within Europe, national governments and private firms have taken noticeably varied responses to the crisis, reflecting the unequal effects by country. While some have preferred to address the crisis on a case-by-case basis, others have looked for a systemic approach that could alter the drive within Europe toward greater economic integration. Great Britain proposed a plan to rescue distressed banks by acquiring preferred stock temporarily. Iceland, on the other hand, had to take over three of its largest banks in an effort to save its financial sector and its economy from collapse. The Icelandic experience has raised important questions about how a nation can protect its depositors from financial crisis elsewhere and about the level of financial sector debt that is manageable without risking system-wide failure.

According to reports by the International Monetary Fund (IMF) and the European Central Bank (ECB), many of the factors that led to the financial crisis in the United States created a similar crisis in Europe.158 Essentially low interest rates and an expansion of financial and investment opportunities that arose from aggressive credit expansion, growing complexity in mortgage securitization, and loosening in underwriting standards combined with expanded linkages among national financial centers to spur a broad expansion in credit and economic growth. This rapid rate of growth pushed up the values of equities, commodities, and real estate. Over time, the combination of higher commodity prices and rising housing costs pinched consumers’ budgets, and they began reducing their expenditures. One consequence of this drop in consumer spending was a slowdown in economic activity and, eventually, a contraction in the prices of housing. In turn, the decline in the prices of housing led to a large-scale downgrade in the ratings of subprime mortgage-backed securities and the closing of a number of hedge funds with subprime exposure.

Concerns over the pricing of risk in the market for subprime mortgage-backed securities spread to other financial markets, including to structured securities more generally and the interbank money market. Problems spread quickly throughout the financial sector to include financial guarantors as the markets turned increasingly dysfunctional over fears of under-valued assets.

As creditworthiness problems in the United States began surfacing in the subprime mortgage
market in July 2007, the risk perception in European credit markets followed. The financial
turmoil quickly spread to Europe, although European mortgages initially remained unaffected by the collapse in mortgage prices in the United States. 

Another factor in the spread of the financial turmoil to Europe has been the linkages that have been formed between national credit markets and the role played by international investors who react to economic or financial shocks by rebalancing their portfolios in assets and markets that otherwise would seem to be unrelated. 

The rise in uncertainty and the drop in confidence that arose from this rebalancing action undermined the confidence in major European banks and disrupted the interbank market, with money center banks becoming unable to finance large securities portfolios in wholesale markets. 

The increased international linkages between financial institutions and the spread of complex financial instruments has meant that financial institutions in Europe and elsewhere have come to rely more on short-term liquidity lines, such as the interbank lending facility, for their day-to-day operations. This has made them especially vulnerable to any drawback in the interbank market.159

Estimates developed by the International Monetary Fund in January 2009 provide a rough
indicator of the impact the financial crisis and an economic recession are having on the
performance of major advanced countries. Economic growth in Europe is expected to slow by
nearly 2% in 2009 to post a 0.2% drop in the rate of economic growth, while the threat of
inflation is expected to lessen. Economic growth, as represented by gross domestic product
(GDP), is expected to register a negative 1.6% rate for the United States in 2009, while the euro
area countries could experience a combined negative rate of 2.0%, down from a projected rate of growth of 1.2% in 2008. The drop in the prices of oil and other commodities from the highs
reached in summer 2008 may have helped improve the rate of economic growth, but the length
and depth of the economic downturn has challenged the ability of the IMF projections to
accurately estimate projected rates of economic growth. In mid-February, the European Union
announced that the rate of economic growth in the EU in the fourth quarter of 2008 had slowed to an annual rate of negative 6%.160 By mid-summer 2009, the pace of economic growth had picked up in both France and Germany.

Central banks in the United States, the Euro zone, the United Kingdom, Canada, Sweden, and
Switzerland staged a coordinated cut in interest rates on October 8, 2008, and announced they had agreed on a plan of action to address the ever-widening financial crisis.161 

The actions, however, did little to stem the wide-spread concerns that were driving financial markets. Many Europeans were surprised at the speed with which the financial crisis spread across national borders and the extent to which it threatened to weaken economic growth in Europe. 

This crisis did not just involve U.S. institutions. It has demonstrated the global economic and financial linkages that tie national economies together in a way that may not have been imagined even a decade ago. At the time, much of the substance of the European plan was provided by the British Prime Minister Gordon Brown,162 who announced a plan to provide guarantees and capital to shore up banks.

Eventually, the basic approach devised by the British arguably would influence actions taken by
other governments, including that of the United States.

On October 10, 2008, the G-7 finance ministers and central bankers,163 met in Washington, DC, to provide a more coordinated approach to the crisis. At the Euro area summit on October 12, 2008, Euro area countries along with the United Kingdom urged all European governments to adopt a common set of principles to address the financial crisis.164 

The measures the nations supported are largely in line with those adopted by the U.K. and include:

• Recapitalization: governments promised to provide funds to banks that might be
struggling to raise capital and pledged to pursue wide-ranging restructuring of the
leadership of those banks that are turning to the government for capital.
• State ownership: governments indicated that they will buy shares in the banks
that are seeking recapitalization.
• Government debt guarantees: guarantees offered for any new debts, including
inter-bank loans, issued by the banks in the Euro zone area.
• Improved regulations: the governments agreed to encourage regulations to permit
assets to be valued on their risk of default instead of their current market price.

In addition to these measures, EU leaders agreed on October 16, 2008, to set up a crisis unit and they agreed to a monthly meeting to improve financial oversight.165 

Jose Manuel Barroso,
President of the European Commission, urged EU members to develop a “fully integrated
solution” to address the global financial crisis, consistent with France’s support for a strong
international organization to oversee the financial markets. 

The EU members expressed their
support for the current approach within the EU, which makes each EU member responsible for
developing and implementing its own national regulations regarding supervision over financial
institutions. 

The European Council stressed the need to strengthen the supervision of the
European financial sector. 

As a result, the EU statement urged the EU members to develop a
“coordinated supervision system at the European level.”166 This approach likely will be tested as a result of failed talks with the credit derivatives industry in Europe. In early January 2009, an EU-sponsored working group reported that it had failed to get a commitment from the credit derivatives industry to use a central clearing house for credit default swaps. As an alternative, the European Commission reportedly is considering adopting a set of rules for EU members that would require banks and other users of the CDS markets to use a central clearing house within the EU as a way of reducing risk.167

Endnotes

156 For additional information, see CRS Report R40415, The Financial Crisis: Impact on and Response by The
European Union, by James K. Jackson.

157 Pan, Phillip P., Economic Crisis Fuels Unrest in E. Europe, The Washington Post, January 26, 2009, p, A1.

158 Regional Economic Outlook: Europe, International Monetary Fund, April, 2008, p. 19-20; and EU Banking
Structures, European Central Bank, October 2008, p. 26.

159 Frank, Nathaniel, Brenda Gonzalez-Hermosillo, and Heiko Hesse, Transmission of Liquidity Shocks: Evidence from
the 2007 Subprime Crisis, IMF Working Paper #WP/08/200, August 2008, the International Monetary Fund.

160 Flash Estimates for the Fourth Quarter of 2008, Eurostat news release, STAT/09/19, February 13, 2009.

161 Hilsenrath, Jon, Joellen Perry, and Sudeep Reddy, Central Banks Launch Coordinated Attack; Emergency Rate Cuts
Fail to Halt stock Slide; U.S. Treasury Considers Buying Stakes in Banks as Direct Move to Shore Up Capital, the Wall
Street Journal, October 8, 2008, p. A1.

162 Castle, Stephen, British Leader Wants Overhaul of Financial System, The New York Times, October 16, 2008.

163 The G-7 consists of Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States.

164 Summit of the Euro Area Countries: Declaration on a Concerted European Action Plan of the Euro Area Countries,
European union, October 12, 2008.

165 EU Sets up Crisis Unit to Boost Financial Oversight, Thompson Financial News, October 16, 2008.

166 Ibid.

167 Bradbury, Adam, EU Eyes Next Step on Clearing, The Wall Street Journal Europe, January 7, 2009. p. 21.
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