AUGUR: Routes to financial recovery in Europe

The major global financial crisis, into which Europe plummeted in 2008, showed the existing framework of banking regulation to be vulnerable. The AUGUR research project explored possible scenarios for Europe’s economic, social, political and environmental position in 2030, and produced a set of recommendations to policy makers on how to tackle the deficiencies in the banking sector. The key is greater cooperation at the international level and ‘macroprudential regulation’.

The banking crisis in 2008 is mainly attributed to the excessive build up of debt across the financial system, miscalculation of risk and overreliance on unstable, short-term funding (non-core liabilities) rather than actual cash flow (core funding). Since 2008, the danger posed by financial institutions previously deemed ‘too big to fail’ has been widely recognised.

It is now accepted that countries should avoid the situation where they are forced to bail-out such institutions. An overhaul of banking regulations is seen as essential to regain stability and to improve the way risk is managed in the long-term. But the important question is what could these changes look like in Europe?

As part of the AUGUR project, an international team of researchers explored a range of feasible scenarios on how regulation of the financial sector could take shape by 2030 and the role of international cooperation.

What is the best strategy for Europe?

The key to overall financial stability, according to AUGUR, is effective ‘macroprudential’ regulation. It requires a level of international cooperation which is consistent with the level of financial integration. This means addressing the stability of the financial system as a whole as well as the stability of individual financial institutions (i.e. banks, building societies, mortgage loan companies and insurance firms).

Such an approach has been proposed before but is still not fully addressed under the Basel Committee Doctrine III1, which is the international regulatory framework set up in 2009 in response to the financial crisis.

The implication of macroprudential regulation is increased supervision of the financial sector by Central Banks, taking into account the systemic risk induced by ‘herding behaviour’ of financial actors. This may imply increased coordination at the international level. Depending on the extent to which a macroprudential approach is taken, the AUGUR researchers envisage four possible scenarios for the future of finance in Europe in 2030:

  • Reduced government – Multinational corporations take advantage of competition between national governments which seek to become more attractive by reducing their regulatory standards. The debt issue leaves most governments with very little room for manoeuvre.
  • China and US intervention – The world of finance is dominated by two super powers which dictate key global finance regulations. This scenario would likely result in two different and competing models.
  • Regionalisation – Economic spaces are created at the regional level and governed by common financial regulations. Regions include the EU and NAFTA (North-American Free Trade Agreement) but also new groupings, for example in Asia.
  • Multi-polar collaboration – Major world economies reach an agreement to create a World Financial Authority to regulate financial markets worldwide.

The first scenario could lead to fragmentation by allowing sovereign states to regulate their own financial services. This ‘reduced government’ scenario would be a retrograde step in terms of financial stability.

The ‘regionalisation’ scenario represents a step-wise progression towards the best-case scenario, which is better allocation of capital and distribution of risk through a multi-polar (global) governance system. The level of coordination required, and the fact that the regions should be of sufficient size to adequately maintain and govern financial stability, means that the most realistic scenario by 2030 is regional regulation of financial institutions.

In order to make progress towards the regional or even multi-polar solution, the AUGUR researchers make the following policy recommendations:

  • Macroprudential policy tools – Develop new instruments to act as early warning indicators of instability, e.g. monitoring the ratio of non-core liabilities to core funding could gauge potential vulnerability.
  • Levy on non-core liabilities – Impose a levy or a tax on the non-core funding that makes banks vulnerable, to limit systemic risk. This would have the effect of an automatic stabiliser while leaving the essential functioning of the financial system unaffected.
  • Liquidity management – Increase the amount of core funding (cash) banks are required to hold, to protect themselves against the risk of unexpected loss. This amount may vary with the level of economic activity in order to support reasonable growth rates.
  • International cooperation – Establish a degree of coordination in line with the degree of financial integration necessary, to avoid international regulatory arbitrage.

What’s next for the project?

In the closing months of the project, the AUGUR team will further explore the links between Europe’s financial future and their projections for Europe in other sectors, including politics, society, trade, transport, the environment and technology. The development of these sectors and particularly of emergent markets, such as green technology and climate change adaptation, are likely to be underpinned by the financial situation in the coming decades, and the extent of regional or international cooperation.

However, the problem is that stability in the financial sector is difficult to predict since, experience tells us, the sector is vulnerable to a wide range of shocks. The question now is whether BASEL III, ratified at the G20 meeting in Seoul (November 2010), can meet the challenge of global stability by incorporating macroprudential innovation, which has previously fallen between the gaps in the regulatory system, and the extent to which this regulatory standard will be implemented by local regulators around the world.

Although the ideal outcome is a multi-polar macroprudential approach, we are also yet to see how far countries are willing to allow international governance of their finance sectors and, therefore, at which level (national, regional, European or international) a solution will emerge.

 

1 International regulatory framework for banks (BASEL III). See: http://www.bis.org/bcbs/basel3.htm and, for an abstract: http://www.bis.org/bcbs/basel3/b3summarytable.pdf

AUGUR – Challenges for Europe in the world of 2030 (duration: 1/10/2009 – 30/9/2012). FP7 Socio-economic Sciences and Humanities, Activity 7 “Foresight activities”, Research area 7.1 “Wide socio-economic foresight on key challenges”. Collaborative project (small and medium scale focused research project).

See: http://www.augurproject.eu/

Contact: Professor Pascal Petit, Pascal.Petit@ens.fr