International financial institutions are striving to implement rules that contribute to stability, reduce risk and maintain fair competition, but the need to solve Europe’s ongoing, severe financial challenges is repeatedly coming into conflict with these goals. The International Monetary Fund’s move yesterday to end so-called “system exemptions”, as well as the European Union’s ongoing negotiations with Italy on proposals to address the problem of non-performing loans, highlight the dilemma international institutions face as they attempt to stem Europe’s economic crisis. Europe’s increasing fragmentation and continued economic challenges mean that international institutions, and the EU in particular, are unable to implement comprehensive policies for avoiding systemic crises, as they instead resort to ad-hoc, short-term measures in an attempt to avoid spillover of economic problems.
The IMF’s suspension of its “systemic exemption” rule, which was introduced in 2010, highlights this dilemma. This rule allowed the Fund to provide financing in cases where a member’s debt problems had a high potential to spill over into the international system, even if there were no plans for debt restructuring and the country’s debts were not expected to become sustainable. The IMF provided this exemption due to fear that crises in Greece, Ireland and Portugal would destabilize the eurozone. While yesterday’s decision was in large part the result of pressure from the U.S. Congress, the IMF has over the past few years sought to transition to a more flexible approach, proposing a middle ground that would allow an extension of maturities, without any reduction of principal or interest, in some cases. The Fund is thus working to create more flexibility and a balance between the need to prevent contagion and the desire to ensure that countries receiving large-scale funding from the IMF ultimately have sustainable debt loads.
The European Union is struggling to maintain a similar balance when it comes to bailout rules. On the one hand, the EU aims to promote fair competition within the bloc, and thus has rules barring state aid to banks. The EU has required its members to adopt measures instituting bail-in rules, with bondholders and shareholders of banks required to take losses before any public money can be used to assist struggling banks. On the other hand, like the IMF, the EU also prioritizes preventing contagion. Right now, Italy is engaged in difficult negotiations with the EU as it seeks ways to create a bad bank, which segregates troubled or risky assets from the rest of a bank’s assets, in order to alleviate the problem of non-performing loans without infringing upon the bloc’s state aid rules. EU institutions do not want to create a precedent for relaxing bail-in rules, but they are aware that a full-scale banking crisis in Italy could have a significant negative impact throughout the bloc, jeopardizing the stability of the entire system.
Over the past few years, both international and European financial institutions have outwardly prioritized adhering to their own rules, but in practice, as crises escalated, they began adopting ad-hoc decisions and bending these rules to maintain a semblance of stability. While some countries such as Germany have pushed for reforms and austerity measures in southern Europe, they have ultimately proven flexible when it comes to heavily indebted countries such as Greece, which is now in its third bailout. For Berlin, the survival of the eurozone is key for continued economic growth and the ability to maintain high export levels to European markets.
Nevertheless, what constitutes systemic risk is subjective. An individual government may view a particular crisis as a systemic threat, while decision-makers in Brussels do not. Financial institutions also sometimes differ in their interpretations of risk. Moreover, European institutions in particular are oftentimes slow to respond to crises, adding to the challenges of resolving problems that have the potential to threaten the stability of the financial system. As can be seen from Europe’s repeated bailouts of Greece, the bloc has failed to implement comprehensive and cohesive solutions to the crisis. In addition, continued delays regarding proposals for safeguarding the stability of Italy’s banking system indicate that the EU is unable to respond effectively to warning signs of instability in one of its key economies.
International institutions, as well as some large economies like Germany, are grappling with competing imperatives, as they seek to both create sustainable, predictable rules and prevent crises from spilling over. Both governments and international institutions tend to ultimately opt for measures designed to prevent contagion, even if it means making ad-hoc, unsustainable choices at a time when crisis is already underway. These moves come with great costs for the financial system as well, and may ultimately be too little, too late.