A decade after the great financial crisis, the euro area
looks set to exit more resilient than it entered it. Much of
the harm caused by the economic downturn has now been reversed
by a consistent period of growth. And some of the institutional
and structural factors that exacerbated the crisis have been
But we know that our Monetary Union is not complete. The
crisis revealed some specific fragilities in the euro area's
construction that so far have not been resolved.
To make our Monetary Union more robust against future
challenges, we need to address these fragilities.
The history of the crisis in the euro
The crisis took place in five main phases.
The first phase was similar across advanced economies. Most
had a financial sector characterised by poor risk management,
low capital and liquidity, inadequate corporate governance, and
weak supervision and regulation – diluted by many
years of excessive optimism in the self-repairing power of
When the Lehman shock hit, banks exposed to toxic US assets
ran into difficulties and some were bailed out by their
In the euro area, these banks were mostly located in
Germany, France and the Netherlands. Bank bailouts took place
on a staggering scale. In 2009, they totalled around 8% of GDP
in Germany, 5% in France and 12% in the
Netherlands.1 These bailouts did not greatly affect
sovereign borrowing costs, however, thanks largely to the
relatively strong fiscal positions of the governments
In the second phase, the crisis spread to banks in Spain and
Ireland that had similar weaknesses, but were instead
overexposed to the collapsing domestic real estate market.
Another wave of bank bailouts followed, and some signs of
tensions in sovereign debt markets began to appear.
Those tensions were compounded by the third phase, which
began when the Greek crisis shattered the impression that
public debt was risk-free, triggering a rapid repricing of
sovereign risk. To those who saw the crisis as a consequence of
moral hazard, this represented a required return of market
discipline vis-à-vis sovereigns – a view that
was reflected in the Deauville agreement in October 2010.
These events spread contagion to all sovereigns now
perceived as vulnerable by financial markets. But they affected
most of all those with high public debt levels, a lack of
fiscal space, fragile market access and, especially, low
growth. Sovereign risk was then transmitted into the domestic
banking sector through two channels.
The first was through banks' direct exposures to their own
Between January 2010 and July 2012, banks in Greece, Italy
and Portugal incurred aggregate losses on sovereign bonds of
vulnerable countries2 amounting respectively to
161%, 22% and 36% of their Core Tier 1 capital.3
Regardless of whether these losses directly affected regulatory
capital4, they had an adverse effect on perceptions
of solvency in those national banking systems.
The second channel was via negative confidence effects.
Because the public sector makes up roughly half the economy
in many euro area countries, and because of credit rating
dynamics, the fear of possible sovereign defaults had a
dramatic effect on confidence in the domestic private sector.
Any distinction between firms and banks, and between banks with
and without high sovereign exposures, disappeared. The general
loss of confidence in these countries' prospects reverberated
through the banking sector via a further fall in
In this way, the crisis spread to banks that did not have
significant exposures either to US sub-prime assets or to
domestic real estate, and therefore had not until then needed
to be bailed out. However, governments in these countries found
themselves unable to substantially respond to the emerging
crisis with public money for the banking sector and
countercyclical fiscal policy, due to lack of fiscal space and
Financial markets then began to fragment along national
lines and cross-border funding dried up, exacerbated by
defensive risk management by banks and ring-fencing of
liquidity by supervisors in the core countries. Lack of
liquidity, coupled with capital depletion from domestic losses,
precipitated a renewed credit crunch.
Countries were trapped in a "bad equilibrium" caused by the
three-way link between sovereigns, banks and domestic firms and
Falling credit aggravated the ongoing recession, increased
loan losses and further weakened bank balance sheets, which in
turn pushed sovereign borrowing costs higher. Fiscal policy,
under the pressure of losing market access altogether, took
mainly the more expedient route of higher taxes, which led
instead to lower growth and therefore renewed market jitters,
somewhat defeating its original purpose.
The fourth stage of the crisis was triggered by investors in
both Europe and the rest of the world. Faced with a downward
growth spiral, many investors reached the conclusion that the
only way out for crisis-hit countries, given the institutional
design of the euro area, was for them to exit from it. This
would, it was believed, allow them to depreciate their
currencies and regain monetary sovereignty.
Fearing redenomination into lower-value currencies,
investors sold off domestic public and private debt, further
widening spreads and exacerbating bad equilibria within
vulnerable economies. In 2012, spreads vis-à-vis German
ten-year government bonds reached 500 basis points in Italy and
600 basis points in Spain, with even wider spreads in Greece,
Portugal and Ireland.
The fifth stage of the crisis then followed: the breakdown
in monetary policy transmission across the euro area. Interest
rates faced by firms and households in vulnerable countries
became increasingly divorced from short-term central bank
rates. As those economies represented a third of euro area GDP,
this posed a profound threat to price stability.
The ECB responded with its announcement of Outright Monetary
Transactions (OMTs), which restored confidence in sovereign
bond markets, helped to repair the monetary policy transmission
mechanism, and broke the downward spiral. With less of a direct
market impact, but fundamental in confirming to the world the
strength of our leaders' commitment to the euro, was the
earlier decision to create the banking union and the European
Stability Mechanism (ESM).
The long trip back to growth had begun.
The unfolding of the euro area crisis yielded lessons for
the financial sector, for individual countries and for the
union as a whole. But the unifying theme was the inability of
each of these actors to effectively absorb shocks. In some
cases, because of their weaknesses, they even amplified those
Indeed, banks fuelled the build-up of imbalances and then
exacerbated the resulting crash. Countries had too low growth
potential, limited flexibility to bounce back from the crisis
and too little fiscal space to stabilise their economies. And
the euro area as a whole was shown to have no public and very
little private risk-sharing.
Risk-sharing within monetary unions
In the classical optimum currency area (OCA) literature,
what makes membership of a monetary union work for all its
members is a trade-off: what they lose in terms of national
stabilisation tools is counterbalanced by new adjustment
mechanisms within the currency area. These mechanisms are
typically held to be labour and capital mobility, as well as
fiscal transfers between different parts of the
In other words, they are ex post and take place after a
recession has set in.
In the United States, which is a relatively well-functioning
monetary union, ex post adjustment plays an important role.
Fiscal transfers through the US federal budget are estimated to
absorb around 10% of shocks7, while about half of
the long-run response to a rise in unemployment takes place
through labour mobility.8 But the outcomes achieved
in the US are not substantially different to those in the euro
Though the euro area does not have a large central budget,
national fiscal policies can still provide significant
stabilisation, so long as countries can use fiscal policy
freely. It is estimated that 49% of an unemployment shock is
absorbed by the automatic stabilisers in the euro area, whereas
the figure for the US is 32%.9
And studies have found a gradual convergence in labour
mobility between Europe and the US, reflecting both a fall in
interstate migration in the US and a rise in the role of
migration in Europe.10
Where the euro area and the US differ more is in terms of ex
ante risk-sharing – that is, insuring against shocks
through financial markets. This was a concept that only
appeared later in the literature on Optimal Currency
Areas.11 But it plays a key role in stabilising
local economies in a monetary union, in two
The first is by de-linking consumption and income at the
local level, which happens through integrated capital
If labour income falls during a recession, but the private
sector holds a diversified financial portfolio, people can
smooth their consumption with the financial returns they
receive on assets in better performing parts of the union.
The second way is by de-linking the capital of local banks
from the volume of local credit supply, which happens through
retail banking integration.
Because local banks are typically heavily exposed to the
local economy, a downturn in their home region will lead to
large losses and prompt them to cut lending to all sectors. But
if there are cross-border banks that operate in all parts of
the union, they can offset any losses made in the recession-hit
region with gains in another, and can continue to provide
credit to sound borrowers.
In the US, both credit and capital market integration have
played an increasingly important role in smoothing local shocks
over the past decades.13
For example, following the oil price collapse in the
mid-1980s, almost every bank in Texas failed, creating a
state-wide credit crunch. One reason for this was that
out-of-state banks were banned from the Texas market, so the
balance sheets of local banks were completely concentrated on
their home state.14
But since then there has been major integration in the
retail banking sector, with the number of multi-state banks
increasing from around 100 in the early 1990s to more than 700
today.15 This has significantly weakened the
relationship between local capital and local credit
supply.16 And as a result, the volatility of
business cycle shocks among US states has become
Overall, it is estimated that around 70% of local shocks are
smoothed through financial markets in the US, with capital
markets absorbing around 45% and credit markets 25%. In the
euro area, by contrast, the total figure is just
Private risk-sharing of course has its limits. Faced with
large common shocks that affect the whole monetary union, the
benefits of diversification can break down, as happened to some
extent in the US during the crisis. One study finds that
capital market risk-sharing in the US dropped by almost half in
the crisis period.19
But this does not alter the conclusion that deepening
private risk-sharing in the euro area would be beneficial for
macroeconomic stability. So how can we achieve it?
The experience of other monetary unions, and our own up to
now, suggests that it does not happen by itself. Rather,
private risk-sharing has to be enabled by public sector
policies at both the national and union levels.
In this sense, private risk-sharing cannot be seen as a
substitute for the further development of EMU. It is a
complement to it and follows from it.
The policies we need fall into two main categories.
Creating a more stable financial
First of all, we need policies that make the financial
system more stable, both by increasing the resilience of banks
and by completing the banking union and the capital markets
The euro area has already made good progress on these
fronts. The post-crisis regulatory reforms have significantly
strengthened the banking sector. The Common Equity Tier 1
ratios of significant banks have risen from 8.7% in 2008 to
14.5% today. In the same period leverage ratios have risen from
3.7% to 5.8%.20 And banks have much more stable
liquidity and funding.
The creation of European banking supervision has also
brought about a more uniform approach to how banks are
supervised. And the new EU resolution framework has shifted the
cost of bank failures away from sovereigns and onto the
financial sector, which creates another channel of private
Without entering into the discussion on which further
regulations may be necessary for the shadow banking sector, we
have to acknowledge that the banking union and the capital
markets union are not yet complete.
We lack a truly level playing field for cross-border banks
and investors, and this stands in the way of deep financial
integration. A single financial market should have one set of
rules and all market participants should be able to operate
freely within it. Yet that is not the case at present.
For capital markets, there are differing rules and market
practices for financial products across countries, and
insolvency and judicial systems vary widely.
This matters because a consistent and efficient framework
for pursuing failed contracts is vital to reduce uncertainty
for cross-border investors. ECB analysis finds that where
insolvency and judicial frameworks are more efficient,
risk-sharing through both capital and credit markets is
For banks, the Single Market is still fragmented along
national lines. First, discrepancies in the regulatory
framework reduce the economies of scale for banks operating
Second, an incomplete framework for bank resolution also
deters cross-border integration. When resolution is not fully
credible, it can create incentives for national authorities to
limit capital and liquidity flows so as to advantage their
depositors in the event of a bank failing. But when the new EU
resolution framework is completed and working properly, such
concerns about depositors should be allayed.
The Bank Recovery and Resolution Directive already places
depositors at the top of the creditor hierarchy in resolution.
And the new minimum requirements for own funds and eligible
liabilities should ensure that there is a sufficient buffer of
loss-absorbing capacity to make depositor bail-in extremely
What is still missing, however, is a backstop for the Single
Resolution needs financing24, and the Resolution
Fund, which is funded by banks, will ensure that it is paid for
by the private sector. But in a very deep crisis, the resources
of such funds can be depleted. That is why in all the other
large jurisdictions, such as the US, the UK and Japan,
resolution funds are backstopped by the fiscal authority.
The aim of such backstops is not to bail banks out: any
funds borrowed are repaid by the private sector over time.
Rather, the aim is to create confidence that bank resolution
can always be enacted efficiently, which has a stabilising
effect in a crisis and prevents more banks from being dragged
In other words, policies that reduce risks for the banking
system as a whole will also lead to larger risk-reduction for
A good example of this is the Federal Deposit Insurance
Corporation (FDIC) in the US, which is also the resolution
authority, and is backstopped by a credit line with the US
Treasury. During the crisis, around 500 banks were resolved in
the US without triggering financial instability. In contrast,
one estimate puts the total number of banks resolved in the
euro area in that period at around 50.25
An orderly resolution of this magnitude was possible in the
US because of confidence in a well-functioning resolution
framework. And the presence of the Treasury backstop was
fundamental in creating this confidence.
Indeed, the FDIC ultimately did not have to draw on its
credit line, but it was clearly reassuring to markets and to
depositors that it had that option as a last resort. In fact,
the FDIC has only borrowed from the Treasury once, during the
savings and loans crisis in the early 1990s, and it repaid in
full a few years later.26
This example underlines that the dichotomy between
risk-reduction and risk-sharing that characterises the debate
today is, in many ways, artificial. With the right policy
framework, these two goals are mutually reinforcing.
Public risk-sharing through backstops helps reduce risks
across the system by containing market panics when a crisis
hits. And a strong resolution framework ensures that, when bank
failures do happen, very little public risk-sharing is actually
needed as the costs are fully borne by the private
So we need to put first things first and complete the
resolution framework in all its dimensions. And creating a
properly designed European deposit insurance scheme would be an
additional element that could further reduce the risk of bank
All in all, a consistent framework of regulations, laws,
judicial enforcement and resolution is essential for deep and
resilient financial integration. Completing the banking union
and the capital markets union is therefore a necessary
condition for the expansion of private risk-sharing in the euro
Yet it is not a sufficient condition. And this brings me to
the second area where public sector policies can complement
private risk-sharing: by increasing economic convergence and
thereby building trust among cross-border investors.
Increasing economic convergence
The crisis showed clearly the potential of some euro area
economies to become trapped in bad equilibria. And plainly, as
long as this risk exists, it will act as a deterrent to
cross-border integration, especially for retail banks that
cannot "cut and run" as soon as a recession hits.28
Put simply, we will not be able to foster private risk-sharing
in our union if crises can call its very integrity into
So, if we are to deepen private risk-sharing, the tail risk
of bad equilibria needs to be removed, and replaced by policies
that lead to sustainable convergence. This requires action at
both the national and euro area levels.
In the eyes of many observers, three features made countries
vulnerable to downward spirals: weak banks, lack of fiscal
space and low growth. Stabilising the financial sector in the
ways I have just described would address one part of the
problem. But the common factor uniting all three was growth.
Very low growth rates reduced fiscal space and harmed bank
At the national level, structural reforms therefore remain a
We know that structural reforms boost growth: looking at the
last 15 to 20 years, euro area countries with sound economic
structures at the outset have shown much higher long-term real
growth. And we know that they help countries recover more
quickly from shocks, which prevents recessions from leaving
That said, while sound domestic policies are key to protect
countries from market pressure, the crisis showed that, in
certain conditions, they may not be enough. Markets tend to be
procyclical and can penalise sovereigns that are perceived to
be vulnerable, over and above what may be needed to restore a
sustainable fiscal path. And this overshooting can harm growth
and ultimately worsen fiscal sustainability.
This creates a need for some form of common stabilisation
function to prevent countries from diverging too much during
crises, as has already been acknowledged with the creation of
two European facilities to tackle bad equilibria.
One is the ECB's OMTs, which can be used when there is a
threat to euro area price stability and comes with an ESM
programme. The other is the ESM itself. But the conditionality
attached to its programmes in general also implies procyclical
So, we need an additional fiscal instrument to maintain
convergence during large shocks, without having to over-burden
monetary policy. Its aim would be to provide an extra layer of
stabilisation, thereby reinforcing confidence in national
It is not conceptually simple to design such an instrument
as it should not, among many other complexities, compensate for
weaknesses that can and should be addressed by policies and
reforms. It is not legally simple because such an instrument
should be consistent with the Treaty.
And, as we have seen from our longstanding discussions, it
is certainly not politically simple, regardless of the shape
that such an instrument could take: from the provision of
supranational public goods – like security, defence or
migration – to a fully-fledged fiscal capacity.
But the argument whereby risk-sharing may help to greatly
reduce risk, or whereby solidarity, in some specific
circumstances, contributes to efficient risk-reduction, is
compelling in this case as well, and our work on the design and
proper timeframe for such an instrument should continue.
This year the ECB is celebrating its 20th birthday, and next
year we will be able to mark twenty years of the euro. In those
two decades the euro has become a feature of our lives and a
symbol of our European identity.
Three-quarters of euro area citizens now support the single
currency.30 And when people are asked to name the
most important elements of European identity, the euro is the
second element cited, after the values of democracy and
The people of Europe have come to know the euro and trust
the euro. But they also expect the euro to deliver the
stability and prosperity it promised.
So our duty, as policymakers, is to return their trust and
to address the areas of our union that we all know are
This article has been adapted from a speech given by
Mario Draghi at the European University Institute, Florence,
May 11 2018. The full and original speech can be freely
accessed at www.ecb.europa.eu.
1. Figures include recapitalisation measures, guarantees,
asset relief interventions, and liquidity measures other than
guarantees. See Financial Crisis Aid amounts for a more
2. This calculation assumes all exposures had been subject
to fair valuation, and applies to bonds of Cyprus, Greece,
Ireland, Italy, Portugal, Slovenia and Spain.
3. Based on end-2010 Core Tier 1 capital.
4. A significant share of government bonds were held by
banks at amortised cost.
5. In fact, internal ECB analysis finds that the
relationship between sovereign and corporate CDSs in this
period was as strong as that between sovereign and bank CDSs.
And banks that had larger sovereign exposures had a similar
correlation with sovereign CDSs as banks with smaller
6. See Mundell, R. (1961), "A Theory of Optimum Currency
Areas", American Economic Review, 51 (4), pp. 657-665;
McKinnon, R. (1963), "Optimum Currency Areas," American
Economic Review, 53, pp. 717-724; Kenen, P. (1969), "The Theory
of Optimum Currency Areas: An Eclectic View," in Mundell, R.A.
and Swoboda, A.K. (eds), Monetary Problems of the International
Economy, Chicago University Press.
7. European Commission estimates. See Nikolov, P. (2016),
"Cross-border risk sharing after asymmetric shocks: evidence
from the euro area and the United States", Quarterly Report on
the Euro Area, Vol. 15, No 2.
8. Beyer, R. and Smets, F. (2015), "Labour market
adjustments and migration in Europe and the United States: how
different?", Economic Policy, Vol. 30, Issue 84.
9. Dolls, M., Fuest, C., Kock, J., Peichl, A.,
Wehrhöfer, N. and Wittneben, C. (2015), "Automatic
Stabilizers in the Eurozone: Analysis of their Effectiveness at
the Member State and Euro Area Level and in International
Comparison", Centre for European Economic Research,
10. Beyer, R. and Smets, F. (2015), op. cit.
11. For a review of the development of this literature see
Mongelli, F. (2002), "New views on optimum currency area
theory: what is EMU telling us?", ECB Working Paper No.
12. For a fuller explanation of financial risk-sharing
within monetary unions, see ECB (2016), "Special Feature A:
Financial integration and risk sharing in a monetary union",
Financial Integration in Europe, May.
13. Asdrubali et al. find that financial risk-sharing in the
United States increased monotonically each decade from the
1960s to the 1990s. See Asdrubali, P., Sorensen, B. and Yosha,
O., "Channels of Interstate Risk Sharing: United States
1963–1990", The Quarterly Journal of Economics, Vol.
111, Issue 4, 1 November 1996.
14. See Hane, G. (1998), "The Banking Crises of the 1980s
and Early 1990s: Summary and Implications", in FDIC Banking
Review, Vol. 11, No 1.
15. ECB calculations based on FDIC data. The term
"institution" refers to a separately chartered commercial bank
or savings institution.
16. See Krozner, R. and Strahan, P. (2014), "Regulation and
Deregulation of the U.S. Banking Industry: Causes,
Consequences, and Implications for the Future", in Economic
Regulation and Its Reform: What Have We Learned?, National
Bureau of Economic Research.
17. See Morgan, P., Rime, B. and Strahan, P. (2004), "Bank
Integration and State Business Cycles", The Quarterly Journal
of Economics, Vol. 119, Issue 4,
18. European Commission estimates. See Nikolov, P. (2016),
19. See Milano, V. and Reichlin, P. (2017), "Risk-sharing
across the US and EMU: the Role of Public Institutions", Policy
Brief, LUISS School of Political Economy.
20. Tier 1 capital to total assets.
21. ECB (2018), "Box A: What could enhance private financial
risk sharing in the euro area?", Financial Integration in
22. For a more detailed explanation, see ECB (2017),
"Special feature: Cross-border bank consolidation in the euro
area", in Financial Integration in Europe.
23. See Carmassi, J. et al. (2018), "Completing the Banking
Union with a European Deposit Insurance Scheme: who is afraid
of cross-subsidisation?", Occasional Paper Series, No 208,
24. This includes guaranteeing the assets or the liabilities
of the institution under resolution; making loans to or
purchasing assets from the institution under resolution; and
making contributions to a bridge institution and an asset
management vehicle. See
25. Sapir, A. and Wolff, G. (2013), "The neglected side of
banking union: reshaping Europe's financial system", note
presented at the informal ECOFIN on 14 September 2013,
26. Ellis, D. (2013), "Deposit Insurance Funding: Assuring
Confidence", FDIC Staff Paper.
27. For a review of the interactions between public and
private risk-sharing, see Ioannou, D. and Schäfer, D.
(2017), "Risk sharing in EMU: key insights from a literature
review", SUERF Policy Note, Issue No 21.
28. For example, cross-border banking mergers and
acquisitions in the euro area have been on a declining trend
29. See Draghi, M. (2017), "Structural reforms in the euro
area", introductory remarks at the ECB conference "Structural
reforms in the euro area", 18 October 2017.
30. Eurobarometer 88.
31. Parlemeter 2016, Special Eurobarometer of the European
Parliament, November 2016.