Vox
October 27, 2011
The dissent brewing throughout Europe hinges on the question of whether the financial burdens of the Eurozone crisis should be shared between weak and strong. This column presents a new paper arguing that the wealthier, more stable economies don’t have much choice.
During the financial crisis, failure or distress of cross-border firms has been met by ad hoc coordinated solutions (eg Fortis and Dexia) or national solutions (eg UK and US banks). However, economic theory (such as Freixas 2003) shows that ‘improvised coordination’ is inefficient as it leads to a general under-provision of the public good (ie financial stability). The European Financial Stability Facility (EFSF) for the Eurozone (EZ) constitutes the first example instead of an ex ante burden-sharing agreement.
But little research has been done on sharing mechanisms, and the possible effects on financial stability. An exception is Goodhart and Schoenmaker (2009), who estimate each country’s contributions for a general fund mechanism and specific burden-sharing mechanism. The authors prefer a specific burden-sharing mechanism, as it is “closer to an efficient solution of the coordination problem”. However, existing research fails to answer two important questions that are particularly important to policymakers:
- What mechanism should we choose according to a determined criterion? And
- Are these mechanisms bringing financial-stability benefits?
In a recent paper (van Lelyveld and Spaltro 2011) we attempt to answer these two questions by constructing a detailed dataset of major international cross-border banks, which allows us to estimate the expected losses for banking defaults in every sovereign. Moreover, we try to give a preliminary understanding of the financial-stability benefits of burden-sharing mechanism by using a Monte Carlo simulation.
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