The euro area needs to embark on a path that brings action and liability back into greater alignment, Bundesbank President Jens Weidmann told 200 guests at the German Embassy in Rome. "The high level of debt held by both banks and states is a result of a shared problem: the drifting apart of action and liability," he remarked.

On the right track

Mr Weidmann explained that much had been done to make banks liable for their investment and lending decisions, pointing to the launch a year and a half ago of the Single Supervisory Mechanism, a body tasked with ensuring that banks are monitored with the same rigour in all member states of the euro area. Banks should above all, he told the audience, hold in reserve more and higher-quality capital in order to be better able to absorb losses, adding that if their capital was still insufficient to cover losses, their creditors would then be called upon. "The use of tax money is only considered as an absolute last resort," he noted. The higher capital requirements and the bail-in rules ensured that banks' shareholders and creditors bear potential losses. Mr Weidmann explained that it was not just a matter of aligning action and liability at the level of the banks – that principle needed, once again, to also apply to a greater extent in policy decisions in the euro area. The Bundesbank President then illustrated two conceivable paths to a viable fiscal framework. Either states transferred both decision-making power and liability for budgetary issues to the European level, for example in the form of a European fiscal union, or, he went on, "the states continue to make their own budgetary decisions but are then held liable for the consequences".

Biggest step in the integration process

Mr Weidmann told his audience that a real fiscal union "could indeed restore the balance between action and liability", for it would force member states to comply with the requirements set by a European fiscal authority. Fiscal union, he reasoned, would be the biggest step in the integration process since the introduction of the euro, and it could not be achieved without making comprehensive changes to the European Treaties and holding referendums in the member states. The same applied to the idea of a single euro-area ministry of finance with its own budget and to a system granting rule-based powers to intervene in existing national budgets. These, Mr Weidmann conceded, were major obstacles: "At the moment, I cannot see any willingness to overcome them – in Italy, Germany or elsewhere."

Independent fiscal authority needed

Continuing his line of reasoning, Mr Weidmann stated, "If we wish member states to retain their national sovereignty in fiscal policy matters, the only remaining option is to anchor action and liability at the member state level, as provided for in the existing Maastricht framework". The Maastricht framework used two mechanisms to force national economic and fiscal policymakers to pursue a stability-oriented policy path – fiscal rules and financial market discipline, though Weidmann conceded that neither had proven to be particularly effective. In fact, he went on, since monetary union was launched, some countries had breached the rules of the Stability and Growth Pact more often than they had complied with them. The fiscal rules may now have been amended in response to the crisis, but the European Commission was now able to exercise greater discretion in monitoring them. The upshot was that "the Commission has repeatedly shown that it is prepared to accept compromises at the expense of fiscal discipline," Mr Weidmann criticised. One solution, he said, could be the creation of an independent European fiscal authority which takes on the Commission's current tasks in the field of budgetary surveillance.

No such thing as risk-free government bonds

At this point in his speech, the Bundesbank President reiterated his call for the nexus between sovereigns and banks to be severed. A functioning decentralised approach would also mean addressing the glaring inconsistencies in the existing framework, "which undermine the principle of individual responsibility and therefore weaken the incentives to pursue a sound fiscal policy". Although the EU Treaty prohibited bail-outs and the monetary financing of governments, the capital regimes for banks nonetheless treated government bonds as risk-free. "During the crisis, if not beforehand, this assumption turned out to be a fallacy."

It was therefore crucial for banks to hold sufficient capital against sovereign bonds in their balance sheets and to also limit their exposure to individual sovereigns, Mr Weidmann stressed, adding, "If we can introduce regulation that ensures that sovereign bonds cease to be a cluster risk, we will be able to sever this bank-sovereign nexus, which in fact served to fan the flames of the crisis". He added that this would also allow sovereign debt to be restructured without bringing down the financial system.

That, he stressed, was also a key prerequisite for the possible introduction of a joint European deposit guarantee scheme. The large, systemically important euro-area banks were now being supervised uniformly by the ECB, he continued, but member states still held considerable sway over the quality of bank balance sheets, not only by virtue of national legislative powers such as national insolvency laws, but also on account of the substantial sovereign exposures in banks' balance sheets. "Therefore, as long as banks have large volumes of debt issued by their own governments in their balance sheets, a joint deposit protection scheme also means communitisation of fiscal risk," the Bundesbank President warned. "That said, mutualising liability among the euro-area countries without a corresponding joint control function would be the wrong path, since it would tend to strengthen rather than weaken the existing incentive to run up debt in a currency union," Mr Weidmann concluded.