European Central Bank must increase co-operation to solve long term challenges


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Current optimism may be misplaced

European Central Bank President Christine Lagarde was confident in her latest press conference as she explained that the euro area economy is improving, inflation is under control and the central bank continues its policy with a ‘steady hand’. This assessment, she added, was shared by all 25 members of the bank’s governing council. Reaching consensus on this was not a given and is an unquestionable success for her. But beyond the short term, the ECB’s horizon is full of challenges.

The first one concerns fiscal policy. The European Commission has announced that European Union budget rules will remain suspended next year. Bundestag president, Wolfgang Schäuble, argued that they should be reinstated in a Financial Times article, where he also explicitly called into question Italy’s prime minister, Mario Draghi.

Behind his warning is the fear, not entirely unjustified, that the present wave of optimism may be due to an illusion that the suspension of rules and the Next Generation EU package, which includes grants as well as debt mutualisation, have removed all budgetary constraints on member states. Not so. If anything, the constraints have been strengthened because public debts have risen. The return to new and better rules are in the interest of all, including the most indebted countries which pay the highest price when markets lose confidence. Negotiations on new rules will take place next year. Whatever the outcome, there will be a transition phase in which there will be no framework to guide market expectations. Centrifugal forces in the euro area could restart.

The second challenge regards the banks. Debt moratoria and credit guarantees have laid a protective blanket on them which conceals their real condition. The banks will be exposed to a wave of post-crisis insolvencies and risks involved in the sectoral reallocation that the NGEU programmes for a greener and more sustainable economy call for. The burden on bank balance sheets will be greater in countries that face more demanding reforms, due to their structural backwardness, and which still have unresolved banking problems. Another potential point of tension within the euro area is a rerun of the infamous doom loop between banks and public finances.

The third looming challenge for the ECB is its strategy review. There are three critical points in this review: the definition of the inflation target; the relationship (and possible co-operation) between monetary and fiscal policy; and the ‘secondary objectives’ of the central bank.

The first point is the most obvious and the least difficult, while the second is the most complex and important. The third, how to bring on board climate change considerations, will be easier to approach if the first two are successfully addressed.

The current inflation target, lower than but close to 2%, reflects the ECB’s primeval anti-inflationary stance, but after the global trend became deflationary, the asymmetric flavour of the wording generates confusion and increases the risk of policy errors. The problem can be resolved by raising the target to 2%. A change of this nature is expected by markets and would be well received. It would express both the desire to counter deflation (alongside inflation) and the sizeable uncertainty in forecasting and controlling price movements.

The real issue is the second one. Once the ECB’s heavy purchases are phased out, new tensions in the euro area are far from resolved. The central bank can counteract these tensions, but to do so credibly and effectively, it needs support from governments. The issue is political but affects the central bank’s strategy as well. Mario Draghi’s famous statement of 26 July 2012 effectively made ‘preserving the euro’ an ECB goal, a subtle and underappreciated change future presidents are unlikely to retreat from. However, this is a goal the ECB cannot deliver alone.

The 2012 statement was an emergency response, applied in special conditions and will be difficult to repeat. The mechanism that averted that potential crisis should be made available for different situations. The conditions triggering central bank interventions must be made more flexible without removing conditionality. Budgetary rules are an essential part of the design, but the central bank should also take a step forward, recognising that its instruments are not always sufficient and that coordinating with governments does not weaken its independence if done voluntarily and in line with its objectives.

The new strategy offers the ECB an opportunity to overcome old preconceptions and signal openness to monetary-fiscal co-operation. This – and only this – can at last, and definitively, keep the risk of a new euro crisis at bay.

AFME/OMFIF European Financial Integration Virtual Conference

I will be speaking at @AFME (Association for Financial Markets in Europe) and @OMFIF’s European Financial Integration Virtual Conference on the 15 June 2021. 

You can register at:



BaFin reforms must go further


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Fallout from the Wirecard scandal is an opportunity to redraw Europe’s financial landscape

In the aftermath of the Wirecard scandal, Germany has an opportunity to reform BaFin, its financial supervisory authority, and help boost regulation and governance across the European Union. The Bundestag is considering a bill that would reform corporate auditing processes, eliminate the role of the financial reporting enforcement panel and strengthen the supervisor’s investigatory powers. BaFin will also get new senior management after its chief, Felix Hufeld, and his deputy, Elisabeth Roegele, resigned at the end of January.

Is there room for hope? Could one of Germany’s biggest financial scandals act as a turning point, forcing a move toward better financial governance? If so, the timing is apt, as Brexit is putting more responsibility on the shoulders of continental financial regulators.

The potential for a capital markets union also strengthens the need for reform in Germany. A European market supervisor – be it an expanded European Securities and Markets Authority or a new institution entirely – needs a strong and reputable German agency as part of its membership. Reforming BaFin is an important prerequisite to the broader European project.

The reform bill now on the table in Germany, with its narrow focus on accounting, auditing and the powers of an otherwise unchanged BaFin, falls significantly short of what is needed. The opportunity to learn from all the lessons of the Wirecard affair may be missed.

In spite of its complexities and the time it took to uncover, the crux of the scandal and its implications for supervision are disarmingly simple. For years, market rumours and articles in the Financial Times advanced the suspicion that Wirecard, a payment fintech and once one of Germany’s most important listed companies, was manipulating its accounts.

No supervisor should act on rumours. But they may prompt action on two fronts. First, to protect market integrity from unproven and potentially disruptive hearsay. Second, to clarify whether those rumours had any substance. If its investigatory powers are insufficient, a competent supervisor should alert other relevant authorities.

From what has emerged so far, BaFin moved only on the first front. It even went so far as to undermine the second by taking legal action against the Financial Times, potentially stopping other investigations. It is hard to explain why without allowing for bias, perhaps rooted in the culture of the organisation.

As the scale of the problem was becoming apparent, another disturbing development occurred. A number of German banks, large and small, came to the rescue of the accused. Wirecard was given sizeable unsecured lines of credit and the banks offered favourable stock market advice, which attributed the rumours to false information spread by speculators. The reputation of the banking establishment and stability of those banks, some already facing other problems that had weakened them, were put at risk.

The problem is that BaFin supervises both the stability of the banks and the integrity of the financial market. This is rare. In the euro area, only in a few, small countries are those responsibilities combined (as one can see by comparing the membership of the European Central Bank’s supervisory board and that of ESMA’s board of supervisors). In Germany, banks have sizeable stakes in the corporate sector. No sufficient firewalls exist to alleviate risks caused by the potentially diverging goals this creates, such as banks undermining their own financial stability to prop up zombie firms they are exposed to. Consequently, the amalgamated responsibilities of the supervisor give rise to a conflict of interest between maintaining market integrity and bank stability.

BaFin’s defence had been that Wirecard was a fintech, a business it has no supervisory responsibility for, and that its banking subsidiary, Wirecard Bank, was prudentially sound and too small to justify supervision of the entire group as a financial conglomerate.

But this is beside the point for two reasons. First, BaFin is also a market supervisor, with responsibility over listed companies. Second, the broader ramifications of the affair on the stability of the entire German and, indeed, European financial establishment were greatly underappreciated.

Such responsibility in Germany cannot belong to any authority other than BaFin, given the breadth of its mandate. That responsibility also means that BaFin cannot interpret its mandate narrowly or disregard what happens just beyond the perimeter of its authority. Admittedly, supervisory fragmentation and boundary problems among supervisors are not unique to Germany. They are typical of regulatory architectures worldwide. A legalistic, risk-averse mindset exacerbates the problem, making authorities reluctant to intervene unless their obligation to do so is absolutely certain. In Germany and elsewhere, supervisory mandates can and should endeavour to correct such inaction bias.

The combination of these three pitfalls provides clues to how the lessons of Wirecard need to be read and what reforms are necessary. The cultural problem can be addressed by a combination of clarity in the supervisor’s mandate, formal statutory independence and hiring people with an appropriate professional background, with a special emphasis on transparency and integrity at all levels. The chance to appoint a new chair is an obvious opportunity to start doing this.

The risk of conflict of interest between banking stability and market integrity can only be corrected by clearly demarcating the two responsibilities; preferably, by investing them in separate authorities.

After the 2008 financial crisis, central banks began playing a much more important regulatory role, with monetary policy authorities assuming full or partial supervisory powers. The ECB does not just manage the money supply. It is a banking supervisor as well. Concerns that there would be conflicts between these roles have, so far, not been born out.

The risks of increasing the Bundesbank’s role are smaller than those of maintaining a blurred distinction between the banking and market supervisor. Be that as it may, the mandates, accountability provisions and co-operation among authorities need to be redesigned to ensure that never again does the supervisor fail to see the bigger picture.

The case for a European banking charter


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In 2012, the European Union launched the banking union to prevent devastating upheavals like the euro area sovereign debt crisis. In the background, however, lied a wider aim: helping euro area banks compete on a global scale. This required two steps. First, removing regulatory barriers which made cross-border activities unsafe and unprofitable. Second, setting up a single supervisory and crisis management framework in the currency bloc. The second condition was fulfilled. The first was not.

Eight years on, despite the progress on fixing balance sheets, it has unsurprisingly failed to meet its broader objective. Euro area banks are as national as they were, if not more. Troubled lenders have sought survival by shedding foreign operations. No relevant cross-border combinations have taken place. Banks with global ambitions are turning inwards, to the relief of domestic politicians. Meanwhile, European banks have lost market shares in key areas like investment banking and advisory. All have scaled down or closed their US operations. Their market valuation has fallen relative to competitors, reflecting the fact that the sector remains fragmented and unprofitable.

Yet opportunities abound for cross-border combinations among euro area banks. Large gaps in price-to-book values could boost the value of acquisitions. Mergers would lead to considerable synergies, for example between banks with large distribution networks and those with an edge in creating innovative financial instruments. There are still benefits to diversifying in the uneven euro area economy. In addition, digital transformation requires significant investments that only large banks can afford.

Once again, the obstacles are regulatory. Banks acquiring foreign subsidiaries or creating new ones face heavy macroprudential requirements. Cross-border participations in the banking union are still treated as foreign, even though they are under the same supervisory and legislative umbrella. The law forbids intra-group cross-border capital movements. National ring-fencing hampers efficient liquidity management. Credit ratings contribute to the hurdle, penalising subsidiaries if the parent company is located in a country with a lower sovereign rating.

I have suggested ways to revive the banking union. The European Commission may re-open the dossier once Covid-related concerns become less pressing. Even so, cross-border barriers are unlikely to disappear any time soon. In the absence of a mutualised deposit insurance scheme, countries will retain strong control over their banking sectors. A dispute on the treatment of sovereign exposures is blocking agreement on such a mechanism. But there is no need for sweeping regulatory changes involving banking union as a whole. Not all banks aspire to become continental or global players. For the handful that do, a bespoke regime may be the easiest solution.

A possible scheme would use a European regulation to create a legislative niche for banks that reach, or plan to attain as a result of a merger, critical thresholds in terms of size and cross-border diversification. Banks applying successfully for pan-euro status would have privileges as well as obligations. They would need to meet all capital requirements (micro as well as macroprudential) set by the European Central Bank, at group level, on a fully-loaded basis. The group would follow, within the banking union, a single-point-of-entry structure, with losses up-streamed to the head company. The latter’s liability structure would meet all loss-absorbing requirements set by the Single Resolution Board, in line with global standards. Loss-absorbing rights and obligations across borders would be set by directly applicable European law.

Dedicated deposit guarantee and resolution schemes would need to be carved out, administered by the SRB and backstopped by the European budget. As a result, credit ratings would become country-blind. Unlike other banks, pan-euro groups would be eligible to macroprudential requirements calculated by considering the banking union as a single jurisdiction. They would benefit from mobility of capital and liquidity within the group, subject to vetting by the supervisor. Preferably, their assets would be subject to a harmonised area-wide insolvency regime.

National laws could, at least initially, govern taxation and labour relations. Their impact on banks’ profitability and cross-border functionality would need to be assessed over time, but it is reasonable to think that, once business can be allocated flexibly within the group, the relevance of these country-specific aspects would diminish.

This scheme would complete the banking union, not undermine it. European directives and regulations would still provide the umbrella for further bank harmonisation. ECB supervision would continue to contribute to a sound banking sector, based on common and transparent supervisory practices. In such an environment, mid-size banks wanting to grow further could more easily go for the final step, applying for membership in the pan-euro ‘club’.

Repairing flaws exposed by Wirecard déjà vu


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Supervisors must move beyond legal minimum of their mandates

For all its peculiarities, the Wirecard scandal conveys a sense of déjà vu. The story of abuse at the now-bankrupt Munich fintech company reveals deep flaws in the way financial supervision is designed, organised and conducted. The answer must be to devise a new system in which the different supervisory entities communicate and act with greater speed and effectiveness.

There are some familiar patterns. Financial misconduct is found; it can be lending malpractice, money laundering, conflicted behaviour, or, in this case, fraudulent bookkeeping. It is discovered after months, even years, in which abuse was known about in relevant circles or at least widely suspected. The discovery is not made by the authority in charge but by an outsider: another authority, the judiciary, or the press. Under pressure to provide explanations, the authority supposedly in control pleads innocence: it had no jurisdiction, or no instruments to intervene, or insufficient evidence or powers. It claims to have done all that could be done. Regardless of whether such defence is justified, the loss – for investors, for market integrity, for institutional and national reputations – can be enormous.

In theory, supervisors are supposed to check compliance with existing rules and detect possible deviations. Supervisory practice, however, is very different. No set of laws describes all real-life situations; legal provisions must be interpreted and put in context. Rules can be circumvented, so formal legitimacy can conceal substantial abuse. When supervisors enter such uncharted waters, their guide must be the spirit, not the letter, of the law. Most real-world banking and market supervisors, have a legalistic, risk-averse mindset. They hesitate to intervene when their legitimacy is not fully certain.

In legal financial frameworks, there always is a grey area between what is unambiguously, provably forbidden, and what is unquestionably allowed. That area evolves with business practices; it grows in times of financial innovation. Laws do not keep up with new types of business and intermediaries. The scope for circumvention, free-riding and fraud increases. Supervisors are more easily caught off guard; risks for investors and the society at large increase.

Supervisory charters should be extended to deal with this problem. With many specialised authorities involved (accounting auditors, money laundering supervisors, and so on), there should be one in charge of connecting the dots and doing the synthesis. It does not need to possess all powers, but it must have the responsibility to raise the flag if needed.

In banking, this role naturally belongs to the prudential supervisor; in securities markets, to the authority responsible for efficient and fair market functioning, including investor protection and information. Such an ‘encompassing supervisor’ must possess a broad culture and understanding of financial markets. It must have the authority to obtain collaboration from specialised supervisors and to ask for supplementary investigation it cannot conduct directly, including from the judiciary. Its accountability should include an obligation to sound alarm bells when intervention beyond its powers is needed.

No existing supervisory framework today conforms to these standards, but some contain useful elements. For example, the EU’s regulation establishing the single supervisory mechanism grants the European Central Bank ample investigatory powers, including the right to obtain information through off-site requests and on-site inspections.

Its statutory goal – to maintain safe and sound credit institutions – is sufficiently broad to cover most relevant cases of banking malpractice. However, there are shortcomings. The need to apply national laws whenever EU law does not exist and to obtain national authorisation (including from the judiciary) to exercise investigatory powers, limits the ECB’s scope. More flexibility would have helped, for example, to put certain money laundering violations under the spotlight at an earlier stage.

Market manipulation is another example. Since 2016, EU countries have been subject to the market abuse regulation, compliance with which is checked in each country by the national market supervisor. The regulation prohibits the dissemination, by any means, of information giving misleading signals on the price of a security.

In Germany, the financial reporting enforcement panel, a privately regulated entity, examines financial reports on a sampling basis, conditional on the company’s co-operation. Bafin, the market supervisor, intervenes if the company does not co-operate or there are serious doubts on the outcome of the first step. The Wirecard episode exemplifies a misconnection between European and domestic law and a reluctance by the responsible authority to act in the grey area in between. An extension of EU powers would help fill this gap.

Whatever the scope of supervisory arrangements, undetected abuses will always exist. No supervisory framework can work without a good dose of ethics. But the Wirecard affair underlines that abuses are more likely to go unchecked if no authority feels compelled to take steps beyond those required by a minimalist interpretation of its mandate. In future, taking those steps should not be just an option. It should be the supervisors’ duty.

Wirecard scandal raises need for common EU market rules


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European banking union should act as model

Crises, historians have noted, can unblock institutional changes which are otherwise impeded by underlying cultural factors. Hopefully this will happen in the case of Wirecard, the Munich-based payments giant struggling for survival after admitting a multiyear, multibillion fraud in its balance sheet.

But what kind of changes are needed? Felix Hufeld, the head of the Bundesanstalt für Finanzdienstleistungsaufsicht (Bafin), the German market authority, spoke about ‘a disaster for Germany’, but Wirecard’s shockwaves are unlikely to remain within German borders. While Brexit redesigns the financial landscape of the continent and the European Commission renews its effort to build a capital market union, the Wirecard calamity is European. So should be the response.

The broad contours of the story provide some guidance on how future action should be directed. Since early 2019 whistleblowers, market participants and the Financial Times have signalled that something was wrong in the accounts of the company, whose burgeoning reported profits had led to a surge in market value and inclusion in Germany’s elite of listed companies. Bafin responded by temporarily banning short sales of the stock but did not consider it necessary to scrutinise the company itself, whose complex business was predominantly located in opaque and unco-operative Asian jurisdictions.

Following a familiar pattern, Germany’s establishment concluded that the allegations were attempts to undermine the country’s business culture. The company’s strategy of obfuscation and deceit culminated, in April this year, with the issuance of misleading statements on a KPMG audit, which the company itself had requested in an attempt to restore credibility. Eventually it took the intervention of banks and authorities in the Philippines, where the company had claimed to hold cash, to uncover the fraud.

While justice runs its course and experts scrutinise the company to see if parts can be saved, regulators must focus on the root causes of the problem. The first one, hardly unique to Germany, is the nexus between a lax market culture and a regulator captured by the industry which holds and promotes that culture. The remedy can only be to create a distance between the regulator and the regulated. Europe has already gone through this experience in the case of the banking union. The creation of a pan-European supervisor in the European Central Bank, breaking the liaison between national supervisors and the respective banking industries, contributed to the success of the banking union in recapitalising the banks and removing bad loans from their balance sheets. Those achievements made banks more resilient in the face of the pandemic.

A second crucial point is to remove ambiguity from the rules and mandates of the supervisors. Wirecard is a fintech specialised in electronic payments, a German bank – which, in view of its small size, is supervised by Bafin and not by the ECB – and a company listed in Germany, again supervised by Bafin. Doubts have been raised as to which authority and rules should apply to this case. Designing a clear mandate for a European financial markets authority, covering all listed companies and securities markets, is the bullet-proof way to remove ambiguity and fragmentation from the regulatory base, thereby creating the conditions for strong supervision. Again, the banking union shows the way: European regulation governing the single supervisory mechanism, drafted in 2012-13, provides a strong and state of the art legal basis for conducting banking supervision in the euro area. The alternative – adjusting and harmonising the rules in each of the 19 member countries – would have been impossible.

A European market supervisor, joining forces with other European authorities in adjoining areas of responsibility – the ECB and the Commission – would also be able to deal effectively with third country jurisdictions. Their co-operation is critical in today’s global capital markets. In the case of Wirecard, early links with and input from Asian financial centres would have avoided the crisis or drastically reduced its impact. That same authority would also solve the root the problem of regulatory arbitrage by third country banks repositioning in the continent, a risk which Brexit has made more serious and urgent.

Europe has for years mulled the launch of a capital markets union. Now is the time to get serious about it. The European Securities and Markets Authority, an agency so far endowed only with weak coordination powers over national market supervisors, should be restructured and empowered with a new statute and legal basis. The conditions which permitted the Wirecard scandal to arise are still with us. They should be removed, not only in Germany, but in the whole of Europe. The motto voiced after the 2008 financial crisis still applies: don’t let a good crisis go to waste.

Key role for Bundesbank after German court ruling


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Challenge from Karlsruhe may strengthen ECB policies

The German constitutional court ruling on the European Central Bank’s quantitative easing appears to open up an irremediable conflict at the heart of the euro area, with potentially fatal consequences for the currency and its central bank. It may not turn out that way.

The court has ruled that the ECB’s public sector purchase programme is illegitimate because it breaches the legal principle of proportionality. This has prompted the ECB, in an unusually terse and pointed statement, to restate its own independence and commitment to price stability. There are many doubts over how the court’s decision will be implemented, relating, in particular, to the delicate interplay between European and German political and juridical bodies involved in the process.

The ruling has some positive features. It forces the ECB to think hard about how best to conduct its policies to achieve its price stability goal, now and in the future. No central bank should operate in a vacuum. In the US, Congress and the executive do not refrain from brutal challenges to the Federal Reserve’s policies. The imperfect institutional structure of the European Union does not allow that.

An assault by a national court is a less than ideal way to provide a necessary counterweight. It is important that the Karlsruhe court decision clears the ground, at least in part, from repeated allegations that the ECB has launched the PSPP not to conduct monetary policy, but to finance states by monetary means or to transfer resources in disguise. By general recognition, the PSPP is now squarely in the camp of monetary policy instruments. The court is asking that the ECB demonstrates that the tool is worthwhile, and all its more general consequences have been considered.

Here however, the troubles begin. The ECB has been given three months to demonstrate that the PSPP was necessary and that its side effects were properly weighed up. Otherwise the Bundesbank – the only part of the ECB subject to German law – would be banned from participating in the programme and forced to divest its purchased securities (entirely consisting of German government bonds).

In one sense, this should be easy. Countless public documents by the ECB, including a multitude of policy meeting minutes, fulfil that aim, using state-of-the-art economic analyses. But those analyses, though accepted and often praised by most professional economists, cannot provide full-scale proof, any more than the rest of economics can. As such, they may not meet the exactitude required by constitutional jurists.

How can the court assess the pertinent economic arguments? As a minimum, they would need to be assisted by an equally powerful team of economists, free from intellectual prejudice and conflict of interest. So far, judging by the outside economists it asked to take part in the public hearings in Karlsruhe on 30-31 July 2019, it does not appear that the court has made use of a group of experts with those characteristics.

Even more troublesome are the implications of the court decision for the two pillars of modern central banking: the independence of the central bank and the clarity of its goal. It is generally accepted that the objective of the central bank and the approval of its charter are political matters. But the way the central bank uses the instruments delegated to it to achieve that objective are a central bank decision, to be protected from external interference. Yet this is precisely the focus of the court’s objection when it wants to decide whether the PSPP was necessary or not.

Moreover, in lamenting that the ECB has not properly balanced ‘the monetary policy objective against the economic policy effects arising from the programme’ the court implicitly contradicts the EU treaty principle that price stability is the ECB’s primary objective, and that only without prejudice for that may other objectives be considered. One wonders why the court did not object, many years ago, to the formulation in article 105 of the EU treaty.

The ball is now in the ECB’s court. The central bank does not lack legal expertise, starting from its president, Christine Lagarde, a lawyer by training. The ECB is accountable to EU bodies alone. The Bundesbank, an institution whose history has been repeatedly marked by conflicts over its own independence, will play a key role in the next steps. The last thing Europe needs in this moment of crisis is a crippling battle at its institutional heart. The issue is serious – but there is still a good chance it may end well.

ECB should turn to supervisory forbearance


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Lagarde must confront the ‘monster’ most feared by central banks: a supply shock

The European Central Bank under Christine Lagarde, its new president, must decide at its governing council meeting on 12 March how to intervene to mitigate the effects of the coronavirus. On monetary policy, almost everyone agrees that beyond a certain point further liquidity injections are ineffective, given generally large holdings of cash. Negative interest rates risk becoming harmful. The ECB must avoid last week’s mistake by the US Federal Reserve. The Fed is better positioned than the ECB, with higher starting rates and higher inflation. Yet the market reacted badly when the Fed reduced rates by a surprise 0.5 percentage points without a convincing explanation.

The ECB can assure markets that liquidity will not be lacking, which will require some signal or additional intervention. But it can also use its now much-increased supervisory role. Normally, supervisory forbearance is bad; but this is not a normal situation. Banks, much more than central banks, are in direct contact with firms and households suffering from lower sales and incomes. Banks bear the brunt of the shock but are also in a position to mitigate the effect of that shock on their clients.As an example, Italy has said it is studying the suspension of mortgage payments – although across-the-board relief would be, in my opinion, rather indiscriminate. The ECB may undertake useful measures and send positive signals.

First, for a certain period (subject to checks and possible subsequent renewal), the ECB and associated supervisors could decide not to increase banks’ capital requirements on virus-related new loans. Second, for the same period (again subject to checks and renewal if needed), it could similarly sterilise the effect on provisioning requirements of virus-induced increases in non-performing loans. Third, supervisory groups could establish enhanced consultations with the banks most exposed to virus-affected areas, so as to receive timely feedback on developments and decide if other forms of support are necessary.

Lagarde has used her ECB honeymoon since 1 November to inaugurate a review of monetary strategy, to be concluded by the end of the year, and to examine new topics such as the green agenda. She is aware of the need to heal rifts caused by the widespread easing on 12 September under her predecessor Mario Draghi.

Now Lagarde must confront the ‘monster’ most feared by central banks: a supply shock caused by a spontaneous reduction in production of goods and services. This brings the threat of world recession. In the past 20 years, China, where the infection appears to have started, has become a giant representing almost 20% of world output (against just under 16% for the US), based on exchange rates adjusted for price differences. The Organisation for Economic Co-operation and Development, using mid-February data, which perhaps underestimate the effects, foresees a reduction in world growth of 0.5 percentage points, or up to 1.5 points if the epidemic spreads.

In framing its response, the ECB must consider that the higher prices normally associated with a supply shock are unlikely to occur this time. Price trends have been falling for years owing to structural and global effects. This accentuates the need for expansionary policy – and for support from fiscal action. Governments must coordinate their action, with the aim of preventing the epidemic from blocking consumption or causing bankruptcies and banking crises.

In Italy, the European country most affected so far, the government has taken draconian action, implementing a country-wide quarantine. Given the drastic effects on demand, some Italian politicians are mounting pressure on the European Commission to take a less stringent approach on Italy’s fiscal targets. Rome and Brussels must work together to promote flexibility over planned debt and deficits. The coronavirus, like all other shocks, will pass. We must hope that the virus upset can provide a necessary stimulus to help pull the country out of its black hole of decline after years of unfulfilled promises. Italy does not have the strength and credibility to face the challenge alone. No national strategy will succeed without a recovery of trust and credibility, also in the benefits of international co-operation.