Gas and bank security have similarities

September 8, 2014

Europe is currently conducting two stress tests. One is on its energy suppliers, to see how badly they would fare if Russian gas was disrupted. The other is on euro zone banks, to ensure they are strong enough to finance economic recovery.

It is hard to know which of the two is the more important. But it is clear that an effective regime for energy security requires many of the same elements as financial stability.

One is the need for credibility in the stress tests. Europe flunked its original bank assessments by modelling scenarios that weren’t sufficiently stressful. The new test being conducted by the European Central Bank looks more credible.

The European Union is only now conducting its first gas test. Member states last month submitted their results to the European Commission, which is now reviewing them before coming up with recommendations next month. It shouldn’t pull its punches.

Part of the gas test involves checking whether countries have done what they are already supposed to have done to improve security. After gas via Ukraine was disrupted in 2009, companies were told they needed to ensure supplies in the event of a 30-day disruption.

But a buffer of that size is not enough. Although Ukraine has agreed a ceasefire with rebels fighting for independence, peace on the EU’s eastern frontier is far from guaranteed. And the EU’s ability to confront Vladimir Putin’s revanchism will be compromised so long as it is worried about running out of gas. Policymakers jacked up capital buffers in the wake of the financial crisis; they should now increase minimum gas buffers following the Ukrainian crisis.

Banks don’t just undergo stress tests. They also have to produce “recovery plans” to make sure they can continue operating if they suffer a shock. Similarly, the gas tests are supposed to be accompanied by contingency plans. Bank recovery plans involve things like raising more capital, disposing business and shrinking balance sheets. Gas contingency plans need to include boosting storage facilities, switching to alternative fuels and rationing supplies. They need to be robust.

One way of trying to stop banks getting into trouble is to forbid them from putting all their eggs in one basket. There are “large exposure limits,” which prevent them lending more than a quarter of their capital to a single counterparty.

What makes the EU vulnerable in the gas arena is that 27 percent of its consumption comes from Russia. Six member states get all their gas imports from Russia. It will take time to diversify supply to other fuels (such as nuclear energy and renewables) or other sources of gas (such as shale and liquefied natural gas). But, eventually, there should be an equivalent of “large exposure limits” to ensure energy security.

Another way of preventing a financial crisis is to engage in “macroprudential” policy. The basic idea is that it is not enough to look at individual banks, because of the cat’s cradle of linkages between lenders. Regulators need to examine the system as a whole.

There is the same imperative in the gas world. The EU already has a body called the Gas Coordination Group, which exchanges information and coordinates action. Meanwhile, member states are required to inform the Commission before signing any intergovernmental agreements in the energy field so it can check that what may be a good deal for one country doesn’t undermine another’s security.

Donald Tusk, the Polish prime minister who has just been chosen as next president of the European Council, has advocated going one step further: involving the Commission in all EU energy negotiations. While this would clearly increase its bargaining power vis-à-vis Russia, it would also contravene trade and antitrust policy.

A more modest idea, though, is worth considering: get the Commission to co-sign all gas deals but give it the power to object only if it believes energy security is being compromised. The Euratom Supply Agency already does this with uranium supplies.

There is, though, one big difference between gas and banking. You can’t print gas in the same way that you can print money, so there can’t be a lender of last resort in quite the same way. But two things can be done that would have a somewhat similar effect.

The most important is to complete the single market in gas. This means ensuring there are enough gas pipelines connecting different national markets. If one country lost access to gas, it could then import it from another. Although the EU as a whole might still face a shortage, the hit would be shared around all 28 countries rather than absorbed by a small number of vulnerable states.

In the past few years, a lot of interconnectors have been built. But the Commission estimates that 17 billion euros still needs to be spent. This is a top priority for the next few years.

Another way of protecting vulnerable countries would be for the EU to set up a fund to help them pay for LNG in the event that Russian gas was cut off, as suggested by Mathew Bryza, director of the Estonian-based International Centre for Defence Studies. Given that LNG is more expensive than piped gas, the fund could finance the extra cost.

The analogy between gas and finance is not exact. But, as Europe takes action to improve its energy security, it can learn the lessons from banking: from its failures as well as its successes.

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