Future proofing for systemic crises

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| The European | 11 January 2021

Covid-19 won’t be the last crisis the world faces, so the EU needs
to plan a more collective public health and economic response –
Professor David Veredas of Vlerick Business School has a proposal
.

Systemic crises have a crippling domino effect on institutions and markets causing dire global economic consequences. But these systemic crises also have significant political consequences for virtually all countries too. For the 27 EU member states, such crises have been previously resolved by a strengthening of the European Union, through solidarity, collective action and regulation. 

Take the 2008 global financial crash for example. This systemic crisis brought several EU countries, like Greece, Spain and Portugal, almost to the brink of default. The pre-existing structures of the EU were simply not sufficient enough to avert disaster. But, lessons were learnt from these mistakes, and a strengthening of the EU came through the adoption of new regulatory and supervisory arrangements for financial institutions, as well as the implementation of EU-wide contingency funds. 

The flagship of which is the European Stability Mechanism (ESM), established in 2012 for providing emergency funding to countries in the euro area that are in financial difficulty. The ESM has about €80bn of paid-in capital from euro area countries and the capacity to raise hundreds of billions by issuing fixed income securities that are sold to institutional investors. Its aim is to act as a permanent firewall for the eurozone, to safeguard and provide instant access to financial assistance programmes for member states of the eurozone in financial difficulty. 

The financial crash of 2008 was described as a once in a lifetime systemic crisis, yet now the world finds itself in another systemic crisis, just 12 years later – The Great Lockdown Crisis of 2020. Covid-19, and the necessary restrictions and regulation brought in to curb the spread of the virus, have caused a global economic crisis, but this time it is of a very different nature – it’s a public health crisis.

The magnitude is of a higher order than that of the financial crisis and the eurozone sovereign crisis that followed. The 2020 contraction is more like the Depression of the 1930s. But, just as in 2008-2011, the current EU systems for dealing with this emergency have not been strong enough, or they have not worked efficiently. And, also as in 2008-2011, the crisis is resolved with an unprecedented EU-debt funded recovery fund and the largest EU budget ever. 

EU leaders, like those of any government across the world, were aware of the risk of global disease epidemics. The viral epidemic episodes in Africa and Asia over the past decade (e.g. Ebola, SARS, MERS) represented a strong early warning sign of the dangers to come, but Covid-19 has caught not only EU institutions and member states off-guard, but the world too. This has resulted in one of the biggest economic, social, and financial crises since the beginning of the 20th century. Not only this, but despite EU countries also scoring highly in international health regulations with potent health systems, many member states were overwhelmed when taking care of large numbers of severely ill patients.

It’s safe to say that the public health crisis has completely overstretched the structures and mechanisms of the EU, in particular those that deal with emergencies. The chances of a next health emergency or systemic crises are high, it’s just we do not know what or when. Climate change, the emergence of new pathogens, and the re-emergence of others poses significant risks to the health security of the EU. Plus, there are chemical, radiological, and nuclear risks to be considered. Risks that demand a similar response.

In order to be ready for the next health emergency, the EU needs effective and unified response arrangements, and collaboration between member states, instead of the country-specific approaches we have seen across all 27 member States. It also needs a significant financial cushion for rapid and predictably increasing funding. 

New support measures

So how could we ensure that a collaborative response is not only possible, but also affordable and realistic for EU member states? The key to this relies on financial innovation. Alongside other Vlerick academics, Professor Simon Ashby and Doctoral Researcher Dimitrios Kolokas, I propose the creation of the Emergency Health Financing Facility (EHFF in short). 

In its broader version, this Facility integrates some of the existing EU emergencies structures, namely the Emergency Support Instrument, and adds a new layer for the most extreme emergencies that does not increase the burden on public finances. This new layer essentially consists of securitising health emergency risks in the form of fixed income securities that are sold to institutional investors. The Facility follows the growth of market-based risk financing facilities across global and regional initiatives, led by the World Bank. 

The EHFF finances can be used for ramping up medical supplies, testing kits, building infrastructures, and sudden increases of personnel, amongst others, in line with rescEU and the Emergency Support Instrument. This is a vital necessity for future crises, after seeing the difficulties at the beginning of lockdowns for EU healthcare systems to obtain medical supplies such as PPE, and enough testing kits to have a desired impact on controlling the spread of the virus.

Specifically, the EHFF is a health risk management tool that provides liquidity when it is most needed, and without allocating large amounts of cash in advance. It will have positive spill-overs on the public finances of EU countries, in the sense that member states will be better off, as part of the EHFF, than managing the risk of a health emergency individually. 

The EHFF is therefore a cost-effective solution that protects national budgets, which are going to be under serious strain for the years to come, from the impacts of health emergencies, and allows all member states to have the funding to tackle these future crises.

Similar facilities exist or are being considered in other parts of the world. The most prominent cases are the Pandemic Emergency Facility of the World Bank, the ASEAN+3 Disaster Risk Insurance Facility, and the Pacific Alliance Catastrophe Bonds that offers earthquake coverage to four South American countries. These have been deemed successful in a cross-country wide approach to tackling large crises, and the EU must follow suit with its own to protect Member States efficiently and fairly. 

The securitisation of risk goes back to the early 1990s. The insurance industry (reinsurers in particular) were pioneers due to the hurricanes in the Caribbean. Securities that result from risk securitisation are known as Insurance Linked Securities, or ILS in short. Catastrophe bonds are the predominant form of ILS. The market of ILS has increased steadily since the mid-90s: from $785.5m in 1997 to $41.8bn in 2020. The predominant risks covered are natural catastrophes, like named storms and earthquakes, though they also cover mortgage, operational, and mortality risks, among others.

It’s safe to say that securitising the potential risks of another public health crisis, or even chemical, radiological, and nuclear risks, is certainly not unheard of. The EU prides itself on collaboration, fairness, and partnership – we must reflect this in our future crises responses, and a joint EHFF is the way to do so. Not only does it strengthen the EU further, therefore improving the response, but due to its financial innovation, it comes at no financial burden to any EU member states’ fiscal budget.

Further information 

www.vlerick.com

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