In concluding my remarks on reforms aimed at making future crises less likely, let me also mention proposals currently on the table for the establishment of a Convergence and Competitiveness Instrument, also known as “reform contracts”, within the EU budget. The proposal is essentially to create a special EU budget account supporting timely implementation of needed (and possibly unpopular) structural reforms following contractual arrangements between Member States and the Commission. A review of the compatibility of product and labour market structures in euro area countries with the requirements of EMU is also underway, which might provide further impetus to structural reforms in the euro area and make countries less vulnerable to future shocks. After describing reforms aimed at crisis prevention, let me now turn to crisis resolution mechanisms. Like fire safety restrictions and fire-fighters, the two elements are individually imperfect but should reinforce each other and work in symbiosis. The European Stability Mechanism (ESM) was created in order to provide financial assistance to euro area countries in financial difficulty. The ESM will function as a permanent firewall for the euro area with a maximum lending capacity of € billion. Euro area Member States can apply for ESM financing if they are in financial difficulty or their financial sector is a stability threat in need of recapitalization. ESM interventions are conditional on Member States first signing a Memorandum of Understanding containing a programme for the needed reforms or fiscal consolidation to be implemented in order to restore the financial stability.
Table 1 The costs of higher capital requirements Benefits  Costs  Required Marginal Probability  present value,  present value,  of 1% rise in risk weighted  % of GDP  % of GDP  capital ratio  Extra Months in the Average Gap between Crises from 25 years  (1) Baseline  55%  4.25  0.077%  5.9  (2) 30% Modigliani-Miller effect  55%  3.25  0.059%  4.5  (3) Tax offset  55%  1.67  0.030%  2.3  (4) More Substitutes to Bank Finance  55%  0.80  0.015%  1.1  (5) Less Sensitive Investment  55%  0.32  0.006%  0.4  Temporary Impact on GDP from Crises  20%  0.32  0.016%  1.2  How do these costs measure against the benefits of a more robust banking sector and a lower frequency of banking crises? I will make the same assumptions as in the FSR, namely that if a bank crisis occurs the initial impact is to reduce output by 10% of GDP. That is almost exactly the amount by which UK GDP is now below the level it would have reached had it continued on the trajectory it was on up to 2007. I assume that three quarters of this reduction lasts for just five years, but that the other 2.5% of lost GDP is gone forever.