The Future of Banking - a new VoxEU.org eBook

Thorsten Beck 25 October 2011

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Three years after the Lehman Brothers failure sent shockwaves through financial markets, banks are yet again in the centre of the storm. While in 2008 financial institutions “caused” the crisis and triggered widespread bailouts followed by fiscal stimulus programmes to limit the fall-out of the banking crisis for the rest of the economy, banks now seem to be more on the receiving end. The sovereign debt crisis in several southern European countries, and potential large losses from a write-down of Greek debt, make the solvency position of many European banks doubtful, which in turn explains the limited funding possibilities for many banks.

The outrage over “yet another bank bailout” is justified. The fact that banks are yet again in trouble shows that the previous crisis of 2008 has not been used sufficiently to fix the underlying problems. If politicians join the outcry, however, it will be hypocritical because it was they, after all, who did not use the last crisis sufficiently for the necessary reforms. After a short period in crisis mode, there was too much momentum to go back to the old regime with only minor changes here and there. This is not too say that I am advocating “radical” solutions such as nationalisation. This is not exactly radical, as it has been tried extensively across the world and has failed. But wouldn’t it actually be radical to force financial institutions to internalise the external costs that risk-taking decisions and their failure impose on the rest of the economy? So rather than moving from “privatising profits and nationalising losses” to nationalising both, I would advocate privatising both (which might also reduce both profits and losses!), an old idea that has not really been popular among policymakers these past years in the industrialised world. Some observers might call this idea naïve, but maybe its time has finally come.

A call for action

A new VoxEU.org eBook, The Future of Banking, contains three headline messages:

  • We need a forceful and swift resolution of the Eurozone crisis, without further delay! For this to happen, the sovereign debt and banking crises that are intertwined have to be addressed with separate policy tools. This concept finally seems to have dawned on policymakers. Now it is time to follow up on this insight and to be resolute.
  • It’s all about incentives! We have to think beyond mechanical solutions that create cushions and buffers (exact percentage of capital requirements or net funding ratios) to incentives for financial institutions. How can regulations (capital, liquidity, tax, activity restrictions) be shaped in a way that forces financial institutions to internalise all repercussions of their risk, especially the external costs of their potential failure?
  • It is the endgame, stupid. The interaction between banks and regulators/politicians is a multi-round game. As any game theorist will tell you, it is best to solve this from the end. A bailout upon failure will provide incentives for aggressive risk-taking throughout the life of a bank. Only a credible resolution regime that forces risk decision-takers to bear the losses of these decisions is an incentive compatible with aligning the interests of banks and the broader economy.

Policy recommendations

There are many policy recommendations, but I would like to point to three:

  • European Safe Bonds: Several authors present the case for a forceful resolution of the Eurozone crisis. Critical of Eurobonds, Markus Brunnermeier and co-authors have proposed an alternative solution in the form of ‘European Safe Bonds’ – securities funded by currently outstanding government debt (up to 60% of GDP) that would constitute a large pool of ‘safe’ assets. The authors argue that these bonds would address both liquidity and solvency problems within the European banking system and, most critically, help to distinguish between the two. ‘European Safe Bonds’ could effectively separate the sovereign debt from the banking crisis, and would allow the ECB to disentangle more clearly liquidity support for the banks from propping up insolvent governments in the European periphery.
  • Capital and liquidity requirements – risk weights are crucial. While ring-fencing might be part of a sensible regulatory reform, it is not sufficient. Capital requirements with risk weights that are dynamic, counter-cyclical and take into account co-dependence of financial institutions are critical. Capital requirements, however, do not work independently, but operate in their effect on banks’ risk-taking in interaction with ownership and governance structures – so one size does not necessarily fit all. Similarly, liquidity requirements have to be adjusted to make them less rigid and pro-cyclical. Though banks are under-taxed, the currently discussed financial transaction tax would not significantly affect banks’ risk-taking behaviour and might actually increase market volatility; in addition, its revenue potential could also be overestimated.
  • The need for a stronger European-wide regulatory framework. If the common European market in banking is to be saved – and the authors argue that it should be – then the geographic perimeter of banks has to be matched with a similar geographic perimeter in regulation, which ultimately requires stronger European-level institutions. Many of the regulatory reforms, including macro-prudential tools and bank resolution, have to be at least coordinated if not implemented at the European level. Critically, the resolution of financial institutions has an important cross-border element to it, which calls for a European-level resolution authority for systemically-important financial institutions.

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Topics:  Financial markets Global crisis

Tags:  banking, banking regulation, Eurozone crisis

Professor of Banking and Finance, Cass Business School; Research Fellow, CEPR

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