The future of banking — solving the current crisis while addressing long term challenges
The future of banking — solving the current crisis while


A call for action

Before discussing in more depth the main messages of this article, let me point to three headline messages:

1. 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.

2. 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?

3. 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.

The Eurozone crisis — lots of ideas, little action

One of the important characteristics of the current crisis is that there are actually two crises ongoing in Europe — a sovereign debt and a bank crisis — though the two are deeply entangled. Current plans to use the EFSF to recapitalise banks, however, might not be enough, as there are insufficient resources under the plans.

Voluntary haircuts will not be sufficient either; they rather constitute a bank bailout through the back door. Many policy options have been suggested over the past year to address the European financial crisis but, as time has passed, some of these are no longer feasible given the worsening situation. It is now critical that decisions are taken rapidly, the incurred losses are recognised and distributed clearly, and banks are either recapitalised where possible or resolved where necessary.

Comparisons have been made to the Argentine crisis of 2001 (Levy Yeyati, Martinez Peria, and Schmukler 2011), and lessons on the effect of sovereign default on the banking system can certainly be learned. The critical differences are obviously the much greater depth of the financial markets in Greece and across the Eurozone, and the much greater integration of Greece, which would turn a disorderly Greek default into a major global financial shock.

Solving a triple crisis such as Greece’s — sovereign debt, banking, and competitiveness — is more complicated in the case of a member of a currency union and, even though Greece constitutes only 2% of Eurozone GDP, the repercussions of the Greek crisis for the rest of the Eurozone and the global economy are enormous (similar to the repercussions of problems in the relatively small subprime mortgage segment in the US for global finance in 2007–8).

One often-discussed policy option to address the sovereign debt crisis is creating euro bonds, i.e. joint liability of Eurozone governments for jointly issued bonds. In addition to their limited desirability, given the moral hazard risk they are raising, their political feasibility in the current environment is doubtful. Several economists have therefore suggested alternatives, which would imply repackaging existing debt securities into a debt mutual fund structure (Beck, Uhlig and Wagner 2011), or issuing ESBies funded by currently outstanding government debt up to 60% of GDP, a plan detailed by Markus Brunnermeier and co-authors in this book.

By creating a large pool of safe assets — about half the size of US Treasuries — this proposal would help with both liquidity and solvency problems of the European banking system and, most critically, help to distinguish between the two. Obviously, this is only one step in many, but it could help to separate the sovereign debt crisis 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.

Regulatory reform — good start, but only half-way there
After the onset of the global financial crisis, there was a lot of talk about not wasting the crisis, but rather using it to push through the necessary regulatory reforms. And there have been reforms, most prominently the Dodd-Frank Act in the US. Other countries are still discussing different options, such as the recommendations of the Vickers report in the UK. Basel III, with new capital and liquidity requirements, is set to replace Basel II, though with long transition periods. Economists have been following this reform process and many have concluded that, while important steps have been taken, many reforms are only going half-way or do not take into account sufficiently the interaction of different regulatory levers.

The crisis has shed significant doubts on the inflation paradigm — the dominant paradigm for monetary policy prior to the crisis — as it does not take into account financial stability challenges. Research summarised by Steven Ongena and José-Luis Peydró clearly shows the important effect that monetary policy, working through shortterm interest rates, has on banks’ risk-taking and, ultimately, bank fragility. Additional policy levers, such as counter-cyclical capital requirements, are therefore needed.

The 2008 crisis has often been called the grave of market discipline, as one large financial institution after another was bailed out and the repercussions of the one major exception — Lehman Brothers’ bankruptcy — ensured that policymakers won’t use that instrument any time soon. But can we really rely on market discipline for systemic discipline? As Arnoud Boot points out, from a macro-prudential view (i.e. a systemwide view) market discipline is not effective.

While it can work for idiosyncratic risk choices of an individual financial institution, herding effects driven by momentum in financial markets make market discipline ineffective for the overall system.
Ring-fencing — the separation of banks’ commercial and trading activities, known as the Volcker Rule but also recommended by the Vickers Commission — continues to be heavily discussed.

While Boot thinks that “heavy-handed intervention in the structure of the banking industry … is an inevitable part of the restructuring of the industry”, Viral Acharya insists that it is not a panacea.

Banks might still undertake risky activities within the ring. Capital requirements might be more important, but more important still than the actual level of such requirements is the question of whether the current risk weights are correct. For example, risk weights for sovereign debt have certainly been too low, as we can see in the current crisis in Europe. Critically, we need to fundamentally rethink the usefulness of static risk weights, which do not change when the market’s risk assessment of an asset class permanently changes.

In addition, capital requirements have to take into account the co-dependence of financial institutions, as pointed out by Acharya and Matthew Richardson. This would lead to systemic risk surcharges, though they might not necessarily be perfectly correlated with the size of financial institutions. And whatever is being decided for the banking sector should trigger comparable regulation for the shadow banking sector to avoid simply shifting risk outside the regulatory perimeter.

Tweaking different levers of the regulatory framework independent of each other can, however, create more risk instead of mitigating it. Capital requirements and activity restrictions that do not take into account the governance and ownership structure of banks can easily have counterproductive effects, as Luc Laeven argues. Stricter capital regulations can actually result in greater risk-taking when the bank has a sufficiently powerful and diversified owner, but have the opposite effect in widely held banks. A one-size-fits-all approach is therefore not appropriate.

Another area of reform has been liquidity requirements, recognised as the biggest gap in Basel II. Enrico Perotti, however, points out that the suggested reforms — liquidity coverage ratios (buffers of liquid assets as a fraction of less stable funding) and net funding ratios (quantitative limits to short-term funding) — are (a) too rigid, (b) procyclical, and © distortionary against efficient lenders. He rather recommends using those ratios as long-term targets while imposing “prudential risk surcharges” on deviations from the targets.



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