11 February 2014

Bundesbank/Weidmann on fiscal policy and financial market integration

Weidmann argued for an adapted regulatory framework to make the financial system more resilient to crisis by restoring greater validity to the principles of competition and liability.

Fiscal policy

In view of past experience with fiscal rules, in particular, I strongly believe that the euro area can only be maintained as a stability union in the long run if its framework sufficiently embodies a key principle of regulatory policy: the principle of liability. In the context of public finances, this means that those who make decisions on spending must also take responsibility for them. In other words, there must be a balance between control and liability.

In principle, the Maastricht framework assigned both liability and control to national governments. During the crisis, the EFSF and ESM bailout funds stabilised the euro area but also increased the mutualisation of liability for previous national errors. To restore the balance between control and liability, I only see two plausible options: either we shift powers to monitor and intervene to European level by creating a fiscal union, or we strengthen the Member States’ individual liability and responsibility in a return to the Maastricht framework. This also ultimately means that sovereign insolvencies cannot – and must not – be ruled out. They must be possible without also causing the financial system to collapse. The current balancing act between individual responsibility and mutualised liability is likely to lead to new strains in the long run. 

Financial market regulation

In order to make the financial system more resilient to crisis, and thus to restore greater validity to the principles of competition and liability, changes will also need to be made to financial market regulation. A particularly severe problem which arose during the crisis was the "too-big-to-fail" problem: whenever banks become too large or interconnected to be wound up without jeopardising financial stability, this undermines the liability principle and ultimately disrupts competition, and represents an invitation to act irresponsibly.

Recent developments in the financial sector, such as increased indebtedness and the burgeoning growth of the shadow banking sector, require new rules as well. There must three primary objectives behind these new rules.

• First, banks have to become more resilient; in other words, they have to acquire a higher quantity of higher-quality capital to protect themselves against potential losses. The new international rules, generally referred to as Basel III, have already taken us a great deal further in this respect. However, there are some who believe the Basel III risk-based approach to be fundamentally wrong. The discussion is ultimately about whether capital adequacy rules should be simple or complex.

• Second, we need effective resolution mechanisms so that, in a worst-case scenario, banks can exit the market without endangering financial stability. Absent an effective bank resolution mechanism, banks could become overly generous in their lending decisions and efforts in terms of ongoing loan monitoring could fall short. Capital would then no longer be allocated to its most productive use; instead, there is a danger that particularly risky lending would tend to be overfunded for too long. And that would weaken the forces of macroeconomic growth. This is exactly the approach underlying the work conducted at European level on a new Banking Recovery and Resolution Directive (BRRD). 

• Third, we need to ensure that these rules cannot be circumvented by taking business elsewhere, such as, for instance, to the shadow banking sector. The rules of the game have to apply to all alike. 

Full speech

© Deutsche Bundesbank