27 January 2014

Bundesbank/Dombret: Striving to achieve stability – Regulations and markets in the light of the crisis

Dombret spoke on the balance between market forces and regulation, pointing out the grey area of systemic risk and necessity for resolution mechanisms. He proposed a ceiling on lending to any one government, and said further regulation was needed in the area of shadow banking and insurance.

Financial stability is not a matter of choosing between the market and the state but rather a case of finding the right relationship between the two. Here, we can turn to the tried and tested principle of letting governments lay down the regulations while the market is allowed to function freely. But especially with regard to the financial markets, there is a "grey area" in which the boundary between the market and the state becomes blurred: the problem of systemic importance.

Large, interconnected banks effectively enjoy insurance protection courtesy of the state. And once the liability principle is abandoned, economic agents change their behaviour, giving rise to moral hazard. Thus, large interconnected banks intrinsically pose a risk to financial stability. At the same time, this is precisely why they engage in such risk-taking in the first place - which all makes for a dangerous feedback loop.

So how can we redraw the boundary between market and state? The possibility of market exit is a key element of any market economy. What we need are mechanisms that enable a bank to be wound up without causing the entire financial system to get into difficulties. Twe crucial questions ehen winding up a bank is: who will pay for its resolution? Here, the bank's owners and creditors have to be first in line when it comes to bearing the losses, with taxpayers at the bottom of the list. This is the only way to reinstate the principle of liability. This "bail-in" option will therefore be an important component of the Single Resolution Mechanism (SRM) which is planned at the European level.

In a market economy, banks should fail if their business model is unsuccessful, yet banks should not crumble under the force of each and every external shock that they experience. In view of this, I believe that two elements will be especially important in making banks more stable: capital and liquidity. Deficits in both of these things were factors which contributed significantly to the financial crisis. The state can bring in regulation to address these deficits, and has done so very successfully. The new Basel III regime significantly raises capital requirements for banks. In future, banks will need to hold more - and better-quality - capital, and the requirements for systemically important financial institutions are stricter still. In addition, Basel III has introduced the very first international liquidity standard.

The need to bail out systemically important banks with taxpayers' money puts pressure on government budgets. This kind of contagion is mainly caused by government bonds held on bank balance sheets. And many banks have large holdings of domestic government bonds, especially in the euro area. Essentially, this is a vicious circle: a country's public finance problems spill over to domestic banks, while banks' woes place a strain on government budgets in the country where they are based. To better protect public finances, we need bank resolution mechanisms and the option of a "bail-in". But how can we shield banks most effectively from the impact of public finance problems?

Bank regulation treats government bonds comparatively generously. Usually, the higher the risk attached to a loan, the more capital a bank must hold against it. Yet this does not apply to lending to governments - and thus to government bonds. Bank regulation classifies them universally as risk-free. Yet since the onset of the sovereign debt crisis, if not before, this treatment has no longer seemed justified, as it has become apparent that government bonds do carry some solvency risk. It would therefore be appropriate to change the rules in the medium term. At the same time, a ceiling could be imposed on lending to any one government, just as lending to other borrowers is subject to a limit of this kind. These two measures combined would shield banks from the impact of public finance problems.

And there is one area of the financial system which is not yet truly regulated: the shadow banking system. In terms of financial stability, the crux of the matter is that these entities can cause similar risks to banks but are not subject to bank regulation. And the shadow banking system can certainly generate systemic risks which pose a threat to the entire financial system. Much the same applies to insurance companies. Although they aren't a direct component of the shadow banking system, they can also be a source of systemic risk. All of this makes it appropriate to extend the reach of regulation.

Full speech

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