26 April 2012

Pentti Hakkarainen: The growth outlook and the challenge of financial stability

Mr Pentti Hakkarainen, Deputy Governor of the Bank of Finland, discusses the question of how the economies of Europe can revive and start growing again when they are still suffering from high debt levels, extreme hoarding of liquidity, and an extraordinary degree of risk aversion.

We face a complex web of many uncertainties. In the US, the big issues of housing, unemployment and the federal deficit are still unsolved. There is a threat of overheating in China, with all sorts of adverse consequences. Japan has experienced about two decades of low growth, if any, and this seems to continue. What poses a downside risk to all economies, however, is the European situation. It is still very fragile and even minor adverse surprises can trigger a vicious downward spiral.

Let me propose two uncertain factors in particular which have to be taken seriously into account. One is how the financially weakest European countries succeed in following their fiscal consolidation programmes. The watchword here is consistency. The situation is still very fragile, and so it is very important that governments avoid creating any uncertainty about their fiscal plans. There is a lot at stake: disruptions in the government bond markets might spill over to the real economy and harm activity again, also in other countries. The second important challenge is how to avoid a prolonged economic stagnation in Europe. There is a risk we end up following the Japanese scenario where growth is hampered, banks are not lending and the government debt continues to accumulate.

There is an unprecedented amount of liquidity in the system. This is seen in the record high central bank deposits of banks, and also the cash holdings of corporations are at very high levels. In a sense this liquidity is a consequence of the central banks’ monetary operations, but it is important to underline that the central banks have merely made this liquidity available against collateral; they have not in any way “pumped” money into the system in excess of what is demanded by banks.

In the European context, the ECB has consistently stressed the priority of reducing the budget deficits, while at the same time seeking to prevent the reduction in bank lending. In today’s situation, the necessary improvement of bank balance sheets should preferably happen through increasing banks’ equity capital rather than reduction of lending. The financial supervision authorities have urged banks to follow this course. Some deleveraging, and the difficulties going with it, is however unavoidable. In particular, ensuring the sustainability of government finances is absolutely necessary for the normal operation of financial markets, and therefore also necessary for the indebted economies to return to a phase of durable growth. Just as important is to encourage the banking sector to adjust and shed any excess capacity that exists in the financial services industry. Otherwise, the European governments in particular may end up supporting a number of ineffective and unviable banks.

There are several regulatory reforms that are currently in progress. Most importantly, banks are required to strengthen their capital ratios. This is motivated by two reasons. Larger capital buffers will make banks more resilient towards losses. At the same time, the owners of bank equity will have a larger stake in a bank’s business and risk-taking. That is expected to encourage better monitoring of the business on the part of the owners. The complaint that in banking, “profits are private but losses socialised”, has motivated political decision-makers to require the new regime to be implemented quickly. New so-called macro-prudential tools are also being developed. The word macro-prudential refers to the aim of these new regulations, which is to steer the market as a whole instead of focusing on the riskiness of individual banks. The macro-prudential regulation should, in particular, reduce the danger of excess indebtedness in the economy and the financing of asset market bubbles in the future.

There are also more far-reaching proposals on the table: In the US and the UK, proposals are under consideration to separate investment banking from the narrowly defined “normal” part of the banking business. In Europe, the need of such structural restrictions is now being considered in a European Commission working group under the chairmanship of Governor Liikanen of the Bank of Finland. At the same time, more efficient procedures of crisis management are being developed. The goal is that the supervisors could intervene in a loss-making bank well before the equity is exhausted. This should reduce the risk borne by taxpayers in rescue operations. The possibility of early intervention by the supervisors can also improve the incentives of the managers and equity holders to avoid excessive risk-taking.

Full speech

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