13 June 2012

Stefan Ingves: Financial crises and financial regulation – thoughts after five turbulent years

Ingves, Sveriges Riksbank Governor and BCBS Chair, explained the value of orderly and well-reasoned financial regulations for the prevention of financial crises. He said the public sector had an "obligation towards the citizens to attempt to prevent and manage financial crises to the best of its ability".

Demands for bank regulation are not infrequently met with resistance from interested parties who claim that regulation is too expensive. Not least, this resistance is aimed at higher requirements for banks’ capital adequacy, as the interested parties claim that capital is more expensive than loans. But in this context, it is important to make a distinction between private costs and social costs. Higher capital adequacy requirements entail private costs for the banks.

The crisis entailed huge costs, both for society as a whole and for the tax-funded public sector. Andrew Haldane, Executive Director of Financial Stability at the Bank of England, has  shown that the crisis cost UK taxpayers just over 1 per cent of GDP. The corresponding figure for the United States is just below 1 per cent, or $100 billion. Eurostat has calculated the figure for the EU as a whole at 0.7 per cent, or €90 billion.

But these figures are only the direct public costs of keeping the financial system more or less on its feet. The real social costs of the crisis are significantly higher. Financial crises lower output and the growth path. In addition, a part of the effect is permanent, even if it is difficult to say how large a part. A historical estimate of the cost of financial crises, calculated as a present value, is about 60 per cent of GDP. For the global financial crisis, this figure is considerably higher.

It is obvious that risks in the financial sector were underestimated before the global financial crisis. One underestimation concerned the degree of correlation of risks in individual institutions. But it could also be argued that we, on the regulatory side, were a little naïve regarding the risk of moral hazard in the governance of banks.

To generalise slightly, it could be said that, before 2008, we felt quite safe when we saw that the risk in individual institutions looked manageable. Today, we know better. Even an individually well-diversified bank has assets that could be highly exposed to the same macro-economic risk. In addition, as the banks largely act as each other’s counterparties, one bank’s problems can easily become another’s. If the banks providing loans suddenly no longer wish to continue lending, the banks that have borrowed money can face problems. And, if they are not affected before, the other banks will be impacted when one or more banks rapidly need to sell their assets, pushing down the prices. To this can be added the vicious circle of negative effects for the real, public and financial economies that I have already discussed.

To continue these generalisations, it could also be said that previously we usually believed that market discipline was enough to ensure that business incentives would correspond to socio-economic efficiency. Following the crisis, we know that this is not the case.

In this speech I have provided an introduction to banks and financial regulation – why banks are needed, but also the risks they entail. I have argued that the differences between a cost-benefit calculation at the social and private levels justifies a strict regulation of the financial sector, and declared that such regulation will always meet with resistance. I have spoken about the global financial crisis, how it was met and how it became a debt crisis in the euro area. I have also spoken about the course we should take in the future, and why. If I were asked to sum up my speech in three reflections they would be as follows:

• We have to distinguish between the economic costs of financial regulation at the social and private levels.
• Problems in the banking sector cannot be resolved unless we do something about them.
• Banks should lend a little more of their own money and a little less of everybody else’s.

Full speech

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