Tuesday, August 4, 2015

President of the Bundesbank talks about Ideas to Improve Stability in Europe

This speech posted on the website of the Bank for International Settlements is by the head of the German Bundesbank, Dr. Jens Weidmann.  The speech was made in Germany on July 23rd.This is a long speech. Readers are encouraged to read the whole speech if time permits. 

Below I picked out a few paragraphs from the section of this speech that talks about concerns that still exist in the banking system in Europe. You can see clearly that concerns do exist and the there are ideas being discussed on how to deal with them, including how to determine what liabilities are eligible for "bail-in". I put some key points in bold type.


The banking system
. . . . However, if the abundant injections of central bank money are used not only to bridge temporary liquidity shortfalls but, in extremis, to keep insolvent banks on long-term life support, matters could get tricky.
The more the central bank safeguards banks against risks and promises them central bank funding even in dubious situations, the more incentive they will have to take on excessive risks, of course. Former IMF Chief Economist and current Governor of the Reserve Bank of India, Raghuram Rajan, as well as last year's winner of the Nobel Prize in economic sciences, Jean Tirole, amongst others, provide evidence in recent studies that the implicit promise of a central bank to step in by lowering interest rates and injecting liquidity when banks default whets banks' appetite for risk.
This also shows that, in this respect too, a balancing act is required when selecting an appropriate strategy for liquidity provision. Being too restrictive in granting liquidity can cause a spark to turn into a fire. Granting liquidity too liberally, on the other hand, and propping up institutions without sustainable business models, may also mean that the water used to extinguish the fire ends up causing more damage than the fire itself.
In the words of the American economist Allan Meltzer: "Capitalism without failure is like religion without sin. It doesn't work." Banks also need to be able to fail - without bringing the entire financial system to its knees. Or put differently: no bank should ever become so entangled in the rest of the financial system that its collapse would pull the whole web apart - banks should not be "too big to fail".
It is clear that the incentive problems I've just described would continue to exist if bail-outs were simply to be transferred from the central bank to fiscal policymakers. An example would be rescuing banks using taxpayers' money even though resolving them would be the wiser course of action.
We cannot have governments providing free insurance, as such an implicit government subsidy makes banks too big and too risky. Systemically important banks, in particular, therefore need to play a role in protecting themselves against default by increasing their equity capital and ensuring a minimum total loss-absorbing capacity (TLAC) for their liabilities.
By having banks bear the costs of their own protection, incentives are set for risk-conscious activities. Banks simultaneously become more resilient, and the contagion effects are reduced should a bank run into difficulties all the same.
We have seen some progress already with regard to equity capital. Basel III significantly strengthened the requirements for both the quantity and the quality of equity capital. However, to date, the binding rules have been based exclusively on risk-weighted capital.
The risk weighting is supposed to prevent banks from investing too heavily in high-risk assets. During the financial crisis, however, we found out the hard way that the risk weighting does not always reflect the actual risk of an investment. Therefore, in my opinion, a capital regime that is also geared to total assets is absolutely necessary. Hence, the leverage ratio is to become part of Pillar 1 of Basel III and thus binding from 2018.
Stricter capital requirements will help to increase the internal capital adequacy of banks. But capital does not come for free. This means that stricter requirements may also reduce the banks' readiness to take on any risks at all; that is, to lend. But that would slow economic momentum. Ultimately, this is also a balancing act.
However, it seems clear that additional efforts to expand banks' capital base would be advisable, especially for systemically important banks and those that will just barely meet the Basel III requirements.
But even stricter capital requirements cannot entirely prevent individual banks from collapsing. And this is okay. After all, the possibility of failure is essential in a market economy.
This is why functioning resolution regimes are crucial for the financial system reform in Europe. With the introduction of the banking union and the adoption of the BRRD and the SRM, important steps have already been taken in the right direction.
However, one critical step is still missing: the establishment of standards for loss-absorbing liabilities, ie debt that can be bailed in. The German government recently submitted a draft act to promote the accumulation of liabilities eligible for bail-in. While this is to be welcomed, more needs to happen.
Although Europe already has a bail-in standard in the form of the minimum requirement for eligible liabilities (MREL), this has so far allowed banks to hold bail-in liabilities of other banks without additional conditions. In a crisis situation, this, of course, increases the risk of contagion. Hence, a bank should, as a minimum, completely back other banks' bail-in-able liabilities with equity capital.

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