A resilient financial system must weather unforeseen events

The global economy is currently in good shape, and the outlook is positive. Favourable economic conditions, low inflation and low interest rates are contributing to high valuations in financial markets. Yet, in such an environment, market participants may become overly optimistic, and risks to financial stability may be building up. Maintaining a resilient financial system thus requires sufficient buffers against unforeseen events and ensuring that reforms are not watered down.

Gazing into the rear view mirror for too long increases the risk of overlooking hazards

Currently, market participants are expecting a gradual increase in interest rates. This would indeed boost the stability of the financial system: banks may see their interest margins recover, in particular if interest rates move out of negative territory permanently. Life insurers and pension institutions would find it easier to generate sufficient income to cover returns they have promised.

But how would markets respond to an unforeseen economic slowdown? What if interest rates stay low for much longer? What if political risks materialize and risk premiums increase abruptly? Such unexpected events may affect multiple market participants simultaneously – thus potentially threatening the functioning of the entire financial system.

History tells us that financial crises usually strike unexpectedly. They can do serious harm to the economy and to society – output is lost, unemployment goes up, and public debt increases. The longer the boom persists, the more current trends are extrapolated into the future, and the weaker the incentives are to take precautions against unforeseen events.

Higher equity capital is the key to a resilient financial system

A resilient financial system thus needs to be in a position to weather unexpected events. Sufficient equity capital is key in this regard. Equity capital represents an insurance mechanism: whenever risks materialize and losses occur, the value of equity adjusts, and dividend payments can be suspended. This means that equity investors bear upside and downside risks, reaping the benefits in good times and covering losses in bad times. Standard debt contracts, in contrast, pay an agreed interest rate in good and bad times alike. Risks are not shared unless creditors agree to restructure the debt or unless all equity is wiped out in insolvency proceedings. Sufficient equity capital thus ensures that banks can cope with bad times. More equity in the banking sector also reduces the likelihood that, in bad times, the entire financial system is harmed.

Many post crisis reforms have exactly that objective: to enhance resilience through higher equity capital. Banks now have to fulfil much higher capital requirements, which are even higher for larger and thus more systemically important banks. And reforms go one step further: because standard insolvency procedures are not designed to cope with large and systemically important banks, new regimes for the recovery and resolution of those banks have been introduced. This reduces implicit public subsidies and political guarantees for bank creditors, who now can no longer expect to be bailed out using taxpayers’ money.

Assessing effects of reforms requires taking a public policy perspective

But have we reached the objective of making the financial system more resilient? And what are the potential side effects? To answer these questions, the G20 has agreed on a structured evaluation framework, by means of which private and public perspectives can be disentangled. Initial evidence suggests that the banking system still serves the real economy through lending. At the same time, it is often argued that the reforms have been costly for the financial sector. Reducing public subsidies, especially to larger banks, indeed implies increased costs for private owners and creditors. This increase in private cost, however, is a benefit for society because systemic crisis become less likely and less severe. In this sense, the reforms yield a “double dividend” – a financial system which contributes to stability and economic growth alike.