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Strengthening the financial system’s defences

Strengthening the financial system’s defences Guest contribution from Prof Dr Claudia Buch published in the Frankfurter Allgemeine Zeitung

04.10.2018 | Claudia Buch DE

How well is our financial system prepared for future crises? The German economy may appear robust, but every boom must come to an end at some point. And there are clearly plenty of risks: geopolitical uncertainties, mounting trade conflicts and the as yet unresolved issue of Brexit. These uncertainties have the potential to exacerbate an economic downturn. Ten years after the onset of the global financial crisis, the question therefore is: how strong are the financial system’s defences?

For an economy to operate efficiently and grow sustainably, it needs a properly functioning financial system – one which allows investment and innovation, protects individuals against risks and ensures that payment systems operate smoothly. If financial stability is jeopardised in a crisis, it is precisely these functions that are no longer guaranteed; problems in the financial system then spill over to the real economy. It is therefore important to lower the likelihood of crises and reduce the impact they have. An important lesson from the global financial crisis is that securing financial stability is a policy objective in its own right.

A functioning financial system requires defences to remain stable, just as the human body must protect itself against viruses and contagion. These defences must be established when times are good. Now is the time to strengthen the financial system against a potential downturn and to equip it with sufficient capital as a buffer against future risks.

1 Financial risks are created by contagion

It became apparent, during the crisis, that individual players have underestimated their importance for the system as a whole. Even microprudential supervision with its focus on individual banks was unable to prevent shocks from spreading through the financial system and ultimately spilling over into the real economy.

How do contagion effects within the financial system come about? And how is it that even small shocks can have severe consequences? The answer lies in the nature of the financial sector: financial market players have close ties to one another and to the real economy. This interconnectedness allows the financial industry to fulfil its key functions: finance the economy, ensure the payment system functions smoothly and diversify risk. However, this high degree of interconnectedness also entails contagion risks.

Other market players may be directly affected through contractual obligations. If one contracting party incurs losses and does not have sufficient own funds to cover these losses, business partners will be directly affected. Indirect contagion is, however, also possible: market participants in similar lines of business may be affected if market prices plummet. In this manner, investors may lose confidence in entire market segments. Anyone active in a market will then suffer.

If all market participants have strong defences, the risk of contagion is lower. Unexpected events will then have less severe consequences. Financial institutions with more capital are thus not only more robust in themselves, they also render the financial system as a whole more resilient.

When deciding on capital buffers, it is, however, difficult for an individual institution to gauge, in advance, how potentially “contagious” it is for the financial system as a whole. It is a different story in healthcare: in principle, everyone knows how flu viruses or bacteria are transmitted. Doctors and the media regularly give advice on how to avoid contagion. Nonetheless, even then people often have difficulty following sensible advice or getting themselves vaccinated in time.

People’s belief that they are no longer contagious or that their own immune system is sufficiently strong often proves overly optimistic. Underestimating the risk of contagion emanating from others or from yourself can allow disease to spread. A person need not even display symptoms of infection to pass it on.

Risks may be underestimated in the financial system, too; the behaviour of individual market participants can impact the stability of the entire system. Insufficient protection against contagion and inadequate precautions against potential losses may result in market players encountering difficulties and shocks spreading.

2 Contagion effects have high economic costs

Financial crises entail high costs for the real economy, and their consequences may weigh on the economy for a very long time.[1] Recessions that are accompanied by a financial crisis are much more severe than normal recessions. The real economic costs of financial crises result from credit lines being terminated, investment being delayed, consumption declining and funding for innovation drying up. On top of that, taxpayers’ money is spent on boosting the economy and mitigating social costs such as an increase in unemployment.

Within Germany, spending in connection with the financial market crisis has caused government debt to rise significantly – more than the measures in connection with the European debt crisis.[2] At the end of 2017, the support measures for domestic financial institutions still accounted for 5.9% of economic output, as measured by gross domestic product, while the assistance measures for euro area countries represented 2.7% of GDP.[3] Although stimulus packages and later a rapid economic recovery meant that the direct social consequences of the financial crisis were felt less keenly in Germany than in other countries, such spending to support financial institutions represents a drain on public coffers.

The cost of rescuing the banks made it clear that governments directly and indirectly bore a considerable portion of the losses in the financial sector. Risks were shifted from the private sector to the government sector. At the same time, if there is an expectation that the government will jump in and stabilise the financial system and support ailing financial institutions, this will affect attitudes to risk. Empirical studies show that implicit guarantees by the government can increase risks in the financial sector.[4]

One of the objectives of the financial market reforms of the past few years has therefore been to develop capacities for dealing with potential financial distress at financial institutions without recourse to taxpayers’ money. Financial institutions should no longer be “too big to fail” and it should be possible for them to exit the market – just like enterprises in other sectors of the economy.

3 Financial stability is now a policy objective in its own right

Ten years have passed since the financial crisis, and we have learnt from our experiences. Internationally, important reforms have been agreed to render the financial system more stable. More capital in the financial system is a central element of these reforms. If a bank is well capitalised, not only does it have greater buffers against unexpected developments, the contagion effects within the financial system are also smaller.

But the reforms do not stop there: implicit subsidies for large banks have been reduced by imposing higher capital requirements, bailing-in private creditors in the event of resolution and improving supervision. Lastly, the markets for derivatives have been reformed and the shadow banking industry is now better supervised.

Many of these reforms have already been put into practice. The G20 is now examining whether they have achieved their goals and whether any side effects have materialised, focusing on the costs and benefits to society as a whole. The reforms aim to reduce the likelihood of future crises and pass on the costs for such crises to those responsible for causing them; if the financial industry stops taking excessive risks and absorbs the costs of crises itself, this will take pressure off society and the taxpayer. But individual financial institutions often have a negative perception of the implications of regulation: certain business models are becoming more expensive on account of increased financing costs, market shares are shifting and there are additional supervisory requirements to be fulfilled. However, from an economic and societal point of view, the cost-benefit analysis looks positive when the costs of crises are shouldered where they arise.

Alongside international reforms, adjustments have also been made within European institutions in order to make crises less likely and to deal better with their fallout. The banking union, the European Stability Mechanism (ESM) and a resolution regime for distressed banks are key components of the new institutional architecture of Europe.

Ultimately, though, financial stability begins at home and is fundamentally a national task – though calling for close collaboration within European and international frameworks. The crisis, after all, was not solely due to distress in the US real estate market, high government debt in other countries or the risky activities of international investment banks.

Rather, the crisis and its effects on Germany were the result of misguided incentives within the German financial system and supervisory authorities which had no way of intervening in cases of overall systemic distress or impending dangers to financial stability. Prior to the crisis, German banks had invested heavily abroad, contributing to risky international financial flows and the build-up of what would ultimately prove to be unsustainable debt.

“Financial stability” is therefore a new policy goal in its own right. It is not enough for microprudential supervision to focus on the stability of individual institutions. Risks in the financial system can be built up and amplified by institutions, and can thus spill over to the real economy.

In order to prevent this, the supervisory authorities can now take additional macroprudential measures to safeguard the smooth functioning of the financial system. Macroprudential policy entails the use of instruments to boost the resilience of the financial system and counteract the build-up of risks in good time. One of these instruments is the countercyclical capital buffer, which can be used when times are good to make the banking sector more resilient against unexpected rainy days. During economic upswings, additional capital is built up, which banks can then use to cushion unexpected losses during downturns. The countercyclical capital buffer which has been available within the EU since the start of 2016 is already in use by six countries and has been announced in four more.[5]

The countercyclical capital buffer addresses a regulatory paradox. Regulatory capital requirements usually do not vary with the business cycle, meaning that such buffers cannot actually be used to offset macroeconomic risks at the very moment when they are needed. In times of economic downturn, banks will consequently restrict their lending and thus exacerbate the slump.

Further macroprudential instruments are designed to counteract structural risks in the financial system. Large, systemically important financial institutions, for example, have recourse to higher capital add-ons. Since last year it has also been possible to take preventative steps against potential financial stability risks stemming from overheating in the real estate market. The supervisory authorities have the option of establishing a loan-to-value limit for housing loans, for instance.

The Financial Stability Act of 2013 laid the foundations for the fulfilment of a new task: “securing financial stability”. Established by this act, the German Financial Stability Committee (AFS) is the central committee for macroprudential surveillance in Germany. It comprises representatives of the German Federal Ministry of Finance, which acts as chair, the Federal Financial Supervisory Authority (BaFin) and the Bundesbank. The Committee evaluates the stability of the German financial system on the basis of the Bundesbank’s analyses and reports to the German Bundestag once a year, most recently in June 2018. In addition, the Committee can issue warnings and recommendations when financial stability is under threat. The Bundesbank performs important functions within the AFS. It drafts analyses of the stability situation and has a the power of veto in voting procedures.

4 Defences must be built up when times are good

The Financial Stability Committee’s latest report presents a nuanced picture. The German banking sector now has higher buffers against risks: the banks’ capital ratio – i.e. tier 1 capital in relation to risk-weighted assets – has climbed from 9% at the start of 2008 to 16.4% at the start of 2018. The capital of German banks stands at just over 6% of total assets. The degree of protection which capital offers against unexpected developments depends, amongst other things, on how well future risks are depicted using risk weights.

At the same time, risks could accumulate on account of the protracted period of favourable economic conditions; the German economy’s insolvency rates are currently at an all-time low. If risks are predominantly estimated on the basis of the economic developments of the past few years, the likelihood of future recessions will be underestimated. Should an economic downturn take place, this may trigger a negative spiral, causing insolvency and credit defaults to increase while losses reduce capital. Banks’ defences against other negative events, such as falls in the prices of securities or a decline in the valuations of real estate, will be weakened. These effects may be reinforced within the system, with losses and depreciations at many banks leading to fire sales of assets, plummeting prices in the markets and further losses and depreciations. It will be impossible to raise more capital in the short term if everyone has been affected to the same extent.

It is difficult for an individual institution to gauge these systemic effects; it is therefore likely not to take sufficient account of them when provisioning for risks. In the same way, an individual cannot predict how their possible failure to take adequate precautions or their level of immunisation will influence the scale of a flu epidemic.

Defences must be built up when times are good. When the weather is fair and you feel well, it is all too easy to forget that times may also take a turn for the worse. Currently, the sun is still shining on the markets, we are experiencing the longest period of growth since the 1970s, and credit losses are low. Now is the time to build up sufficient capital, which will strengthen the resilience of individual institutions and the financial system in the event of an economic downturn. A slump could otherwise be exacerbated by banks drastically curtailing their lending activities.

A strong financial system is all the more important given that the financial industry is not immune to structural change. Forward-looking policies complement the necessary adjustments without jeopardising growth and stability. The new international and European rules and institutions provide a framework for this. Financial stability has also been established as a policy objective in its own right.

Current analyses show that in spite of larger buffers in the financial system and sound economic conditions, vulnerabilities have built up – not least as a result of increased global debt and above-average asset valuations. For this reason, the financial system must be equipped in the here and now to deal with potentially difficult times in future. National policies and the Financial Stability Committee have a key role to play here.

List of references

  • Atkeson, Andrew G., Adrien d’Avernas, Andrea L. Eisfeldt and Pierre-Olivier Weill (2018), Government Guarantees and the Valuation of American Banks, NBER Working Paper No 24706, National Bureau of Economic Research, Cambridge MA.
  • Federal Ministry of Finance (BMF) (2016), German stability programme, 2016 update, Berlin.
  • Deutsche Bundesbank (2018a), Maastricht debt: methodological principles, compilation and development in Germany, Monthly Report, April 2018.
  • Deutsche Bundesbank (2018b), German general government debt down in 2017 by €53 billion to €2.09 trillion – debt ratio down from 68.2% to 64.1%, press release of 29 March 2018, Frankfurt am Main.
  • Laeven, Luc and Fabian Valencia (2013), Systemic Banking Crises Database, IMF Economic Review,Vol. 61(2), pp. 225-270.
  • Lo Duca, Marco, Anne Koban, Marisa Basten, Elias Bengtsson, Benjamin Klaus, Piotr Kusmierczyk, Jan Hannes Lang, Carsten Detken und Tuomas Peltonen (2017), A New Database for Financial Crises in European Countries, ECB Occasional Paper Series No 194, European Central Bank, Frankfurt am Main.

Footnotes

  1. Lo Duca et al. (2017) and Laeven and Valencia (2013).
  2. See Federal Ministry of Finance (2016), Figure 6.
  3. See Deutsche Bundesbank (2018a, 2018b).
  4. See Atkeson, d’Avernas, Eisfeldt and Weill (2018).
  5. Denmark, France, Ireland and Lithuania have announced the buffer. The Czech Republic, Iceland, Norway, Slovakia, Sweden and the United Kingdom have already implemented it.
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