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What is a resilient bank? A resilient bank is able to withstand shocks and enjoys the confidence of investors and customers. Thus, it will receive funding – both wholesale and retail – at adequate prices even during periods of stress. To sum up the characteristics of resilient banks, we can state that they are well-capitalised and have enough liquidity, that they have profitable and sustainable business models and that they are managed prudently. First and foremost, it is certainly the banks’ responsibility to fulfil these criteria. It is the responsibility of regulators, however, to put in place a stable regulatory framework.
Nevertheless, in designing such a framework they have to look beyond the individual bank. Setting regulatory standards to increase the resilience of individual banks is necessary but by no means sufficient. Authorities have to take into account the problem of systemic risk which can be created by cyclical or structural developments, such as exposure concentrations or externalities caused by the interconnectedness of financial institutions.
The "too-big-to-fail"-problem
The first step in this regard is to acknowledge that even resilient banks can fail. And this might become a problem if the failing bank is very large and interconnected. In such a case it can drag other banks down with it and cause a systemic crisis. Consequently, we have to ensure that such systemically important financial institutions (or SIFIs) can fail without destabilising the whole financial system. What we need are insolvency frameworks that are in tune with the interconnectedness and complexity of the financial sector.
The bank-sovereign nexus
Nevertheless, there is still another aspect of interconnectedness that has to be taken into account: the link between banks’ balance sheets and public finances. The crisis has exposed a vicious circle in that connection. If many banks run into financial difficulties at the same time, that can threaten the stability of the entire financial system. Governments then often have no option but to bail out these banks to prevent the system from collapsing.
By the same token, if government finances run into difficulties, that causes problems for banks – firstly, because many banks have large government bond holdings and, secondly, because the general economic situation initially worsens when a government has to adjust its finances.
This feedback loop between banks and sovereigns has to be severed in order to promote financial stability. One measure would be to establish resolution regimes for banks - having them in place would shield the government from having to rescue banks with taxpayer money. Another measure refers to capital requirements for banks - the objective is to ensure that banks’ economic situation no longer depends on the state of public finances. We can only achieve this if we stop giving government debt preferential regulatory treatment over other loans or securities...
But what about the banks themselves? Have they finally understood their role in the recent crisis? Have they looked beyond their own losses and realised the burden they have put on society?
I have argued that we have to look beyond the individual bank to safeguard financial stability and what I was referring to was the systemic perspective. But we also have to look beyond the banks to capture the personal perspective. Eventually, it is the bankers’ attitude and culture that are the most essential building blocks of financial stability. Here we still need a change. Bankers have to subscribe to the idea that the financial system is, in essence, a service provider for the real economy.