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Links between the Financial System and the Real Economy
Take, for example, the LTROs which provided banks with liquidity for a period of three years. These LTROs have made the links between the public and the banking sector in some countries closer, not wider meaning that the system is even more vulnerable to systemic contagion than before. Another example is the issue of deleveraging and forbearance.
In Europe, many banks’ balance sheets are too large. Most of you probably agree that it is necessary for these banks to shrink their balance sheets. At the same time, some fear that deleveraging cuts off corporations from their financing sources. From a theoretical viewpoint, however, a distinction needs to be made between good and bad deleveraging. Good deleveraging, for instance, means scaling back the exposure to other financial intermediaries whereas bad deleveraging means that lending to the real economy is being reduced.
The problem with this view is that, in practice, the distinction is not at all so clear-cut. The issue becomes even more complicated, when we additionally introduce the concept of forbearance, i.e. postponing the act of declaring a doubtful loan to be a doubtful loan.
What is the best response to this issue? The first answer is transparency. At this point, transparency is more easily said than done. But we need it, particularly in the context of a banking union and possible bank recapitalisations. And transparency is especially important with a view to legacy assets and forbearance of the problem banks.
How do we proceed further? Repairing the banks’ balances sheets and injecting capital is one answer. However, some fear that repairing balance sheets has procyclical effects and could damage the availability of credit for the real economy. In my view, however, repairing balance sheets will have a long-term positive impact on potential output growth more than offsetting the possible short-term cyclical effects.
The Limits of State Interventions
I often hear that the banks were responsible for the crisis. But can governments do better?
As you know, one reason for the financial crisis was the use of risk models based on assumptions, which concentrated on expected values rather than tails... If regulators and banks essentially use the same models for their risk management, why should we expect a better financial stability outcome? Of course, one solution is to improve our models. But I do not think that this is the end of the story.
I rather believe that regulators can do better if they acknowledge their own limitations. Regulators should employ the market mechanism to find the best risk management tools. In an ideal world the market is a discovery process. First, each individual agent knows better what is good for him. But at the end of the discovery process – in theory – we will get the best risk management tools, if – and this “if” is the decisive word here – if banks with weak risk management processes are allowed to fail, having to leave the market. This is one reason why resolving the “too-big-to-fail”-problem needs to be a top priority on the regulatory agenda.
As far as I can judge, we are only beginning to understand how well-established instruments like the capital ratio work and what effect they have on the banks’ behaviour. And there are other new macroprudential instruments where our knowledge is even more limited.
Take the counter-cyclical buffer. The idea is simple and compelling. When the regulators identify a bubble developing, this buffer is activated, thereby leading banks to reduce their lending. If all works well, this buffer prevents the exuberances altogether, or at least mitigates it.
However, it is not clear how the buffers should be calibrated in order to achieve better financial stability. Moreover, not much is known about possible time lags. In the worst situation, these buffer effects are not counter- but pro-cyclical. Things become even more complicated if different instruments are applied at the same time. As you can easily see, there are many questions waiting to be answered, many problems waiting to be resolved...
To sum up, every intervention in the market needs to be justified by market failures, something that, unfortunately, is not hard to find in many areas of the financial system. There is no guarantee, however, that governments can do a better job. But at least the state has an incentive taking into account the negative externalities of banks’ decisions and thus to minimise tax payers’ losses. When the state is aware of its own limitations there is a good chance that the outcome will be better than one in which the financial system is left to its own devices.