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Speech by Dr Jens Weidmann, President of the Deutsche Bundesbank, at the Eurobörsentag 2015, Frankfurt am Main, 23 July 2015.
2. The money market
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The Governing Council of the ECB reacted swiftly and decisively [to the financial crisis] by switching its refinancing operations to tenders with full allotment. As long as banks were able to pledge adequate collateral, they received unlimited amounts of liquidity from the Eurosystem. In practice, this allowed them to bypass the strained interbank market. The Governing Council also offered additional longer-term refinancing operations including, naturally, the three-year refinancing operations at the end of 2011 and the beginning of 2012 in particular.
In this way, the Eurosystem took over a major part of the money market's role as an intermediary. The closer involvement of the Eurosystem is, of course, associated with risks. However, it can reduce the danger of a widespread bank run, which is good news for the economy as a whole.
3. The banking system
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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. [...]
This also shows that, in this respect too, a balancing act is required when selecting an appropriate strategy for liquidity provision. [...]
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".
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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.
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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.
4. Government bond markets
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The problems associated with intervention in the government bond markets are even more diverse and serious, which is also why central banks should steer clear of lending to sovereigns. It is for this reason that Article 123 places strict constraints on the Eurosystem by banning the monetary financing of governments.
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In addition, where a central bank takes on the task of lending to governments it neutralises the disciplining effect of the capital markets. Bad fiscal policy is not penalised while good fiscal policy is not rewarded through lower financing costs. This poses a particular problem in a currency union, as the price of unsound budgetary policies may to some extent be passed on to all the other member states.
Conversely, there are economists like Paul de Grauwe who argue that there was no such disciplinary effect ahead of the sovereign debt crisis. [...]
However, I beg to differ for a number of reasons.
First, it is at times hard to determine the "correct" risk premium ex ante. Hence, it is not always evident to a central bank whether a government is merely illiquid or truly insolvent. [...]
Second, where a central bank steps into the breach another equilibrium may also come into play as well, namely the forces of fiscal dominance which I alluded to earlier. [...]
Third, the Eurosystem lacks the legitimacy to redistribute fiscal risks between member states. [...]
So how exactly can bridging payments via the ESM be safeguarded in turbulent times without absolving existing creditors from their liability?
One suggestion put forward by the Bundesbank envisages, for example, an automatic three-year maturity extension for all bonds. This would be activated the moment a government applies for an ESM programme. Such a mechanism would dramatically reduce the level of funding required for any ESM programme, which would then only be needed in order to spread the fiscal adjustment over a longer period, thus simplifying this procedure while avoiding any repayment of legacy debt.
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5. Risk sharing
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Things look different in Europe, however. Here, it is mainly the credit markets which absorb economic shocks - and not particularly effectively at that. All told, only around 40% of a given shock is cushioned before it impacts on consumption.
Boosting the role played by the equity markets and their cross-border integration would thus contribute to improving risk sharing in Europe. And it would cushion precisely those regional shocks to which a single monetary policy simply has no response.
6. Capital markets union
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Yet there are opportunities aplenty for pushing ahead with capital market integration, and the European Commission touches upon a number of them in its green paper, entitled "Building a Capital Markets Union". One is the market for high-quality securitisation; other priority areas include private placements, crowdfunding and harmonising the prospectus regime.
Dismantling barriers in these areas would represent a step towards greater prosperity in Europe, so the Commission's initiative merits our support.
But looking further into the future, we need to go one step further. Creating a European level playing field in insolvency law, for instance, would also improve the integration of the capital markets, particularly those for venture capital.
7. Unequal treatment of debt and equity capital
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Interest payments can be deducted from taxable income; equity costs cannot. Eliminating this distortion would encourage businesses to bolster their equity base.
That isn't just important for the development of equity capital markets, with all the positive side-effects I've already mentioned - it would also dampen pro-cyclicality in financial markets and promote risk sharing.
A strengthening of the equity base would naturally also have a positive impact on those businesses for which it has been most hotly debated and called for in recent years - the banks. [...]
Though the authors caution that the impact will probably be less substantial for the largest banks, these numbers are nonetheless remarkable, especially when one considers the 3% leverage ratio proposed under the Basel III regime.
And no less remarkable would be the potential savings that sovereigns could reap from having to pay less to bail out ailing banks. [...]
Putting an end to the debt bias in the corporate taxation regime, then, could also prove to be a major pillar safeguarding financial stability - one that could potentially provide lasting relief for the public sector.