Most observers have realized by now that a core problem of the Eurocrisis is the close interconnection between banking and sovereign fragility. The ongoing sovereign debt crisis in Europe continues to put strains on banks’ balance sheets — full of government bonds — while continuous bank fragility increases (contingent and more and more real) government liabilities. Rather than disentangling the sovereign debt and bank crises, recent policy decisions have tied the two even closer together. The use of the additional liquidity provided by the European Central Bank (ECB) through longer-term refinancing operations by some banks to stock up on government bonds has also tied the fate of sovereigns and banks closer together. Similarly, the initial plan to use European Financial Stability Facility (EFSF) or European Stability Mechanism (ESM) resources to recapitalize Spanish banks via a loan to the Spanish government bank support agency (FROB) would have exacerbated the Spanish sovereign debt crisis rather than helped to alleviate it, as such a loan would have added another heavy burden to the Spanish debt-to-GDP ratio. These short-term stresses come on top of doubts about the long-term sustainability of the EU Single Market in banking without a regulatory and supervisory framework that matches the geographic perimeter of banks’ activities.
Thorsten Beck's blog
For better or worse, banking is back in the headlines. From the desperate efforts of crisis-struck Eurozone governments to the Occupy Wall Street movement currently spreading across the globe, the future of banking is hotly debated. A new compilation of short essays by leading financial economists from the U.S. and Europe analyzes the short-term challenges in addressing the Euro-crisis as well as the medium- to long-term regulatory issues. The essays cover a wide variety of topics, ranging from Eurobonds to ring-fencing and taxation, but there are several themes that come through across the chapters. First, many reforms have been initiated or are under preparation, but they are often only the first step towards a safer financial system. Second, there is a need to change banks’ incentive structure in order to reduce aggressive risk-taking. Third, there is an urgent – also political – need to move away from privatizing gains and nationalizing losses, thus from bailing out to bailing in bank equity and junior debt holders.
I will not be able to touch on all the topics discussed in the book, so let me discuss some of the main messages in more detail. Ring fencing – the separation of banks’ commercial and trading activities, known as the Volcker Rule but also recommended by the Vickers Commission in the UK – continues to be heavily discussed among economists. While Arnoud Boot thinks that “heavy-handed intervention in the structure of the banking industry … is an inevitable part of the restructuring of the industry”, Viral Acharya insists that it is not a panacea as long as incentive problems are not addressed. Banks might still undertake risky activities within the ring or might even have incentives to take more aggressive risk. Capital regulations have to be an important part of the equation.
Editor’s Note: This is the fifth and final contribution in a series of posts that preview the findings of the forthcoming Financing Africa: Through the Crisis and Beyond regional flagship report, a comprehensive review documenting current and new trends in Africa’s financial sectors and taking into account Africa’s many different experiences. The report was prepared by the African Development Bank, the German Federal Ministry for Economic Cooperation and Development and the World Bank. In this post, the authors argue that all financial sector reform has to start locally, taking into account political constraints, but also aiming to create a constituency for financial sector reform.
What has the recent crisis taught us about the role of finance in the growth process of countries? The global crisis and the ensuing Great Recession have put in doubt the paradigm that financial deepening is good for growth under any circumstance. For students of financial systems, the bright (growth-enhancing) and dark (instability) sides of financial development go hand in hand. The same mechanism through which finance helps growth also makes finance susceptible to shocks and, ultimately, fragility.
Editor’s Note: This is the fourth in a series of posts that preview the findings of the forthcoming Financing Africa: Through the Crisis and Beyond regional flagship report, a comprehensive review documenting current and new trends in Africa’s financial sectors and taking into account Africa’s many different experiences. The report was prepared by the African Development Bank, the German Federal Ministry for Economic Cooperation and Development and the World Bank. In this post, the authors focus on the regulatory and supervisory challenges for financial systems in Africa.
In our previous contributions, we stressed the importance of competition in the banking system and the financial system at large. However, this also poses additional challenges for regulators and supervisors. The recent Nigerian experience of widespread and systemic fragility linked to (though not necessarily caused by) rapid changes in market structure and capital structure of banks shows that regulators and supervisors have to develop the capacity to monitor such changes carefully. It also shows that increased competition has to be accompanied by improvements in governance. Similarly, expanding financial service provision beyond banking poses additional challenges to regulators and supervisors. This concerns not only the challenges in the supervision of insurance companies and pension funds, but also coordination between bank and telecom regulators. It also requires an open and flexible regulatory and supervisory approach that balances the need for financial innovation with the need to watch for fragility emerging in new forms.
Editor’s Note: This is the third in a series of posts that preview the findings of the forthcoming Financing Africa: Through the Crisis and Beyond regional flagship report, a comprehensive review documenting current and new trends in Africa’s financial sectors and taking into account Africa’s many different experiences. The report was prepared by the African Development Bank, the German Federal Ministry for Economic Cooperation and Development and the World Bank. In this post, the authors focus on the challenges and opportunities in providing long-term finance for enterprises, households and governments. Long-term finance is a critical element for financial systems to fulfill their growth-enhancing role.
Despite recent encouraging innovations in banks, contractual savings institutions, and the capital market, we find that lengthening financial contracts remains a challenge for financial systems across Africa. Figure 1 illustrates the short-term nature of African banking; more than 80% of deposits are sight deposits or with a maturity of less than one year and less than 50% percent of loans have a maturity of more than one year. Providers of long-term finance that are well developed in the industrialized world, such as insurance companies, pension and equity funds and venture capitalists are small in most African countries and inefficient in their operation. This goes hand in hand with a limited supply of long-term equity and debt instruments across the continent.
Editor’s Note: This is the second in a series of posts that preview the findings of the forthcoming Financing Africa: Through the Crisis and Beyond regional flagship report, a comprehensive review documenting current and new trends in Africa’s financial sectors and taking into account Africa’s many different experiences. The report was prepared by the African Development Bank, the German International Cooperation (GIZ) and the World Bank. In this post, the authors focus on the challenges and opportunities for expanding access to finance in Africa, a central issue for Africa’s financial sector development.
Traditionally, we have observed low access levels by households and enterprises across the African continent. Sadly, these low access levels persist. Less than one in five households have a formal bank account (Table 1) and, on average, only 23 percent of enterprises have loans or lines of credit, while the corresponding share among enterprises in non-African developing countries is 46 percent (Figure 1).
In mid-September, the African Development Bank, the German Federal Ministry for Economic Cooperation and Development and the World Bank will launch Financing Africa: Through the Crisis and Beyond , a comprehensive review documenting current and new trends in Africa’s financial sector and taking into account Africa’s many different experiences. During the coming weeks and leading up to the formal launch of the book in Ethiopia on September 15, we will give a sneak peek of the book’s main findings and recommendations. In this first post, we’ll summarize our main messages.
In a recent Economist debate, Franklin Allen and I discussed the relationship between competition and stability. In the debate I argued that it is not so much the degree of competition in the banking market but rather bank regulation and supervision that drives bank fragility. In a recent paper with Olivier de Jonghe and Glenn Schepens, we now combine these two areas and test whether the regulatory and supervisory framework influences the competition-stability relationship. And we indeed find several dimensions of the market, regulatory and institutional framework that influences the degree to which competition harms or helps bank fragility.
But let us first review what theory tells us about the competition-stability link, and then examine how this relationship might vary with certain country features.
Access to banking services is viewed as a key determinant of economic well-being for households, especially in low-income countries. Savings and credit products make it easier for households to align income and expenditure patterns across time, to insure themselves against income and expenditure shocks, as well as to undertake investments in human or physical capital. Up to now, however, there is little cross-country evidence which documents how the use of financial services differs across households and, in particular, how cross-country variation in the structure of the financial sector affects the types of households which are banked. In a recent paper with Martin Brown, we use survey data from 28 transition economies and Turkey to:
- document the use of formal banking services (bank accounts, bank cards and mortgages) across these 29 countries in 2006 and 2010,
- relate this use to an array of household characteristics,
- gauge the relationship between changes in bank ownership and the financial infrastructure (deposit insurance and creditor protection) over time within a country and changes in the use of banking services, and
- assess how cross-country variation in bank ownership structures, deposit insurance and creditor protection affect the composition of the banked population.
Understanding the role of banks in cross-border finance has become an urgent priority. The recent Global Financial Crisis and ongoing European crisis have shown the importance of creating the necessary regulatory and macroeconomic conditions for a Single European Banking Market to function properly in good and in tough times. Together with five other economists (Franklin Allen, Elena Carletti, Philip Lane, Dirk Schoenmaker and Wolf Wagner) I have published a CEPR policy report that analyzes key aspects of cross-border banking and derives policy recommendations from a European perspective. We argue that for Europe to reap the important diversification and efficiency benefits from cross-border banking, while reducing the risks stemming from large cross-border banks, reforms in micro- and macro-prudential regulation and macroeconomic policies are needed.
The benefits and risks of cross-border banking have been extensively analyzed and discussed by researchers and policy makers alike. The main stability benefits stem from diversification gains; in spite of the Spanish housing crisis, Spain’s large banks remain relatively solid, given the profitability of their Latin American subsidiaries. Similarly, foreign banks can help reduce funding risks for domestic firms if domestic banks run into problems. However, the costs might outweigh the diversification benefits if outward or inward bank investment is too concentrated. Based on several new metrics, we find that the structure of the large banking centers in the EU tends to be well balanced. However, problems are identified for the Central and Eastern European countries which are highly dependent on a few West European banks, and the Nordic and Baltic region which are relatively interwoven without much diversification. At the system-level, we find that the EU, in contrast to other regions, is poorly diversified and is overexposed to the United States.