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.
However, we need to think beyond mechanical solutions that create cushions and buffers (exact percentage of capital requirements or net funding ratios) to the incentives of financial institutions. How can regulations (capital, liquidity, tax, activity restrictions) be shaped such that they force financial institutions to internalize all the repercussions of their risk, especially the external costs of their potential failure? While there have been lots of discussions on capital requirements, the discussion has focused on the numerator of this ratio, while more emphasis should be put on the denominator, or more specifically, the risk weights attached to different assets. For example, risk weights for sovereign debt have certainly been too low, as we can learn from the current crisis in Europe. Critically, we need to fundamentally rethink the usefulness of static risk weights, which do not change when the market’s risk assessment of an asset class permanently changes. In addition, capital requirements have to take into account the co-dependence of financial institutions, as pointed out by Acharya and Matthew Richardson in their contribution.
The recent global crisis has shown the important global financial interlinkages. While attempts at regulatory reforms often have to be undertaken at the national level, closer cooperation is necessary, especially in two areas. One is on global systemically important financial institutions (SIFI) that currently have the status of too-big or too-important-to-fail. Rearranging the balance of powers between banks and supervisors, resolution schemes have to be put in place that set the right incentives for decision takers in these banks so that they internalize the negative externalities their failure imposes on the global financial and economic system. Living wills that allow for the orderly resolution if not liquidation of SIFIs are an important first step. A second important need is for more coordination within Europe. Cross-border banking in Europe can only survive with a transfer of regulation and resolution of cross-border banks to the European level, as emphasized by Dirk Schoenmaker. If the common market in banking is to be saved, the geographic perimeter of banks has to be matched with a similar geographic perimeter in regulation, which ultimately requires new European-level institutions. Critically, the resolution of financial institutions has an important cross-border element to it. In 2008, authorities had limited choices when it came to intervening and resolving failing banks and, in the case of cross-border banks, resolution had to be nationalized. Progress has been made, but Europe still lacks the necessary institutional framework to resolve large banks, a gap that will be critically felt in the upcoming bank restructuring round.
Proposals to introduce a financial transaction tax, in one form or another, have emerged in the political arena over the past three years with a regularity that matches the changing of the seasons in Europe. As Harry Huizinga and I point out, such a tax would not significantly affect banks’ risk-taking behavior. Rather, it might actually increase market volatility and its revenue potential might be overestimated. Banks are under-taxed, but there are better ways to address this gap, such as eliminating the VAT exemption on financial services or a common EU framework for bank levies.
Above all, however, it is important to remind ourselves of why we care about the banking sector in the first place. Given the roles of credit default swaps, collateralised debt obligations, and other new financial instruments in the recent financial crisis, financial innovation has garnered a bad reputation. But in his contribution, Ross Levine reminds us of the powerful role of financial innovation through history in enabling economic growth and the introduction of new products and providers in the real economy. Financial innovation fosters financial deepening and broadening. Rather than stifling it, we have to harness it for the benefit of the real economy.