The Future of Banking

Edited by Thorsten Beck, a new VOXEU e-book has been released on this topic.  An overview is here, while the free download of the e-book is here.

A call for action

A new VoxEU.org eBook, The Future of Banking, contains three headline messages:

  • We need a forceful and swift resolution of the Eurozone crisis, without further delay! For this to happen, the sovereign debt and banking crises that are intertwined have to be addressed with separate policy tools. This concept finally seems to have dawned on policymakers. Now it is time to follow up on this insight and to be resolute.
  • It’s all about incentives! We have to think beyond mechanical solutions that create cushions and buffers (exact percentage of capital requirements or net funding ratios) to incentives for financial institutions. How can regulations (capital, liquidity, tax, activity restrictions) be shaped in a way that forces financial institutions to internalise all repercussions of their risk, especially the external costs of their potential failure?
  • It is the endgame, stupid. The interaction between banks and regulators/politicians is a multi-round game. As any game theorist will tell you, it is best to solve this from the end. A bailout upon failure will provide incentives for aggressive risk-taking throughout the life of a bank. Only a credible resolution regime that forces risk decision-takers to bear the losses of these decisions is an incentive compatible with aligning the interests of banks and the broader economy.

Policy recommendations

There are many policy recommendations, but I would like to point to three:

  • European Safe Bonds: Several authors present the case for a forceful resolution of the Eurozone crisis. Critical of Eurobonds, Markus Brunnermeier and co-authors have proposed an alternative solution in the form of ‘European Safe Bonds’ – securities funded by currently outstanding government debt (up to 60% of GDP) that would constitute a large pool of ‘safe’ assets. The authors argue that these bonds would address both liquidity and solvency problems within the European banking system and, most critically, help to distinguish between the two. ‘European Safe Bonds’ could effectively separate the sovereign debt from the banking crisis, and would allow the ECB to disentangle more clearly liquidity support for the banks from propping up insolvent governments in the European periphery.
  • Capital and liquidity requirements – risk weights are crucial. While ring-fencing might be part of a sensible regulatory reform, it is not sufficient. Capital requirements with risk weights that are dynamic, counter-cyclical and take into account co-dependence of financial institutions are critical. Capital requirements, however, do not work independently, but operate in their effect on banks’ risk-taking in interaction with ownership and governance structures – so one size does not necessarily fit all. Similarly, liquidity requirements have to be adjusted to make them less rigid and pro-cyclical. Though banks are under-taxed, the currently discussed financial transaction tax would not significantly affect banks’ risk-taking behaviour and might actually increase market volatility; in addition, its revenue potential could also be overestimated.
  • The need for a stronger European-wide regulatory framework. If the common European market in banking is to be saved – and the authors argue that it should be – then the geographic perimeter of banks has to be matched with a similar geographic perimeter in regulation, which ultimately requires stronger European-level institutions. Many of the regulatory reforms, including macro-prudential tools and bank resolution, have to be at least coordinated if not implemented at the European level. Critically, the resolution of financial institutions has an important cross-border element to it, which calls for a European-level resolution authority for systemically-important financial institutions.

    • 18 replies on “The Future of Banking”

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    # It’s all about incentives! We have to think beyond mechanical solutions that create cushions and buffers (exact percentage of capital requirements or net funding ratios) to incentives for financial institutions. How can regulations (capital, liquidity, tax, activity restrictions) be shaped in a way that forces financial institutions to internalise all repercussions of their risk, especially the external costs of their potential failure?

    Along these lines, it’s worth mentioning a recent interview of Nassim Taleb, of Black Swan fame. In it he argues that because banks–de facto–will always be bailed out by the state, relying permanently on the taxpayer, they should be treated as utilities and bankers should not earn more than civil servants of equivalent rank. Now in Ireland, that would still be a pretty good deal, but it would still have reined in the banks’ bonus fuelled reckless.

    Taleb argues that because bankers–the employees/managers–never have to face the downside of their actions, they should never face an upside either. It is a question of symmetry.

    Taleb also has a recent interview about how the banks have hijacked the government. There has indeed been a worldwide “Banking Putsch”.(which has taken a frightening turn in Ireland with the recent AGs letter). Whatever we do, we must make sure that the Future of Banking does not see it seize overt control of states across the globe.

    It is time we started looking on banks in their present form as a threat to the state.

    @Philip

    Thank you for taking the time to post a summary of this book as time is a precious commodity which often restricts our reading wishes.

    I am not sure I know the editor but judging by his first name it is probably fair to guess that he may come from one one of the Nordic countries which have already learned quite a bit about banking crises.

    Either way (regardless of the editorś actual nationality) I am sure , judging by your summary, that the book is very interesting and provides some useful information and pointers. IMHO the ponts made about the endgame are especially useful to all stakeholders.

    Best…L

    I understand that in Sweden there is a law which automatically enforces (without opportunity to argue or appeal) state ownership if capital ratios fall below 8%.

    I read a dramatic story in the Economist Magazine a few years ago about how one of the Swedish banks narrowly averted state ownership during the Scandinavian banking crisis. One would imagine the ownership of that bank would not want to repeat the same experience too quickly.

    Not surprisingly Swedish banks try to avoid the “Souper Trouper” when performing their delicate dance steps on the financial stage. Unfortunately the “Baltic” part of their performance is a bit less disciplined and the stage management is often tempted to shine the lights on that part of the dance.

    Equity in exchange for aid was how the government dealt with the crisis in the 90s & during that time there were some jokes about what you’d get for 10 SEK: A hot dog or a certain bank (the market cap was very low).

    The owners of that particular bank did not like the experience of almost losing the bank, they are still in control of that bank & unsurprisingly this bank has avoided most of the crisis.

    That bank has actually had a very good crisis as the government response has been to try to allow banks to earn themselves out of their losses. The government response might have saved banks which did have big losses and it also made this bank even more profitable.

    As for the banks with big losses in the Baltic: Some have been arguing that it doesn’t matter that the bet on the market was won; the risk (it was/is argued) to the bank was too great and should have been controlled better. However, it seems that although many persons in positions of responsibility have been replaced, nobody got fired for the adventure.

    Bad incentives led to excessive risk-taking, however, I think the ones who argue that it doesn’t matter how you measure (& consequently reward/incentivise) performance would disagree. It has been claimed that most economists believe that it doesn’t matter how you measure performance & if that is true then economy truly is a dismal science.

    & just for the fun of it: Some insight into how the Swedish finance minister handles his personal finances:
    http://www.thelocal.se/36940/20111024/
    Does government ministers having negative equity in their homes indicate a housing/credit bubble? 😉

    “Only a credible resolution regime that forces risk decision-takers to bear the losses of these decisions is an incentive compatible with aligning the interests of banks and the broader economy.”

    What is most astoniishng is that obvious ideas such as this and it’s corollary described by OMF above:

    “Taleb argues that because bankers–the employees/managers–never have to face the downside of their actions, they should never face an upside either. It is a question of symmetry.”

    are somehow considered as revolutionary insights. Has common sense become such a rarity in financial circles? It was a revelation to ordinary folk when this crisis broke that this cocooned banking aristocracy with such outrageous pay and bonuses was ever allowed. Recently the much praised (in this forum) regulator Matthew Elderfield was calling fo a lifting of the salary cap on bank chiefs pay. What planet is he on?

    We need banks which are, as Taleb pointed out, utilities – and all the other casino type derivitive garbage should be banned or shifted out to Las Vegas where it properly belongs.

    @ All

    Martin Wolf and Jean Pisani-Ferry are particularly worth reading in the FT this morning, as is the paper by Paul De Grauwe to which Martin Wolf provides a link.

    http://www.ft.com/intl/cms/s/0/bd60ab78-fe6e-11e0-bac4-00144feabdc0.html#axzz1bdAZffj6

    http://blogs.ft.com/the-a-list/2011/10/26/europes-leaders-must-start-making-tough-decisions/#axzz1bs7ag5GQ

    A clearer exposition of the situation confronting European leaders would be difficult to find (although the timing of Martin Wolf’s “open letter” to Draghi could hardly be worse).

    If one were a betting man, the ultimate solution that is likely to be most politically acceptable is one of the options suggested by Pisani-Ferry.

    “Another way is to make the financial system safe by putting limits to the banks’ exposure to their sovereigns and creating a eurozone-wide deposit insurance. It implies that states renounce the convenience of having ‘their’ banks”.

    @DOCM

    “Another way is to make the financial system safe by putting limits to the banks’ exposure to their sovereigns and creating a eurozone-wide deposit insurance. It implies that states renounce the convenience of having ‘their’ banks”.

    While Wolf’s open letter was a good read (Dual mandate Keynesian central banking anyone? It can not be long before Mr Wolf starts wearing a beret.) perhaps a blog devoted to the Irish economy is not the best place to mention Jean Pisani-Ferry’s theory that one of the sources of the current crisis was that banks took on too much sovereign risk rather than the state found itself forced into assuming all national banking risk?

    It seems efforts are still ongoing to rebrand the global financial sector crisis as a global fiscal policy crisis.

    Bankers.

    @ All

    There appears to be some scene-setting going on with regard to the meeting of the European Council and its little (big?) brother, the EZ 17, this evening. Merkel is hardly going directly from her parliament to Brussels to get a bloody nose. And Sarkozy would hardly be reported as making arrangements for his first generalised television address since February tomorrow if he was expecting to announce another failure.

    The idea that everything would be tied up in a neat global package without any loose ends was never a realistic proposition. But there seems to be enough agreed to allow the final final summit to be deemed a success.

    The capacity of the Merkel-Sarkozy duo to get things wrong cannot, however, be underestimated. But Sarkozy has no room for manoeuvre left. Joining in a mutual public put-down of the leader of another country may be now par for the course in a Europe run in the manner to which it has had to become accustomed but not coming from another leader who has to tell his own country – perhaps tomorrow! – that growth will be half of what is expected with a consequent need to raise around another 10 billion euros to meet the 3% deficit target.

    If there has to be some drama, it will probably be around the central issue; the role of the ECB. The leaking of probably the most sensitive sentence in the draft conclusions to Reuters can hardly have helped the atmosphere.

    http://www.reuters.com/article/2011/10/25/us-eurozone-crisis-ecb-idUSTRE79O2KY20111025

    @DOCM

    A rather neat reminder from the Guardian of the great German hang-up.

    I read that article earlier, do you not think that it was a little bit lazy?

    I would suggest that the imagined spectre of hyper-inflation followed inevitably by a disastrous land war in Asia that apparently haunts the German psyche and dominates government policy is just one of those convenient historical explanations for a dominant political viewpoint that helps avoid serious discussion (“Have those who argue for loose monetary already forgotten the Holocaust?” and so on).

    In fact the second commenter in that Guardian blog entry (PhilpD) points to an interesting article by Matt Ygelsias on the same issue.

    http://thinkprogress.org/yglesias/2011/09/14/319468/history-underexplains-german-obsession-with-hard-money/

    @Shay Begorrah
    I agree with you. I think the Germans like hard money because, well, it is hard. It is hard to earn, so once you have earned it, you want it to retain its value while you save up for what it is you want. Of course, if you satisfy your desires with credit, then the softer the money, the better.

    One of the lessons from the Yugoslav inflation – once you get your salary, spend it immediately. It doesn’t matter what on. You can swap what you buy for other things (don’t buy perishables, clearly!). Pay all your bills by cheque by post. By the time they are cashed, they cost you nothing.

    @ Shay Begorrah

    Hang-ups, by definition, defy explanation.

    Draghi obviously agrees with the view that the German hang-up in relation to inflation is misplaced.

    The ECB has the gun, the ammunition and clearly the willingness to fire it as the necessary majority exists in the governing council.

    The really intriguing question is whether the German “establishment” agree with this view but does not wish to be seen to be taking political responsibility for it.

    The substantive question is whether the markets share this view.

    @Jesper

    Thanks for that link.

    Actually that link also includes two short interesting articles about banking and Swedish Government concerns regarding the Euro dated 19th October and 12th October which readers may find interesting.:)

    At the risk of sounding stupid, I wonder whether people have considered getting rid of deposits.

    In particular, why do we let people hold large deposits?

    What would the cost be of simply, by law, getting rid of anything but either small deposits or one year financing or at least putting all large deposits junior to senior debt?

    Clearly banks play a role in maturity transformation and this facilitates investment.

    But lets say, outside the box for a minute, you just said that the distorting effect of insuring these deposits is too high versus the benefit gained.

    I mean, what is the difference, in practical terms, between a tradable/liquid five year bond and a deposit.

    The fact that it can be redeemed within three months vs redeemed in a year is only really of commercial value when the bank is facing insolvency or you can’t trade the right to repayment, (and the only time you wont be able to trade it is when the bank is facing insolvency).

    If the bank is facing insolvency well, tough luck – take more care placing your deposit.

    Basically, given that bank bonds can be traded in liquid markets, why do we tolerate investors (as opposed to retail guys) putting money on deposit?

    In other words, is the funding of banks by deposits, and the insurance thereof, just an historical accident that flows from the fact that in the past there was no secondary market for loans/deposits to banks

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