“Bankruptcy of a financial institution should not be a taboo”
As personal adviser to Wim Duisenberg, the first president of the European Central Bank (ECB), Dr. Lex Hoogduin played a key role in the introduction of the euro. He is professor of monetary economics and financial institutions at Robeco and since 1980 has worked in different roles at the Dutch Central Bank, including executive director to the governing board from 2009 till 2011. In this interview Dr. Hoogduin gives his views on the origins of the financial crisis, Basel III and the tension between micro- and macro-economics.
If you were the minister of finance today, what measures would you take?
“I would look for ways to restore the financial buffers and would, at the same time, let the financial sector play an important role in improving the economic outlook. It is all part of a broader theme: restoring confidence in the financial sector. Confidence has been seriously shaken – the relationship between government, financial sector and society definitely needs to be improved.”
How can confidence in the financial sector be restored?
“It will not be easy, but I would engage in a dialogue with the financial sector and work to move away from the animosity that still exists. Government should be consistent with its message that the financial sector is pivotal for outgrowing this crisis. But the government must also be willing to make a gesture. The prime focus is on banks and their stability, but there has to be more than just stability. I cannot help thinking that while the current measures might have been very useful in 2005, they may now – should we not be more careful – be counterproductive instead of supportive to recovery. Imposing overly rigid regulations on the banks, for example, will not lead to recovery. I would therefore be careful about adding new measures such as the banking and transaction taxes, which for sure I definitely would not do.”
On the road to recovery, is there too much focus on banks?
“One should look at the broader picture. One of the key issues we face is the impact of Basel III and our general aversion to risk on the long-term financing markets. As regards the Dutch financial markets, in my opinion a larger part of institutional capital could be used for long-term funding. That simply is part of the sector’s DNA.”
Pension funds for example, should then provide long-term funding?
“Yes, more than they are doing today, but without making it mandatory. When you look more closely at that sector, many things have changed in the past decades. The majority of the large pension funds invest a lion’s share of our savings abroad From the perspective of an individual pension fund that might be – for reasons of diversification – very logical. The consequence of this on a macro level is that we save a fair portion and create major surpluses on our trade balances with foreign countries. At the same time the government and the banking sector grow dependent on foreign wholesale markets for their funding. This creates systemic risk that makes the Dutch economy more vulnerable since foreign financiers are in general more sensitive and withdraw more easily. All in all we have created a more vulnerable financial structure and I wonder if we have not gone too far with this diversification. This systemic risk is the risk for the taxpayers – pension funds do not take that into account when making decisions
Does diversification mean a risk for the system?
“In the last 30 years the financial sector has exploded. There has been a movement towards ‘modern investment theory’ with a large emphasis on diversification. Because of this many parties invest in the same way and use the same models. From a micro perspective that is fine, but when everyone responds in the same way on new information the macro effects may be quite different. Liquidity at such moments will evaporate. The market will function better when more parties take decisions independent from each other. Therefore, it is mandatory to assess the financial market as a whole. From this point of view, Basel III is not the conclusive response. There are plenty of examples when on a micro level the outcome is positive, while on a macro level the same decisions do not make sense. On a micro level you may want to restore capital buffers, while on a macro level you would argue: we have built buffers, now is the time to use them.”
“Both Basel III and Solvency II stand in the way of thinking ahead”
In addition to micro versus macro, is the issue not predominantly one of short-term versus long-term?
“That is correct, in essence the response at micro level is that one becomes more careful and focuses more on the short-term. The demand for more liquidity is really just taking the short-term perspective. The concept underlying the Net Stable Funding Ration (NSFR), part of Basel III, was to finance ‘long’ with ‘long’ But when long-term funding becomes problematic, due to its association with higher risk, funding will shrink. For banks this is a problem. If we could keep a part of the institutional wealth within the Netherlands and we could direct that towards long-term funding, the bottleneck can be cleared, because banks are simply bypassed It is a paradox: the crisis came about due to too many short-term gains, but the mitigating measures seem to encourage maintaining this short-term focus. Both Basel III and Solvency II stand in the way of thinking ahead. I think this tension between micro and macro has the biggest impact in the area of liquidity: if everyone has to comply with the same liquidity requirements and starts making the same assets liquid, the individual banks will be fine, but the system as a whole becomes more vulnerable.”
How about banks that cannot comply with these higher buffer requirements, because they already have problems?
“Supervision on a micro level will continue, so the bad apples in the basket will remain in view. I strongly support the view that banks should be able to go bankrupt. The system as it was, a kind of ‘constructive ambiguity’ whereby banks could go to almost any private institution for assistance, does not solve all problems. You cannot take away moral hazard completely. Additional buffers, with capital that can also be obtained from non-shareholders, will make banks less dependent on government support. Restoration plans with the purpose of making this ‘constructive ambiguity’ more credible are the right foundation and this should remain so. The issue is that there can be cases that spread through the system like an oil spill and that may create such damage that it becomes rational for the government to intervene. The chances such cases may occur should be made as small as possible. In any case it should not be something banks can rely on; when government intervenes, it is never a pleasure. Looking at the costs incurred as a consequence of this crisis, one should realize that there are macro-economic consequences that by far exceed the costs of the assistance governments have provided to the banks Missing out on six years of growth, at a rate of 2% per year, will cost 70 billion a year. Nevertheless, the bankruptcy of individual financial institutions should not be a taboo.”
Would Basel III have been able to prevent or dampen the effects of the current crisis?
“You can never know for sure. In essence Basel III means higher buffers. It does not mean lower risks. However, buffers would have to be correlated to the risk taken. More parties will split the bill of the accumulated risk. It is as yet unclear how this will work out. It makes parties less vulnerable to shocks in the system. When something happens, time can be bought to solve the problem. The ripple effect to other parties will also be less – they also have buffers. The problems in the US housing market, for example, could have been less virulent if buffers had been in place, or the problems could have been contained on a local level. But in a financial crisis, it is often not just one local market that derails; it was not just the US housing market, but also certain developments in private equity and the wave of mergers and acquisition. Risk premiums were very low – it was a broad movement, with ample liquidity. Can situations like that – that develop over years, not from one day to another – be countered with buffers? Yes they can, but what could also happen is that the train goes on for even longer and the consequences are worse; if the price on the market continues to rise and the buffers reflect a higher value than they really should, the fall-out can be harder at a later moment in time.”
“If we put limits on all innovation, we will create a static economy in which everything is predictable”
And regulation cannot prevent a financial crisis?
“No financial crisis is the same. Why do they arise? I think for two reasons: human nature – herd behavior, greed, looking for sensation – and the fact that the future is fundamentally unknown. (Laughing:) Basel III will not address the first reason. The financial pattern of a financial crisis is that new opportunities arise as a consequence of regulation, deregulation or innovation. That is how real growth, how prosperity, works: we step in, but because we are fundamentally unsure, we cannot objectively calculate the value of these new developments – a price has not been established yet. In addition, that price can rise to unfeasible levels. Moral considerations also play a role, mostly at the end of a boom period: when the market becomes saturated and earlier returns can no longer be maintained. When the market and regulators realize that the party is almost over, then there is market correction. Chuck Prince, former CEO of Citigroup, demonstrated this beautifully in the current crisis: two weeks before the bubble burst, he said: “As long as the music is playing, you’ve got to get up and dance”. And one should. That is how these mechanisms work. You can push back a little with regulation, but if you really want to get rid of these mechanisms, you have to be willing to throw the baby out with the bathwater – so put limits on all innovation. That price is too high; we would then create a kind of static economy in which everything is predictable. We will turn banks into public utility companies that make the same products all the time. That is of course not desirable”
“The ECB is in my view the biggest victim of the European debt crisis”
What is in your view the role of the European Central Bank (ECB)?
“The ECB is divided and is, in my view, the biggest victim of the European debt crisis. The conditions to pursue one monetary policy have not been complied with, because of the differences in interest rates. We have one central bank but the requirements for having one have not been met. By the way, we have not even met the criteria as written down in the treaty itself, including not the agreed convergence criteria. There is no permanent basis, so it is not possible to pursue a single monetary policy. Thus far there have not been real problems because everyone needed a generous policy – the consequences are not yet visible however, but it will be untenable. These differences in interest rates are not caused by the ECB and it cannot solve this problem permanently – governments should do this. But if they don’t, the tension on the markets rises and that puts pressure on the euro. Therefore although it is not her job, the ECB acts and gets dirty hands by doing it – it is a cure with side-effects.
Could you clarify these side-effects?
“The problem arises because of the combination of unlimited access – provided one has collateral – and low interest rates This provides the wrong incentives to healthy banks, while at the same time it obscures the problems of banks that have difficulties and it reduces the incentive to solve those difficulties You can buy time for governments, when at the same time you remove the pressure for them to take measures. It distorts the functioning of the market, it subverts certain corporate models, puts pressure on pension systems and foots the bill in a not-so-transparent way with the individual savers, it blocks change and maybe even creates zombie banks – it is therefore a rather blunt instrument with side-effects. But what else could it do? It is a very unpleasant situation.”
Does it endanger our prosperity?
“No, I do not see how it would. Adding it all up, our prosperity increases because we invent new things; innovations lead to higher productivity. That potential will always be there. We can benefit from the catching up of emerging economies – our economic policy should stimulate the same, get our growth from there. With the lower value of the euro we also see an increase in the export to those regions. Solving the crisis will not be without costs or risks, but I see no reason to be pessimistic.
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