Martin Hellwig: The current reforms in the banking sector are not sufficient

06 November 2014

According to Martin Hellwig, Max Planck Institute for Research on Collective Goods, the current reforms in the financial sector are not going far enough. In Hellwig’s view, the 2007-9 crisis could not have been prevented even if today’s regulations had already been in place since 2000. On 22 October, during his lecture at the CFS Colloquium Series “Risk-taking in the European Economy: Financial Institutions and Markets”, he explained that many reform plans had nothing to do with the crisis but had served other agendas like, for example, the implementation of new European institutions, the regulation of hedge funds and short sales, or the financial transaction tax. The reform of capital requirements for banks was still insufficient as well as the reform of bank resolutions.

Although the new European Bank Recovery and Resolution Directive (BBRD) and the implementation of the Single Supervisory Mechanism (SSM) are large improvements, a resolution of systemically important banks that operate across boarders would still cause great damage for the economy. Also, the resources from bank levies and funds were not sufficient to stabilize the system, Hellwig said. As long as it was not possible to resolve banks without damaging the system, it would hardly be possible to get rid of “zombie” banks – banks that are heavily indebted but cover this up by an unrealistic valuation of their assets – and to reduce excess capacities in the banking sector. As long as these overcapacities still existed, banks would have to take high risks to make profits at all.

As it is not possible to properly resolve large banks, prevention is key. However, to appropriately address this issue, the causes of the crisis need to be analyzed first. As opposed to the US, this has not happened in Europe so far. The extent of the crisis was not only due to bad loans, for example for real estate in the U.S., Ireland or Spain, but also to the high interconnectedness and the high indebtedness of banks. Both causes have triggered the crisis in different ways so that also moderate regional losses have endangered the global financial system. The reforms agreed on since 2008 would hardly counteract these developments.

According to Hellwig, the increase in capital requirements for banks by Basel III is small and mostly thanks to “improvements in the management of risk weights” and not to increasing the liable capital. The risk weighting is still not appropriate and prone to manipulation; also, it creates incentives for artificial interconnectedness. When talking about bank liquidity, people would discuss whether mortgage securitizations should be considered as “liquid” or not – even after the experiences of 2007! Little thought has been given to the genuine problem, the dependence of banks on money market funds, and to the possibility of runs to and by money market funds. Structural measures (Volcker, Liikanen) were dominated by nostalgia and illusions: The separation of investment and commercial banks in the U.S. had caused the crisis in the eighties that had nothing to do with investment banking and that was very expensive for taxpayers; Lehman Brothers, as an investment bank, did not have any deposits but still was systemically important. The structural problem would have to be tackled practically. The question was which structures were the best to manage surpluses from customer deposits, to ease the effects of contagion during a crisis and to make bank resolutions easier. So far these questions remain unanswered.