More requirements for banks will lower the risk of a new systemic crisis, but the work is not finished yet

28 September 2016

The crisis which has spread around the world since 2008 is said to be mainly caused by ‘systemic risks’ within the financial sector. In his inaugural lecture, Aerdt Houben, professor at the University of Amsterdam (UvA) and director of financial markets at DNB, argued that the financial sector is much stronger now, ‘but we aren’t there yet’.

‘Since the credit crisis emerged, systemic risk has not been an abstract concept any longer’, said Aerdt Houben in the inaugural lecture he held on 16 September 2016 following his appointment as Professor of Financial Policies, Institutions and Markets at UvA Economics and Business. What started with a property crisis in the United States in 2007 turned into a worldwide banking crisis and eventually into a debt crisis in European countries. Nearly nobody foresaw the depth and extent of the crisis. The crisis led to huge costs: it is estimated that the loss is a half-year’s worth of economic production.

Financial systemic risks are caused by the fact that financial institutions are strongly interconnected with each other as well as by the complex relationship between the financial sector and the real economy. After the first shocks in 2007, it became clear that banks could drag each other down because they had been lending to each other on a large scale. After that, lending to consumers and businesses faltered, which led to more problems for the banks.

Since the crisis occurred, policy makers and financial supervisors have worked hard to take measures aiming at lowering the risk of a next systemic crisis. This macroprudential policy comes on top of the already existing microprudential rules – which, incidentally, have been tightened – focussing on the financial robustness of individual financial institutions. Macroprudential supervision is the subject Houben teaches at UvA and which has been his key task for many years now as a divisional director at the Nederlandsche Bank (DNB).

If it were up to Houben, macroprudential measures would be in force on a structural basis. A quick intervention just before a systemic crisis arises is impossible, simply because one cannot foresee such a crisis. ‘The key of financial systemic crises is that they are made up of relations you cannot enter into a model, and which are therefore not predictable’, Houben says when explaining his point in an interview. ‘This is the result of human emotions, herd instincts and the vast self-enforcing cyclical component which is one of  the characteristics of the financial system. The financial system is unstable in itself, so often one does not know whether a movement is going towards an equilibrium, or moving further away from it.’

Extra capital requirements

One of the tools of macroprudential supervision is the extra capital requirement for big and complex European banks which are seen as important junctions within the financial system. Another is that all banks need to maintain more capital when the economy is growing, in order to have an extra buffer for harsher times. Other measures aim to limit the interrelations between banks, try to lower the concentration of banks within a country or set maximum levels for the amount of loans, for example mortgages.

The important question right now is whether the existing and proposed measures are enough to prevent a next crisis. In the run-up to his inaugural lecture, Houben presented this proposition to a wide group of policy makers, economists, employees in the financial sector and the public. Remarkably, the majority of employees in the financial sector think that the measures that have been taken are sufficient, while the majority of economists disagree. DNB supervisors are divided in their opinion.

In line with his colleagues at DNB, Houben has a thoughtful answer. ‘Research shows that in most European countries government support for banks would not have been needed if today’s requirements had been in place at the time. Only the governments of Ireland and Greece would have had to bail out banks.’

This result is surely positive, but it does not reassure Houben completely. ‘We are going the right direction with the current measures, but we are still vulnerable. Even if the current measures to manage systemic risks had been in place at the time, no less than one out of twelve banks would have had to be saved. In my opinion, that is still too much. Moreover, the fact that the system can now cope with a shock like the one in 2008 does not mean that  the sector will be able to recapitalise quickly enough to survive a possible subsequent shock.’

New risks 

In a changing economic environment, there are some risks that did not even exist in 2008, or that have risen closer to the surface. One such risk is leakage. Houben: ‘This is the phenomenon of financial agents looking for alternative ways of financing when the requirements for the financial institutions within a country are tight. So the supply of credit from abroad will rise when the supervision is strict.’ Another effect is the emergence of so-called shadow banks. These non-bank financial institutions such as crowdfunding platforms, pension funds and insurers will more actively provide direct loans to households or companies. ‘In itself, it is a positive development that the financial risks are more spread out when these type of institutions are growing’, Houben says. ‘At the same time, however, these institutions are narrowly interconnected with the financial system as a whole and they too are actors contributing to the business cycle. Therefore, these institutions are system-relevant, but they are usually not covered by macroprudential supervision. We have to think a lot more on how to deal with shadow banking.’

Another new type of risk is the severe debt problem of some European countries. This was a result of the banking crisis and puts great pressure on the monetary system. ‘The vulnerability of the monetary union has its effects on financial stability’, Houben says. ‘It became clear that the differences in business cycles between countries are much bigger than we thought.’

According to Houben, the European Central Bank (ECB) is not able to solve this problem, because this institution cannot do much more than impose a single interest level for all European countries. ‘On the other hand it is true that risks of financial instability rise when monetary policy is lax. They are the kind of risks we can reduce with macroprudential supervision.’

Houben emphasises that the announced macroprudential measures have not been fully brought into force yet. ‘The choice was made to implement the so-called Basel capital requirements in phases and have them fully effective by 2019. American banks, however, took relatively tough measures and are ahead of the European banks. Additional research will be needed to determine whether banks which transform themselves quickly after a crisis experience a growth or a decline in lending. I am in favour of quick transformations.’

And even after 2019 there will be work to be done. ‘It is important to take the proper measures. The further the last crisis is in the past, the weaker the urge to take measures becomes, and this can be a danger. We have to create incentives to ensure that these measures will really be taken’, says Houben. ‘At this moment the ECB already has some powers to correct national supervisors. However, the evidence that this is enough to solve the problem is not very powerful. In the last three years the ECB didn’t use its powers even once.’

More information? Email A.houben@uva.nl.

By Bendert Zevenbergen

Published by  Economics and Business