If you are interested in critical economic analysis and thought-provoking new approaches please read Welfens, P., Issues of modern macroeconomics: new post-crisis perspectives on the world economy, in: International Economics and Economic Policy, Issue 4, 2014
Prof. Dr. Paul J.J. Welfens, Jean Monnet Professor for European Economic Integration; Chair for Macroeconomics; President of the European Institute for International Economic Relations at the University of Wuppertal (EIIW, Rainer-Gruenter-Str. 21, D-42119 Wuppertal; +49 202 391371), Alfred Grosser Professorship 2007/08, Sciences Po, Paris, Research Fellow, IZA, Bonn;
Non-Resident Senior Fellow at AICGS/Johns Hopkins University, Washington DC
EIIW 2015 = 20 years of award-winning research October 30, 2014
Welfens has testified before the US Senate, the European Parliament, the IMF
Banking, Capital Markets and Stagnation Problems in the EU
In the wake of the Transatlantic Banking Crisis policy makers have had good reasons to impose tighter regulation on banks since so many big banks in the US, the UK and some Eurozone countries had engaged in excessive risk taking; not to mention cases of market manipulation concerning certain interest rates and exchange rates. Without doubt, many big banks should face sanctions and effective penalty payments for grave misconduct over many years. However, there is no reason to impose excessive regulation on banks and to thereby trigger enhanced regulatory arbitrage which will stimulate the expansion of shadow banking. Moreover, if there is excessive regulation of banks, this will not only raise the cost of banking but it will undermine the prospects for growth in credit and investment, respectively. Careful and adequate regulations are required along with the implementation of the new Basel III rules. While more regulation in certain fields of banking naturally is adequate, one also could remove much regulation if the three main problems of the Transatlantic Banking Crisis could be solved:
- Banks generated excessive risk in the context of an originate and distribute model which did not involve sufficient risk-taking by the bank itself: Too many loans could be packed by the respective bank in an opaque way into Asset-Backed Securities (ABS) and too many ABS easily obtained AAA rating by the leading rating agencies so that the pricing of risk was flawed in 2003-06 (this mispricing was strongly visible in the US corporate bond market as has been emphasized by Goodhart: Journal International Economics and Economic Policy). As long as the rating agencies quality of work has not seriously improved, this problem will remain and better quality hinges on the creation of at least one major rating agency in Europe, preferably on the basis of a scientific consortium of research institutes that would work under the umbrella of a Eurozone/EU Rating Foundation. Governments of Germany, France and other EU countries could sponsor such a scientific foundation and this is a field of joint policy initiative that should easily find consensus Berlin and Paris. Given the dominance of bank financing in the Eurozone compared to the US, it would be desirable to give impulses for the growth of capital markets as well as bank lending.
- According to recent empirical analysis, the integrity of banks as underwriters has a significantly positive impact on the rating of corporate bonds placed in the market by the respective banks. Regulations should require banks to publish codes of conduct on their websites and to report on integrity (for example in the case of balance-sheet restatements). By encouraging the quality dimension of the competition process in the banking sector, capital markets and banks’ business can be stimulated and here individual EU countries as well as the European Commission should be more active.
- The behavior of some of the managers of big banks was doubtful in the run-up to the banking crisis and characterized not only in certain banks by breaching rules but also by visible short-termism combined with the adoption of unrealistically high targets for the rate of return on equity. As regards the problem of short-termism, the easiest way to correct this would be to introduce a tax on the volatility of the rate of return on equity so that bank managers would have strong incentives to more carefully consider which long-term bank products and expansion strategies are sustainable. EU countries could easily adopt such a new tax – possibly on the basis of a bonus/malus system.
The Banking Union has created a new framework for financial services in the Eurozone and the EU; and the stress test results from October 2014 – plus the results of the asset quality review by the European Central Bank – signal that the Eurozone’s major banks need some adjustment measures. However, the overall picture on the European banking sectors’ leading banks is rather favorable and policymakers would be wise to encourage the expansion of capital markets and banking business as a basis for more investment in all euro countries. Policy makers should not forget that excessive regulation can critically reduce overall lending and investment by firms; this in turn will contribute to lower growth, tax revenues and employment.
As much as insufficient regulation has been a problem prior to the banking crisis, the wave of new regulations in the banking sector in Germany and many other EU countries seems to be an overdose of intervention. The micro-regulation of banks is unnecessary and not contributing to a better quality of financial products and efficiency gains. Such gains should be expected from more long-term competition and a better setting of innovation standards in the financial industry. So far, the banking sector can make all kinds of innovations, however, there is no standardization, no patenting and no established procedure for evaluating financial innovations. Here reforms are urgent.
Insurance companies and banks could have a bigger role for investment financing in trans-European infrastructure network projects if there would be common standards for joint private public partnership (PPP) financing of big infrastructure projects. The main interest of governments could be not only to obtain additional private sector financing but also to get rid of critical risk, e.g. operational risk. The largely negative critique against PPP by the Federal Court of Auditors (Bundesrechnungshof) in Germany is not adequate, since ex post evaluation of project performance is easy while the adequate point of reference are the perceived risks and expected cash flows from the project; the typical view of the Bundesrechnungshof to fully ignore the expected risks in major infrastructure projects is an analytical pitfall from an economists’ perspective. If there would be more PPPs at the EU level, this could also be a natural starting point for supranational euro bonds. Whether or not those would later be a basis for quantitative easing by the ECB in the Eurozone is an open question. If such supranational bonds are to be launched, one should do this on the basis of an exclusive long-term maturity spectrum – member countries of the euro area should skip this specific range of maturities and rely both on more medium-term and more very long-term financing. Such an approach would allow to jump-start a highly liquid supranational bonds segment; the additional backing of such bonds through reserves/gold would be useful.
The US economic recovery after 2009 has been much stronger than in the Eurozone. The cumulated transatlantic growth gap in the period of 2008-2015 (forecast values) is about 10% for the comparison between the US and Eurozone. Based on the US recovery, one may argue that there is a lack of about €1,000 bill. between 2008-2015, or about €1,000 per household. Reforms in the US banking sector, the restructuring of banks through the USFDIC – some 450 between 2008 and 2013 – and the established capital market lead of the US have contributed to the stronger US recovery. The EU and Eurozone countries should quickly draw major conclusions from these observations. Excessive regulation in the EU will contribute to stimulating the growth of the shadow banking system and will generate insufficient credit growth for a strong recovery.