Mr Meister reviews the subject of bank insolvencies and moral hazard
Statement by Mr. Edgar Meister, a member of the Directorate of the Deutsche Bundesbank, at a
symposium hosted by the University of Frankfurt on 1/2/99.
One of the pillars of our market economy is the fact that entrepreneurs are personally responsible
for their business activities. Generally, this principle also applies to banks. However, banks, as
financial intermediaries and providers of financial services, play a special role in an economy. A
crisis of one major bank, let alone the whole banking system, would have a serious impact on
economic activity, and this also goes for the real sector. But then again, the special role of banks
must not be interpreted to mean that bank boards can count on government support in
emergencies. If they could, the risk of a precarious situation in the banking sector would increase
even more. This would create a "moral hazard", which would result in banks taking excessive
risks in order to obtain higher returns, in the confidence that they could rely on government
support in the event of a failure.
Banking supervisors must try to prevent both scenarios - serious external effects of bank
insolvencies, for one thing, and moral hazard, for another - from happening. The crisis in
South-East Asia has shown that government guarantees and expectations of international
assistance - which were met in the end - can lead to serious misalignments in a crisis situation
(To quote Tietmeyer: "Do not display too much money in the shop windows").
Avoiding crises must be the prime concern. Efficient banking supervision can make an essential
contribution to this objective. Supervisors should be guided by the principle: "As much
entrepreneurial leeway as possible, yet as much state supervision as required". There have been
some recent proposals to confer more supervisory tasks to the private sector (G30). In principle,
increased mutual monitoring among the banks, and hence a strengthening of market discipline, is
a welcome idea. Nevertheless, conceptual and practical problems should not be overlooked. For
instance, more self-regulation by the market participants implies a transfer of legislative powers,
but it does not mean that responsibility for resolving systemic crises would also shift to the
private sector.
State supervision will remain necessary as long as systemic risks exist which cannot be limited
sufficiently through preventive measures or eliminated within the context of market control.
Besides, the self-regulation model, inter alia, assumes that the financial sector is highly
transparent for the market, e. g. regarding in-house procedures, which is hardly feasible.
Allow me to briefly outline the German prudential approach:
• Banking supervision is guided by the principle that a bank's management is responsible for its
business decisions. Therefore, banking supervision in Germany does not actively intervene in
banking activities, i. e. by making specific recommendations.
• From the central bank's perspective, I would like to stress that it cannot be the task of a central
bank to bail out insolvent credit institutions. The Ministry of Finance would be responsible for
that, if tax revenue were required for assistance measures. But even cases such as financially
sound institutions merely having liquidity problems should, if possible, be resolved with the
help of private or semi-private lenders before reaching the gates of the central bank. The
Liquidity Consortium Bank in Germany is such a "lender of penultimate resort". In addition to
the three categories of credit institutions, the Bundesbank also has a stake in this Consortium
Bank, and it provides refinancing against collateral. Apart from that, the Bundesbank has not
committed itself in a binding manner to take action in the event of a crisis. It would also be
desirable if a liquidity consortium bank or comparable institutions were established in other
European countries.
• If it were not possible for the creditworthiness of an institution to be restored either by other
institutions or with the help of the deposit guarantee scheme, having that institution exit the
market would, in general, be a feasible consequence. However, if such a step posed a serious
threat to the stability of the banking system, i. e. if the institution in question were "too big to
fail", a joint solution would have to be found by all the private market players and public
bodies concerned. Already the number of institutions we must consider to be "too big to fail"
has risen in the recent past, and further mergers will cause this number to keep rising. Mergers
of global players do not only raise new questions in banking supervision. They also pose the
risk that size leads to moral hazard effects. For precisely this reason, each crisis must be
assessed individually. The key principle is that the government's response must not be
predictable and that private market players should be involved in potential rescue operations
to the greatest possible extent.
• The recent financial crises have been increasingly drawing attention to international crisis
management. In my opinion, the aforementioned principles should be applied in this context,
too: there should be no explicit or implicit government guarantees regarding the solvency of
the respective banking system; temporary liquidity crises should be resolved, wherever
possible, before government intervention becomes necessary; the private sector should be
comprehensively involved both in crisis management and in loss-sharing.
International support measures must always remain an exception and never become the rule.
•
Under no circumstances should private investors be able to rely on public bodies to assume
their losses in the end. Instead, I believe it would be desirable to create an international
liquidity safeguarding fund made up of the major global players, which would also have the
most to gain from a largely deregulated and sound financial system. This will not be an easy
undertaking, since there seem to be few incentives for a bank to assume other institutions'
risks. Nevertheless this road should be taken in order to strengthen market discipline. I believe
that membership in a club comprising the major global players would be a special quality
which could actually become attractive for those institutions. Besides, it seems quite
conceivable that banking supervision might be willing to grant those institutions more
selfregulatory powers.
The case of the Hedge Funds LTCM proves that the private sector can find solutions without
having recourse to public funds. At that time, the Federal Reserve Bank of New York was only
acting as an intermediary to bring national and international financial institutions together, which
then provided the necessary funds.
The same principle applies both nationally and internationally: moral hazard problems can only
be prevented by emphasising and requiring that responsibility be taken by financial market
participants, and by limiting the intervention of public bodies. Avoiding moral hazard will also
increase the stability of the system and improve crisis management.