Axel A Weber: International risk sharing and global imbalances
Concluding remarks by Professor Axel A Weber, President of the Deutsche Bundesbank, at
the Bundesbank Spring Conference on "International Risk Sharing and Global Imbalances",
Eltville, Germany, 28 May 2010.
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1. Introduction
Ladies and gentlemen,
Before this spring conference on "International Risk Sharing and Global Imbalances" comes
to an end, I would like to thank you for your contributions, your interesting papers and your
enlightening discussions. For me as a central banker and a former academic, the conference
was highly stimulating. The topic of the conference was well chosen, as there is a continuing
debate on the role of global imbalances and international financial integration as an amplifier
or even a cause of the current financial crisis.
There is no doubt that the degree of international financial integration has determined the
size of the crisis and the speed with which it has spread. The quick spillover of the financial
turmoil from the US housing market, where it started in the summer of 2007, to financial
markets all over the world and the fact that virtually all industrialised countries have been
affected are unprecedented. A more subtle question is the extent to which financial
integration and global imbalances contributed to its emergence. However, this question
cannot be addressed without looking at deficiencies in the structure of the financial market
such as developments in the risk transfer process and regulatory failure, which have been
rightly identified as the major causes of the financial crisis. Let me therefore first address the
interdependencies between financial market integration, global imbalances and the financial
crisis. Thereafter, I will briefly comment on the global reform process, which is under way.
2. Global imbalances in the light of the financial crisis
Opinions differ greatly on the extent to which global imbalances have contributed to the
financial crisis. Whereas some economists believe that the imbalances are not closely linked
to the financial crisis, others argue that they have been one of its main causes. These are
both extreme positions and, as is often the case, the truth may lie somewhere in-between.
The line of argument put forward by Obstfeld and Rogoff is fairly convincing, namely that
global imbalances and the financial crisis have common causes and that international
financial integration was an important factor contributing to the build-up of global imbalances.
It is these causes, not the resulting current account positions, that we should focus on.
Of course, without the integrated financial system, deficit countries would not have been able to
maintain the persistently high private and public spending we observed in the decades before
the financial crisis. By implication, export-oriented countries accumulated unprecedented
amounts of wealth abroad, even though the underlying mechanisms were quite different.
Naturally, in this global setting, financial innovation went hand in hand with the transfer of huge
amounts of funds from surplus to deficit countries. It is important to note that the emergence of
current account deficits and surpluses is not bad per se. For an economy with an ageing
population, for example, current account surpluses and the associated accumulation of net
foreign wealth might well be a reasonable and efficient market outcome as its consumption rate
is expected to grow in the future. As long as the global distribution of production and
consumption reflects undistorted saving and investment decisions that put capital to the most
productive use, it contributes to global growth and prosperity. In the same vein, financial
innovation generally has positive effects, as it provides access to high-yield investment projects
and thereby allows better risk sharing and lifecycle consumption smoothing.
However, we know that in reality both processes have not always functioned that well. The
undervaluation of exchange rates due to fixed exchange-rate regimes in some emerging
market economies as well as the false perception of wealth which accompanied the
emergence of asset price bubbles have distorted the global distribution of production and
consumption and caused a build-up of global imbalances. In addition, the financial crisis has
revealed serious deficiencies in the process of financial innovation and international risk
sharing, which were not only harmful and inefficient per se but also further promoted the
build-up of global imbalances. Instead of reducing risk and increasing transparency, the
process of global capital transfer via highly structured products encouraged savers to
accumulate more risk than they were aware of and than they could afford, which in turn
reduced borrowers' discipline rather than ensuring it. The paper by Mendoza and his
co-author "Financial Innovation, the Discovery of Risk and the US Credit Crisis" presented at
this conference sheds light on the underlying mechanism by which insufficient knowledge
about the true riskiness of the financial environment - which was, as we know today, the rule
rather than the exception in the years preceding the financial crisis - can lead to a period of
over-optimism in the financial markets. In this situation, investors are inclined to
underestimate the deterioration of economic fundamentals and to over-borrow. The following
readjustment, by contrast, may cause a credit crunch, a surge in private savings and
therefore a collapse in consumption.
In the course of the crisis, many of these effects along with a serious economic downturn
could be observed in most industrialised countries. Moreover, global trade declined
dramatically when the financial crisis spread to the real economy, a development which also
hit the previously fairly unaffected emerging market economies. Overall, the extent and the
depth of the recent crisis have raised awareness that the ongoing global integration of
financial markets and economic activities increases the vulnerability of the whole system
despite the unquestionable positive effects with which it is associated. With the stabilisation
of the markets and the incipient recovery, the focus has therefore shifted from managing the
current crisis to preventing future crises. Given the international dimension of the crisis, this
process is rightly taking place at the international level. In the following, I would like to outline
the main elements of the reform process initiated by the G20 in order to create a more stable
financial system.
3. Elements of the regulatory reform process
A cornerstone of the attempt to create a more stable financial system is the reform of
banking regulation. Thereby we should begin with the individual bank ? that is, on the
microprudential level of regulation. The relevant regulatory framework on this level are the
Basel II rules, which have been implemented by a large number of countries. As the crisis
revealed some shortcomings of the Basel II framework, the G20 commissioned the Financial
Stability Board and the Basel Committee on Banking Supervision to work towards a reform of
the current rules. A first set of relevant measures was published in the summer of 2009 as a
direct reaction to the subprime crisis. Among others, these measures include stricter capital
requirements for market risk and securitisation as well as heightened risk management
requirements. Additional proposals were put forward in December 2009. Aiming at enhancing
the resilience of the banking sector, these proposals include a new liquidity standard as well
as a revised definition of capital, which should increase its quality, consistency and
transparency. Apart from that, the introduction of countercyclical capital buffers should help
to mitigate procyclicality. Furthermore, the introduction of a leverage ratio is planned to
alleviate a problem which is addressed in another paper presented at this conference. Tille
and his co-authors highlight the danger which highly leveraged institutions present for
financial and macroeconomic stability in their paper "Rational Risk Panics". Throughout
2010, the proposed measures will be calibrated on the basis of an extensive quantitative
impact study. The fully calibrated set of measures will then be issued by the end of 2010 and
the new standards will be phased in by the end of 2012 provided that economic recovery is
assured.
Although the envisaged reforms will strengthen the existing rules, they will not change their
underlying principles. In essence, the Basel II framework seeks to limit banks' risk-taking
behaviour by making it more expensive and thus less attractive. Against this backdrop,
recent proposals to prohibit certain risky activities altogether pursue a more radical course.
One fundamental problem of such an approach is that the complete prohibition of certain
activities is a very far-reaching market intervention, especially since these activities do not
necessarily have zero economic value-added. Contrary to the Basel II approach, the penalty
imposed on risky activities would become infinite. Thus, given the inherent trade-off between
the efficiency costs of intervention and its benefits, a reformed Basel II framework might
provide a more balanced solution. This is also the case with regard to the introduction of an
additional tax for the banking sector. Even though such a tax could be useful in recouping
some of the costs of the crisis, it is an inferior instrument in terms of internalising the effects
of risky activities on financial stability. Hence, the reform of the Basel II framework is rightly
given preference by regulators and should be implemented with priority by policymakers.
Regardless of its actual design, the general objective of regulation on the microprudential
level is to have a first line of defence by reducing the likelihood of individual bank failures.
However, given our globalised and interconnected world and the interdependence of
financial institutions and markets, even the failure of a single institution might lead to
systemic disruptions. Thus, it is necessary to complement a strengthened microprudential
regulation with a macroprudential stance which as a second line of defence takes into
account the stability of the financial system as a whole. One major aspect of macroprudential
regulation would be the treatment of systemically important financial institutions. Although the
revised Basel II framework is part of a solution to this problem, broader reforms are
necessary. These might include capital surcharges for systemically important institutions,
better resolution regimes as well as a stronger market infrastructure.
On the whole, the G20 agenda is a very ambitious endeavour to strengthen the resilience of
the financial system. Many of the regulations I have mentioned are highly complex, and the
right calibration is very important. Therefore, economic research plays a crucial role in
ensuring the success of the initiated reforms. This is particularly true of the design of
procyclical capital buffers and surcharges for systemically important financial institutions. But
of course there are many other very interesting strands of research, some of which have
been covered at this conference. Quite a few papers aim, for example, to create a deeper
understanding of systemic risk and contagion mechanisms, which are surely key issues
when it comes to dealing with future crises. In their paper "Structural Estimation of Systemic
Risk: Measuring Contagion in the Sub-Prime Crisis", Rigobon and his co-authors have
developed a measure of international contagion which allows us to assess the role of
systemic risk for the global economy.
4. Conclusion
Ladies and gentlemen
Addressing the broader context of global developments which have contributed to the
financial crisis and in particular the role which global imbalances have played, you have dealt
with an interesting but also very complex issue at this conference. This question is far from
being resolved, and I am sure that it will occupy researchers for quite some time to come.
That is not less the case for those strands of research that deal with how to strengthen the
financial system. Seen in this light, times have seldom been as exciting for economic
research as they are right now. I would like to encourage you to continue with your work and
wish you much success.
Thank you for your attention.