Jens Weidmann: Welcome remarks - Bundesbank conference on debt
and financial stability
Welcome remarks by Dr Jens Weidmann, President of the Deutsche Bundesbank, at the
Bundesbank conference on debt and financial stability, Frankfurt am Main, 27 March 2015.
* * *
1. Introduction
Ladies and gentlemen
I welcome you all to the Bundesbank conference on debt and financial stability. It is a
pleasure to have you here.
The financial crisis and the euro-area sovereign debt crisis have certainly tainted the notion
of debt. Listening to some of the discussions on the economic effects of debt, one could get
the impression that debt is shorthand for "destroying economies big time".
And certainly, the notion that debt can be dangerous cannot be dismissed. Leverage does
seem to be a crucial ingredient for financial crises - what matters most for financial stability
may not be the size of a bubble, but how it was funded.
Seminal work by Kiyotaki and Moore1 as well as by Bernanke, Gertler and Gilchrist2 in the
1990s has shed light on how credit can amplify shocks to the economy. In a downturn, the
deteriorating balance sheets of borrowers and lenders constrict new lending, which in turn
curtails investment and hence worsens the downturn.
So, too much debt can be dangerous. But it remains equally true that debt is indispensable. It
allows someone with an idea but without capital to follow through on that idea, thereby
enabling wealth creation that otherwise would not have happened. Many studies show that
financial development and growth go hand in hand.3
Doing away with debt is not an option. Rather, debt, like so many other economic issues, is
not a question of "yes" or "no", but a question of "how" and "how much" - a Goldilocks issue.
Or, as former BIS chief economist Stephen Cecchetti and his colleagues Madhusudan
Mohanty and Fabrizio Zampolli put it: "Debt is a two-edged sword. Used wisely and in
moderation, it clearly improves welfare. But, when it is used imprudently and in excess, the
result can be disaster."
The question then naturally arises: How much is "just right", to say it in the words of
Goldilocks? Cecchetti, Mohanty and Zampolli4 come up with concrete numbers. They find
that when household debt goes beyond 85% of GDP, it becomes a drag on growth. The
same threshold applies to government debt, while the figure for corporate debt is slightly
higher at 90%.
According to these estimates, in the euro area we are already in the danger zone - at least
with regard to public debt standing at 91% and corporate debt at 105%. Household debt
currently stands at 62%. Some caveats are in order here, though. Correlation does not
necessarily equal causation. Does debt slow growth, or does a slowdown in growth cause
the debt-GDP ratio to rise? The policy implications would be different, depending on what
really drives what.
And identifying turning points in econometric models is a notoriously tricky business. The
thresholds presented by the BIS researchers should probably not be taken as precise
estimates of when growth falls of a cliff, but rather as one more piece of a growing body of
evidence that too much debt can be as harmful to growth as too little.
This growth slowdown can either take the form of a gradual tectonic shift, as high levels of
debt weigh on new investment. Or it can take the form of an explosive eruption, as we have
witnessed during the global financial crisis. And while both forms raise serious questions for
policymakers, it is mainly the latter that today's conference will address, since financial
stability is part of the central banks' remit.
For the reasons I have just outlined, it would probably be a futile undertaking to try to pinpoint
exactly when debt starts subtracting from rather than adding to economic welfare. In the end,
the amount and the form of financial intermediation has to be determined by market forces. It
is therefore all the more important that this market process functions as efficiently as
possible.
And this is where the regulators come in. It is our job to make sure that the regulatory
treatment of debt does not give rise to incentives that endanger financial stability. And it is
our job to make sure that, if things still go wrong, the financial sector can still deliver its
important services to the real economy.
As the financial crisis and the euro-area sovereign debt crisis have shown, there is ample
room for improvement here. In particular, we need to ensure that all actors bear the
responsibility for their respective decisions.
To me, three issues are of special relevance in this regard: the question of bail-in vs. bail-out,
the regulatory treatment of sovereign debt, and the tax preference of debt over equity.
2. Bail-in vs. bail-out
Let me start with a question that has been debated heatedly since the crisis broke out: the
issue of bail-in vs. bail-out.
The financial sector is unique in that a malfunctioning of this sector impairs the functioning of
all other sectors of the economy. And the crisis has served as a stark reminder that a
malfunctioning cannot be ruled out. Some form of protection is therefore called for -
otherwise, innocent bystanders in the real economy will inevitably get hurt.
Depending on the kind of malfunctioning, the central bank might be able to provide the
protection. If the issue is a temporary dry-up of liquidity, it can act as a lender of last resort
and supply the necessary funding - on an interim basis.
But if the issue is one of solvency, then the central bank has no role to play, as taxpayers'
money might be ultimately at stake. Rather, it is then for politicians to decide whether to let a
bank fail or not.
Providing insurance in the form of a bail-out comes with obvious moral hazard problems. If
banks know that they are too big to fail, they are tempted to make the most of this insurance
and take on excessive risks, at the expense of society at large. As the Bank of England's
Chief Economist Andy Haldane put it: "Only in banking do control rights and incentive wrongs
combine so uncomfortably."
Instead of the public providing cost-free insurance for banks, the onus is on banks to insure
themselves against failure. Only then are risk and reward aligned in a way that serves the
public good. Or, as my predecessor Axel Weber likes to say: "We need to put the market
back into the financial markets."
Two aspects are crucial here: the loss-absorbing capacity of banks - that is, their capital -
and their resolvability.
With regard to capital, a lot has already been done. Basel III has increased considerably the
demands for both: the quantity and the quality of bank capital. But will that be enough?
Second, the capital rules that are binding as of today are risk-weighted. As a general rule,
this makes sense: otherwise, banks have an incentive to invest in the riskiest assets. But
risk-weighting also means that there are potentially two ways in which sufficiently high capital
ratios may come about: high equity or low risk weights. If meeting the requirements is based
on the latter, the capital buffer might prove to be a mirage when push comes to shove.
This is why we have to supplement the risk-weighted approach with an unweighted capital
ratio: the leverage ratio. From this year on, banks are required to disclose the leverage ratio.
But transparency alone is not enough. Now, we need to make sure that after a final
calibration, the leverage ratio becomes a binding Pillar 1 requirement by 2018.
But capital shields against losses only up to a point. And in any case, if the business model is
no longer viable, the bank must be allowed to fail - otherwise, incentives are stunted for bank
managers to exercise prudence and to improve efficiency.
Regarding the development of resolution regimes, progress has been made, although in
some countries more so than in others. One crucial issue still needs to be resolved: the
establishment of a common standard for bail-inable capital, the so-called Total Loss
Absorbing Capacity, or TLAC.
Here, it is imperative that this insurance can really be called upon when needed. And this
means that a bank should be discouraged from holding the bail-in debt of another bank, as in
the event of a system-wide financial crisis, the insurance has to be provided by
lessleveraged market participants. Otherwise, the crisis might be spread instead of contained.
3. The treatment of sovereign debt
The importance of realigning risk and return has come to the fore with regard to yet another
issue: the regulatory treatment of sovereign debt, which is the second financial stability facet
of debt I would like to touch upon.
Currently, the proposal to end the preferential treatment of sovereign debt is being dealt with
in the same way as physical exercise is. Everybody agrees it's a good thing in theory. But in
practice, it's very hard to get off the couch.
Hence, as of now, sovereign debt denominated in an advanced country's own currency is still
considered risk-free. Danièle Nouy recently grasped the nettle and pointed out: "Sovereigns
are not risk-free assets. That has been demonstrated, so now we have to react."
I wholeheartedly concur and have repeatedly asked to put this issue on the regulatory
agenda. Sovereign debt needs to be backed by capital, and exposure to a single sovereign
must be capped, just as is the case for any private debtor.
I welcome that the regulatory treatment of sovereign debt is now being discussed by the
Basel Committee. But if these discussions fail to produce an agreement, we need to move
forward with a European solution. In contrast to other jurisdictions, the Eurosystem is for
good reasons forbidden to act as lender of last resort for governments. The risk profile of
euro-area sovereign debt is therefore different.
4. The tax deductibility of interest
As Benjamin Franklin famously said, nothing is certain except death and taxes. But actually,
this timeless quip does not apply to debt. Interest expenses are tax-deductible, while equity
disbursements are not.
How sensitive are banks to this difference in tax treatment? A study5 by IMF economists
suggests that they are as sensitive as any other firm. What does this imply for the leverage of
banks?
The IMF economists estimate that abolishing the preferential tax treatment of debt would
raise average unweighted bank equity by 2.2 to 4.2 percentage points. Even though the
authors caution that the effect is likely to be lower for the biggest banks, these numbers are
sizable by any measure, especially considering that the proposed Basel III leverage ratio is
3%.
Doing away with the preferential tax treatment of debt could therefore provide a major boon
for financial stability.
5. Conclusion
Ladies and gentlemen, debt is like oxygen: indispensable for economic life, but when you
overdose on it, you first get high, and then you faint.
Air quality regulation has made great strides over the last decades, at least in the advanced
countries. I hope we can replicate this regulatory progress with regard to debt as well. And I
am confident that today's conference will contribute to this process.