Jens Weidmann: Of credit and capital - what is needed for an efficient
and resilient financial system?
Speech by Dr Jens Weidmann, President of the Deutsche Bundesbank, at the IIF (Institute of
International Finance) Europe Summit, Frankfurt am Main, 25 June 2015.
* * *
1. Introduction
Ladies and gentlemen
Thank you for inviting me to speak here before you today.
The former Italian President Sandro Pertini is quoted as joking that speeches were always
harmful. "Before lunch they spoil people's appetite, and after lunch they spoil people's
digestion." With this in mind, I'll try to be brief so that the immediate effect of my speech
should - hopefully - be limited.
But lunch is actually an excellent cue, for it calls to mind one of the fundamental principles of
economics: "There ain't no such thing as a free lunch." Interestingly, though, the phrase was
coined not by an economist, but by the American science fiction writer Robert A Heinlein.
Although it may have come from the pen of a science fiction author, this adage has proven to
be far more durable than many theories put forward by economists. And the fact that you
now have to sit through my speech would strongly suggest that Robert Heinlein might have
been onto something here.
That something is a pretty fundamental insight: that each and every economic decision
involves a trade-off that needs to be factored into that decision. As such, economic
decisionmaking is about weighing benefits and costs, about striking a delicate balance.
Take central banks, for instance. The task of monetary policy is to find the interest rate that
neither chokes off the economy nor causes it to overheat. Only in balance will inflation be low
and stable - and this is usually a central bank's mandate. Economist Knut Wicksell termed
this rate the "natural rate of interest".
And striking the right balance is the core challenge with regard to another central bank
function as well - its role as lender of last resort. Overly restrictive provision of liquidity in
times of financial turmoil might fail to quell the upheaval - possibly causing a conflagration.
But providing too much liquidity for too long might end up causing problems as well. If
nonviable banks are kept on life support with central bank money, they will go on to make
evergreen loans to non-viable companies - a situation which heightens the risk of future
problems in the banking system. And if the liquidity is channelled towards sovereigns that
find it otherwise hard to access the markets, we run the risk of blurring the lines between
monetary and fiscal policy.
Greece is a case in point here. The emergency liquidity assistance (ELA) - which was
originally conceived as a temporary source of liquidity for financially sound banks in return for
good collateral - has been provided for a protracted period of time and has become the
banks' only source of funding. This casts doubt on their financial solidity. The latter is
especially undermined by Greek policy decisions that have sparked capital flight and
largescale cash withdrawals.
Banks receiving ELA should be urged to do their utmost to improve their liquidity situation
and be prevented from worsening it further by rolling over illiquid T-bills of their sovereign.
Against this background, it should be clear to all the parties to the current negotiations that
the Eurosystem must not provide bridge financing to Greece even in anticipation of later
disbursements. When banks without access to the markets buy debt of a sovereign which is
likewise locked out of the market, taking recourse to ELA raises serious monetary financing
concerns.
Respecting the core principles upon which our monetary union is built is not a matter of
dogmatic German stubbornness, but a key policy condition for long-term economic prosperity
in the euro area and for maintaining popular support for the historic project which European
integration no doubt is.
Besides the balance that monetary policymakers themselves have to strike, there is another
state of balance they count on to maintain price stability - a well-balanced financial system.
2. Credit and capital: Competition or complementarity?
Let us have a closer look into the relationship between bank-based financing and
marketbased financing. Does one detract from the other, or can one deliver benefits where the other
one comes up short? To put it succinctly: Are credit and capital competitive or
complementary?
The debate on the superiority of bank-based or market-based financial systems is decades, if
not centuries old.1
One notable development that sparked this debate was the differences in growth between
Germany and the UK in the late nineteenth and early twentieth centuries. Some argued that
it was the pre-eminence of banks and their close relationship with their clients that facilitated
the rapid growth of Germany's manufacturing industry. Others pointed out that while
manufacturing growth in Germany was faster, overall growth rates were broadly the same.
Similar arguments are being made today. In general, proponents of the bank-based system
argue that banks are better suited to dealing with information asymmetries, as their
longstanding ties with their clients allow them to glean information about firms and managers.
This information leads to more efficient capital allocation and better corporate governance.
The long-standing ties of banks to their clients deliver a quality of information exclusively to
the bank. Naturally, it is inclined to keep this information to itself. In contrast, financing via
capital markets quickly disseminates information on firms, as Joseph Stiglitz2 pointed out.
This may, however, stunt incentives for the individual investor to acquire private information
on the soundness of creditors.
Proponents of market-based systems make the opposite claim: large and liquid financial
markets strengthen rather than weaken incentives to gather information about a firm, as the
information can be used on a grander scale.3
And rather than banks' using their private information on firms to channel resources to those
which are most productive, they might use the information to shield their existing clients from
competition.4
At first sight, the two views seem irreconcilable. On closer inspection, though, the
contradictions begin to disappear - regardless if one takes the perspective of the individual
firm or a broader macroeconomic view.
Whether a bank credit, a bond or an equity issue is preferable from the perspective of the
individual firm depends to a large extent on what stage the firm is at in its economic life cycle.
Or put simply: If it is an innovative start-up, it might benefit from the expertise of a venture
capital fund. If it is a small firm with long-standing ties to its bank, chances are that a bank
credit is best. But if it is a large, developed firm, a bond issue might be the route to take.
So from the perspective of the individual firm, the answer to the question "credit or capital" is
"it all depends". But maybe the answer is more clear-cut when taking a systemic
perspective?
Well, there are some indications that market-based systems might be more procyclical than
bank-based systems.5 The more pronounced asset price booms and busts in market-based
systems might be the explanation for that. But we know from the extensive literature on the
financial accelerator effect that procyclicality besets bank-based systems as well.
And while research conducted by the Bank for International Settlements has shown that
bank-based systems are more effective in smoothing the impact of "normal" business cycle
fluctuations, market-based systems allow for a speedier recovery after financial crises.6 That
the US economy made up lost ground more quickly than Europe after the Great Recession,
even though the crisis originated in the US, is a case in point.
Therefore, the answer to the question is not an "either/or". From a macroeconomic
perspective, credit and capital are complementary. Little would be gained by simply
substituting one leg for another. We need to supplement Europe's financial system, not
supplant it.
This does not mean that the European financial system of the future will look exactly like the
American one, for instance. The structure of the financial system reflects the corporate
structure of an economy - and in an economy with a comparatively high share of small firms,
like the European one, one would expect a prevalence of bank-based financing.
Another question is whether the large proportion of very small firms in Europe is optimal.
Research strongly suggests that the answer is no: Larger firms are, on average, more
productive and are better placed to compete in export markets.7
Unfortunately, the growth of small, innovative enterprises is hindered in some European
countries by a plethora of red tape that kicks in when firms reach a certain size.
In France, for instance, many regulations become binding when a firm reaches a size of
50 employees.
Other size-contingent regulations exist in other countries such as Portugal or Italy, where the
threshold is 15 employees. What these regulations all have in common is that they deter
firms from expanding. Therefore, they are a drag on growth.
Structural reforms that remove these barriers are urgently needed. But they will only have
their full effect if firms can find a suitable form of financing as well. And this is why we need to
remove the impediments to a fully integrated European capital market.
3. Capital markets union
These impediments still abound, and some of them are addressed by the European
Commission's proposals for the design of a European capital markets union: the market for
high-quality securitisation is one example. Other areas for early action include private
placements, crowd-funding or the harmonisation of prospectuses.
Eliminating these impediments would be a step forward towards a more prosperous Europe,
which is why the Commission's initiative deserves our support.
With a view to the longer run, however, we will probably need to go further. Harmonising
insolvency laws across Europe, for instance, would improve the integration of capital markets
as well - and of venture capital markets in particular.
3.1 Tax deductibility of interest
In addition to the existing impediments, the development of equity markets in general suffers
from what the Economist has recently called "the great distortion at the heart of the world's
economy": the preferential tax treatment of debt vis-à-vis equity. While interest is
taxdeductible, equity is not. Removing this bias in taxation would encourage companies to
strengthen their equity base.
And this is not only important for the development of equity markets, but spills over to the
other side of the financial system, i.e. banks. A study8 by IMF economists suggests that
abolishing the preferential tax treatment of debt would raise average unweighted bank equity
by 2.2 to 4.2 percentage points - implying no less than a doubling of the leverage ratio.
Even though the authors caution that the effect is likely to be lower for the biggest banks,
these numbers are sizeable 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 boost
to financial stability.
3.2 Improved risk-sharing
But in Europe, in particular, the benefits of stronger equity markets extend even further. It
might be the single most important step we can take towards bringing Europe closer to an
optimal currency area.
Economists like Robert Mundell and Peter Kenen have highlighted the importance of
effective risk-sharing arrangements for the functioning of a monetary union. In public debates
the most frequent (and most contested) proposal is to strengthen fiscal risk-sharing
arrangements. But this debate runs the risk of missing the bigger picture.
In the United States, for example, studies9 show that fiscal policy cushions only 10% to 20%
of economic shocks, so that a local income shock does not translate into a drop in
consumption to the same extent.
Integrated capital markets play a far larger role - especially integrated equity markets, which
smooth out around 40% of the cyclical fluctuations among the US federal states. Another
share of around 25% is cushioned via the credit markets. Altogether, around 80% of a given
economic shock in the US is absorbed before it can affect consumption. Studies for Canada
yield similar results.10
In Europe, the picture looks different. Here, it is mainly credit markets that cushion economic
shocks - and they are not very effective in doing so. Altogether, only around 40% of a given
shock is absorbed before it can affect consumption.11
Increasing the share of capital markets and integrating them across borders would therefore
help improve risk sharing in Europe and also protect monetary policy by containing economic
divergence.
The recently published "Five Presidents" report on the future of the euro area underlines the
importance of capital markets with regard to strengthening risk-sharing arrangements, too.
The report also proposes establishing a fiscal risk-sharing mechanism in the longer run. But
extending common liability would have to be balanced by a commensurate shift towards
European control; otherwise, the incentives for fiscal prudence will get out of kilter. Here, the
sequence is of the essence: Shifting fiscal control and intervention rights to the European
level must come first; after that, the mutualisation of liability may follow.
But let's be frank here - the Greek drama has eroded public and political support for further
transfers of national sovereignty to the European level as it has raised doubts over some
parties' determination to assume their responsibility for preserving European monetary union
as a stability union that is firmly grounded on a set of commonly agreed rules. So it's crucial
for further solidarity to be linked to a strong conditionality and for agreements to be adhered
to. This holds true not only because the root causes of the Greek problems will otherwise
never be fixed, but also for the stability of monetary union itself.
By the same token, a European deposit insurance system seems feasible only if the policy
areas that influence the health of banks are European responsibilities. Otherwise, it will open
the door to a situation in which the burden of bad national policy choices can be shifted to all
Europeans creating severe moral hazard problems.
4. The sovereign-banking nexus
Ladies and gentlemen, strengthening capital markets will bring about tangible benefits only if
we reduce barriers to their functioning, not if we introduce new distortions to shift activity from
banks to markets.
By the same token, the regulation of banks will produce lasting success with regard to
fostering financial stability only if we harness the disciplining forces of the market. Implicit
subsidies and bail-out expectations have to be a thing of the past. As Bank of England
Governor Mark Carney has put it: "To make the system fairer, the days when banks
privatised gains but socialised losses must end." Eventually, this means tackling the overly
tight embrace of banks and sovereigns, as this compounds the issue of systemic relevance.
The Basel III liquidity and capital requirements as well as the recently introduced resolution
regimes are major steps towards cutting off the channel of contagion from banks to
sovereigns.
In Europe, the banking union that includes the SSM and the SRM goes a long way towards
making it more likely that stumbling banks will not be rescued at the taxpayer's expense.
In Germany, the government has presented draft legislation specifically designed to boost
German banks' bail-inable debt and steps in this direction are welcome.
But if we want to sever the link between banks and sovereigns for good, we need to stop
contagion from sovereigns to banks as well. And this means ending the preferential
regulatory treatment of sovereign debt.
In the past, the call to end the preferential treatment of sovereign debt was dealt with in the
same way as some people see taking out the garbage. We all know it has to be done some
time, but for now, let's pretend the chore doesn't exist. Unfortunately, at least in the euro
area, things have started to get smelly.
In contrast to other jurisdictions, the Eurosystem is, for good reason, forbidden to act as
lender of last resort for governments. The risk profile of euro-area sovereign debt is therefore
different - and Greece illustrates that. Acknowledging this fact with regard to regulation
would make the monetary union more stable, as sovereign restructuring would cease to be a
systemic event.
To achieve this aim, 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 the fact that the regulatory treatment of sovereign debt was acknowledged as a
major topic by the G7 finance ministers and central bank governors at our meeting in
Dresden and that it is now being discussed by the Basel Committee. While it is sensible to
conduct this review in a "careful and holistic manner", this should not be allowed to lead to
procrastination.
5. Banker's code of conduct
Adequate regulation is crucial if we are to strengthen the leg on which Europe's financial
system has hitherto rested. But not everything can be dealt with by regulation. It is a bank's
culture that lays the ground for misdemeanour. And the influence of regulation on a bank's
culture is indirect and limited at best.
Out of enlightened self-interest, banks should take the initiative and do everything possible to
establish a culture in which responsibility is rewarded and recklessness rejected. A banker's
code of conduct, for instance, might be helpful in this respect. Introducing a voluntary
selfcommitment might overcome banks' qualms about embracing cultural change within their
respective institutions.
Still, Mark Carney is also right in saying: "This is a major opportunity for the industry to
establish common standards of market practice. But if firms and their staff fail to take this
opportunity, more restrictive regulation is inevitable."
6. Conclusion
Ladies and gentlemen, let me conclude.
The crisis has shown that Europe's one-legged bank-based financial system could do with
another fully developed leg - market-based finance.
Doing away with the impediments that hamper the full integration of European capital
markets is key not only to diversifying sources of funding in a crisis, but also to strengthening
the risk-sharing arrangements a monetary union requires.
By the same token, the regulatory gaps that still amount to implicit subsidies for banks must
be removed once and all without allowing the emergence of unregulated systemic entities
elsewhere.
Banks provide important services to society, and many banks do not deserve the reputation
the banking industry has gained during the crisis. However, unless banking becomes an
industry that is more similar to others with regard to market entrance, exit, and power, further
regulatory steps are necessary, especially in terms of resolving the "too big to fail" issue.
Thank you for your attention.