Jens Weidmann: The financial crisis, ten years on - what have we
learned?
Speech by Dr Jens Weidmann, President of the Deutsche Bundesbank and Chairman of the
Board of Directors of the Bank for International Settlements, at Ruhr University Bochum,
Bochum, 22 May 2017.
* * *
1. Introductory remarks
Professor Paul
Professor Roos
Ladies and gentlemen
Students
I'm well aware that I'm not the first central banker to speak before you in the "ikf impulse" series.
Indeed, my predecessor Axel Weber delivered his third-to-last speech as Bundesbank President
here in April 2011.
I, too, will deliver my third-to-last speech today - but that's just for the month of May.
Incidentally, his speech was titled "The role of economic policy after the crisis", which, from
today's perspective, seems somewhat premature - after all, the euro area had not yet put the
crisis behind it at that time. Quite the opposite, in fact - the crisis had yet to come to a head in the
euro area. As the situation in Greece and other member states progressively worsened, some
even went as far as to question the continued existence of monetary union.
With that in mind, "after the crisis" is more likely referring to the global financial and economic
crisis, which began in 2007 and reached its crescendo in autumn 2008 with the collapse of
Lehman Brothers and the severe economic downturn that followed. To that extent, it is not
premature to talk to you here today about the financial crisis ten years on and to ask what we
have learned.
However, I will scarcely be able to do justice to the complexities of the crisis, complete with its
causes, implications and the lessons we can learn from it, in just over 45 minutes. I would
therefore like to focus on aspects that are especially relevant from my perspective as a monetary
policymaker, while noting that the observations I am about to make are not exhaustive.
2. The significance of the liability principle
Ladies and gentlemen
If you give some thought to the causes of the crisis, it becomes clear that the financial crisis and
the later euro-area crisis follow a common theme: the liability principle was undermined in the
run-up to both events.
Walter Eucken, founder of the Freiburg school and a pioneer of the social market economy,
condensed the liability principle into a simple formula: "Whoever reaps the benefits must also
bear the liability."
This tenet was so dear to him that he declared it a constitutive principle of our economic order -
for, in his view, economic agents will make responsible decisions only if the liability principle is
enforced.
For instance, when banks become so big that their failure could bring the entire financial system
to its knees, they can rely on politicians to throw them a lifeline if they run into difficulties. Thanks
to this implicit insurance policy against the risk of insolvency, the banks benefit from a funding
advantage even in normal times, as investors perceive the risk of default to be lower, and the
capital market, deeming them too big to fail, therefore cuts them a certain amount of slack.
Furthermore, complex financial market products and confusing market structures had caused a
fog to descend on the financial markets, with the resulting lack of transparency likewise serving
to help drive the mispricing of risk. As a result, many banks were therefore undercapitalised in
terms of their balance sheet risk.
But the rules that apply to enterprises, banks and investors must ultimately apply to
governments, too. Their purse strings also tend to be loosened if they are absolved, either in part
or in full, from bearing the financial consequences of their projects. In a monetary union, the
impact of one country's debt - felt in the form of rising interest rates - becomes more widespread
across all of the other member states, not only because of the single capital market but also,
similarly to the response to the too-big-to-fail problem, it makes sense for member states to
come to each other's rescue during times of crisis. To this extent then, too, there is a greater
incentive to run up debt.
Of course, the founding fathers of monetary union were well aware that, as a general rule,
unsound public finances are an Achilles' heel to a monetary union in which a single monetary
policy has been put in place while fiscal policy remains a matter of national responsibility. For this
reason, the framework of monetary union is actually designed to safeguard sound public
finances. In addition to setting out annual budget deficit and debt ceilings, it highlights the
member states' individual fiscal responsibility. A no-bailout clause was introduced precisely to
prevent euro-area countries from stepping into the breach for another member state and
providing financial aid.
The thrust of both measures is keep in check those financial risks to which the euro-area
countries may be exposed as a result of participating in monetary union. At the same time,
however, the no-bailout clause is designed to help enforce the liability principle on the market for
government debt. The no-bailout clause also served as a warning to private creditors that the
member states are solely responsible for their finances, even in times of crisis, meaning that
government bonds do not constitute a risk-free investment.
Now, these two pillars have clearly not been enough to safeguard sound public finances. One
reason for this is the weak binding effect of the fiscal rules, with repeated breaches leaving them
permanently impaired. Germany was one of the primary culprits here, having worked together
with France in the first half of the 2000s to water down the rules of the Stability and Growth Pact.
On balance, however, the second pillar was also too weak: the capital markets' disciplinary effect
on euro-area countries proved to be inadequate.
The capital markets had assumed that the euro area was a union with a common destiny and
that, despite the existence of the no-bailout clause, its member states would provide financial
assistance to one another in the event of a crisis. Despite the huge disparity in economic power
and indebtedness between the member states, they therefore paid similar levels of interest on
their debt prior to the crisis.
However, it is also worth remembering that, although some of the countries that later found
themselves in need of financial assistance were indeed experiencing rising macroeconomic
imbalances prior to the crisis, their public finances were only actually thrown off track when the
banks were bailed out.
It's worth keeping these root causes of the crisis in mind as I now look back at how the crisis has
unfolded since 2007 and later ask what remains to be done in order to put an end to the crisis
once and for all.
3. Flashback
Ladies and gentlemen
In 2007, we Germans became acquainted with a term that, at most, only financial market experts
had previously ever heard of - and even they were likely unaware in many cases of the risk
involved. I'm talking about subprime mortgages.
This was the name given to mortgages issued to borrowers in the United States with low - in
other words, not "prime" - credit ratings. It goes without saying that the term "subprime" was a
euphemism, as loans were granted en masse to households whose credit ratings could be
charitably described as questionable.
The subprime boom was boosted by three developments: low interest rates, a property bubble
and the securitisation of subprime mortgages.
The interest rate environment led to a "search for yield". What's more, thanks to the low interest
rates, low-income households were also able to shoulder the debt. At the same time,
homeowners' debt levels were falling as a result of ever-rising property prices, irrespective of
their mortgage repayments. In the United States, many homeowners used this opportunity to
refinance and take out additional mortgages. Borrowers became all the more vulnerable to rising
interest rates and falling property prices, culminating in the subprime crisis of 2007.
The ability to securitise and re-securitise subprime mortgage created an incentive to issue as
many subprime mortgages as possible, as various links in the "value chain" turned a profit from
processing fees. In the end, the risk attached to such loans did not remain with the banks that
had made the credit decision but was rather passed on. As a result, not only were risks created
on a large scale - the seeds for the subsequent spread of the crisis were also sown.
And so the subprime crisis quickly spilled over to Germany and Europe, where some financial
institutions that had invested particularly heavily in the corresponding securities found
themselves in financial distress.
This is yet another demonstration of the fact that, if it is possible to take risks for which one is
ultimately not liable, misincentives will be created. Credit assessments will no long be carried out
with the necessary due diligence and the risks taken will be too high.
The financial markets were then left well and truly paralysed by the bankruptcy of US investment
bank Lehman Brothers on 15 September 2008. Lehman had been a major cog in the subprime
mortgage securitisation business and suffered critical losses in the wake of the crisis.
I know from my conversations with my US counterparts at the time what a tough decision it was
to opt against saving Lehman using taxpayers' money. At the end of the day, a bail-out would
have further eroded the liability principle and given additional credence to the implicit
too-big-tofail assumption held by many senior bank executives and market participants. And so, with the
fall of Lehman, it was necessary to accept potentially sweeping contagion effects in the financial
system.
An important lesson learned from this experience is undoubtedly the fact that it is only possible to
resolve an institution without triggering major financial market turmoil if the contagion effects are
contained and the other financial market participants are sufficiently resilient.
But this was not the case at the time: following the Lehman bankruptcy, financial market
participants sought refuge from risk and continued to invest only in the safest of assets, primarily
the government bonds of certain countries. The decline in the price of risky securities
accelerated, and the uncertainty that this triggered regarding the financial shape of many banks
ultimately meant that financial institutions had to be rescued using taxpayers' money in order to
avert a meltdown of the global financial system.
In Germany, the Financial Market Stabilisation Fund (SoFFin) was set up to help either rescue or
resolve several banks, Hypo Real Estate being the most significant and arguably best-known
example.
Despite the enormous amount of government aid provided to the world's banks, it was not
possible to prevent the global financial crisis from spreading to the real economy. The period
covering the fourth quarter of 2008 and first quarter of 2009 was subsequently marked by a sharp
contraction in world trade and a massive economic slump in many countries. In the G7
countries, real GDP declined by 3.8 % in 2009, with this figure even hitting 4.5 % in the euro area.
Many countries launched debt-financed economic stimulus packages designed to partially
compensate for the shortfall in demand and thereby avoid a downward spiral. Some of you will
no doubt still be able to remember the car scrappage scheme in Germany.
Incidentally, one factor that should not be overlooked here is the G20 states' joint commitment at
this time to not strive for unilateral advantages and to refrain from protectionist measures.
While the appetite for risk had been excessively high prior to the crisis, the crisis led to a drastic
reassessment and a growing aversion to risk in the financial markets. This was particularly
evident in the market for government bonds of some euro-area countries.
At the same time, it was now becoming increasingly clear that some economies in the euro area
were not exactly in the best of shape. Countries were vulnerable in the face of pronounced
current account deficits and high reliance on capital inflows from abroad. A large part of the funds
they received had also previously been used for non-productive purposes, be it high government
spending, private consumption or excessive housing investment. To put it bluntly, some
euroarea countries were living beyond their means prior to the crisis.
To make matters worse, the bursting of the property price bubble in countries such as Ireland
and Spain shook the banking system, which had helped to finance the construction boom on a
large scale. Negative feedback effects of government support measures included a drastic
deterioration in public finances, which intensified the banking crises in these countries even
further. This was because banks held sizeable amounts of bonds from their own countries.
This sovereign-bank nexus is a particularity of the euro crisis, in which troubled banks and ailing
states mutually dragged each other down further and further.
Above all, this episode shows how quickly the risk assessment of the market participants can
change. This is partly because the fundamentals had worsened, but also because the overblown
expectations were corrected and have now been reversed. One of the main issues debated by
regulators after the crises was therefore how buffers can be created to make the banking system
more resistant, not only to such turnarounds in sentiment but also to adverse developments in
general, by ensuring a more solid liquidity position or a more robust financing structure.
Moreover, the severing of the unhealthy ties between sovereigns and banks is still seen by
many - and rightly so - as an urgent necessity.
At first, however, controversial emergency measures were taken to prevent the crisis from
spreading throughout the euro area: in April 2010, Greece, which had become heavily indebted,
was practically unable to obtain any further loans on the capital markets and had to ask the other
countries in the euro area for financial assistance. Together with the IMF, the donor countries
provided fiscal support to the ailing country and, as you all know, this was not the only "financial
assistance package" that Greece was to receive.
Following this ad hoc measure, the euro-area member states drew up a rescue package to be
made available to all countries, which was initially temporary but later became a permanent
fixture. A total of five countries (Ireland, Portugal, Greece, Spain and Cyprus) received financial
assistance from this fund.
In doing so, the euro-area member states, for all practical purposes, established a kind of joint
liability. This, in itself, increased the incentive for these countries to run up debt. To prevent this
from happening, the ESM rescue package may only be activated as a measure of last resort to
thwart an immediate threat to the stability of the euro area as a whole. Furthermore, assistance
may only be provided to help with liquidity problems, but not solvency problems, as the liability
principle would require the creditors to be bailed in, ie a restructuring of debt. The no-bailout
clause would also clearly exclude such aid.
Moreover, the granting of financial assistance is subject to strict conditions, true to the motto
"solidarity against solidarity". Assistance loans should therefore only be paid if the recipient
countries have met the previously agreed conditions. Ultimately, ESM funds can only finance the
necessary adjustment process, and thus "buy time". Only economic policy in the affected
country itself can treat the root cause.
As a result, the Bundesbank came to the conclusion at the time that, given the threat to the
stability of the European monetary union, the assistance fund that was created and the aid
programmes, with their strict fiscal and economic conditionality, were by and large justifiable
from an economic perspective - provided that the restrictions and conditions are actually met.
Ladies and gentlemen
As we all know, the Eurosystem was also compelled to take measures to prevent the crisis from
escalating. Yet these measures, too, only acted as strong painkillers. Although they did manage
to alleviate the symptoms, such as banks' liquidity squeeze and the sharp rise in risk premiums
for individual euro-area countries, they did not tackle the actual root causes of the crisis.
And just like any other medicines, you should read the package insert carefully, because the side
effects can sometimes be quite nasty. The Bundesbank was therefore very critical of some of
the measures taken.
Here I am referring to the government bond purchase programme in May 2010. Under the
Securities Markets Programme (SMP), Greek bonds were initially purchased; the programme
was later extended to include Irish and Portuguese government bonds. From the summer
of 2011, Spanish and Italian bonds were also added to the programme.
I am also, however, thinking of the OMT programme adopted in the summer of 2012, which
replaced the SMP and which still exists today. Unlike the SMP, the OMT programme potentially
envisages unlimited purchases, which, however, are conditional on the successful
implementation of an adjustment programme.
As a result of the targeted purchase of bonds from countries with a poor credit rating, their risk
premiums were offloaded onto the capital markets. The Eurosystem and its bond purchases
therefore had a significant impact on the government bond interest rates of these countries and
consequently encroached deep into the realms of fiscal policy. It therefore also exposed itself to
the danger of coming under political pressure to ease the burden on fiscal policy time and time
again and consequently weakened the disciplinary function of the capital markets.
Moreover, the purchases resulted in sovereign liability risks being mutualised via the
Eurosystem's balance sheet. However, the mutualisation of sovereign liability risks is inherently a
political decision. Governments and parliaments, and not the central banks, have the task of
determining which burdens the taxpayers in the member states should ultimately shoulder in
order to stabilise the euro area.
The independence of the central banks requires a narrow mandate and a clear separation from
fiscal policy.
Ladies and gentlemen
Just like so many others, Queen Elizabeth II also asked the simple, yet not so easy to answer
question during a visit to the London School of Economics in the spring of 2009: "Why did no one
see it coming?"
The reputation of economists has undoubtedly suffered as a result of the crisis.
In his book "The Art of Thinking Clearly", the Swiss author Rolf Dobelli writes: "in 2007, economic
experts painted a rosy picture for the coming years. However, twelve months later, the financial
markets imploded. Asked about the crisis, the same experts enumerated its causes: monetary
expansion under Greenspan, lax validation of mortgages, corrupt rating agencies, low capital
requirements, and so forth. In hindsight, the reasons for the crash seem painfully obvious, and
yet not a single economist (...) predicted how exactly it would unfold. On the contrary: rarely have
we seen such a high incidence of hindsight experts."
"The hindsight bias", Dobelli goes on to write, "is one of the most prevailing fallacies of all. We
can aptly describe it as the 'I told you so' phenomenon."
In my opinion, however, most (serious) economists do not claim to have always known it would
happen. Rather, many would agree that the risks in the financial system were underestimated for
far too long. Dobelli is, however, right in the sense that the logical ex post facto explanation of the
crisis should not lull us into a false sense of security.
Economists who study history, such as Kindleberger, Galbraith or Reinhart and Rogoff, would in
any case argue that financial crises are always recurring phenomena. They write about
speculative bubbles which occurred a long time ago, such as the Tulip Mania in Holland in the
17th century or the South Sea bubble in the 18th century. And just a few years before the
subprime crisis, the New Economy bubble burst.
And so the recent financial crisis will not have been the last crisis that we encounter. This is
assured by the "This time is different" syndrome, as described by Carmen Reinhart and Kenneth
Rogoff. Its core consists "of the firm belief that financial crises only happen to other people in
other countries; a crisis cannot occur here and now in our country. We are doing things better,
we are smarter, we have learned from past mistakes."
But even if we do not fall for the "This time is different" trap, even the best economists in the
world are not exactly sure what will trigger the next crisis.
Maybe the next crisis will be triggered by cyber attacks or hacker attacks and not by risks in
banks' loan books. After all, the increasingly digitalised nature of financial market infrastructures
is leaving our financial system increasingly exposed to such risks. And in contrast to the usual
credit risks, where the default of a single creditor does not as a rule profoundly shock a bank, it
may even be enough under certain circumstances for one of the many cyber attacks carried out
on a daily basis to succeed and to paralyse the activities of a bank for a while, thereby throwing
the financial system into disarray.
And that is why it is so important to place a greater focus on the potential dangers associated
with cybercrime than has been the case to date. The Federal Ministry of Finance and the
Bundesbank have therefore put cyber security on the G20 agenda. And last week's events have
underscored the wisdom of this decision. But perhaps a new crisis is brewing elsewhere.
However, knowing how difficult it is to accurately predict a crisis certainly does not give us a
licence to just sit back and do nothing about it. The very least we can do is to draw the right
conclusions from past crises. The aim is not only to eliminate individual risk factors but to make
the financial system more robust as a whole, so that future crises no longer result in such
dramatic consequences.
And so we now come to the question "What have we done to reduce our vulnerability to crises
and to strengthen the resilience of the financial system?"
4. Consequences of the financial and debt crisis
First and foremost, the stricter financial market regulation is particularly worthy of mention. Its
fundamental objective was to restore greater validity to the principle of liability in the financial
markets.
First of all, the root causes of the subprime crisis were tackled. Obvious moral hazard in the
securitisation business was corrected, for example by introducing a mandatory deductible for
securitisation transactions in the EU. In addition, rating agencies are now more closely
supervised and are obliged to be more transparent.
The more stringent capital requirements under the Basel III framework also mean that the
owners, and thus those who are ultimately responsible for taking entrepreneurial decisions, now
have to bear greater responsibility for their actions. After all, more money is now at stake for
them. At the same time, the institutions have "greater room to manoeuvre" in the event of
negative developments, and their loss-absorbing capability increases.
The average tier 1 capital ratio of the major German banks improved from 5.4 % in 2011 to
12.1 % in the middle of last year.
The major banks in Germany and the other euro-area countries have also been directly
supervised by the ECB, in cooperation with national supervisors, since November 2014. The less
significant banks - around 3,500 in the euro area as whole - are supervised by the national
supervisors according to uniform standards.
This is also an important step on the road to a more stable banking system, especially as
national supervisors occasionally tended to see "their" banks through rose-coloured glasses. The
creation of a single supervisory mechanism (SSM) should also be used as a means of
counteracting regulatory arbitrage, ie the targeted relocation of business to countries with the
least strict supervisory regimes.
But the SSM is just one pillar of the European banking union. The other, at least equally as
important, pillar is the Single Resolution Mechanism for banks, or SRM. This mechanism is
designed to facilitate the resolution of a failed bank and ensure that there is a clear hierarchy of
liability in place, with the taxpayer as the last possible port of call, in line with the "bail-in instead of
bail-out" principle.
To a certain degree, bail-ins are the implementation of something Martin Luther had demanded of
lenders 497 years ago: "If you want to have an interest in the gains, you must also have an
interest in the losses."
To be able to shoulder major losses, there naturally has to be bail-inable capital in excess of
other capital as well, which is why minimum requirements for bail-inable liabilities were
developed at both the global and European level. For the large, systemically important banks,
these requirements play a role in curbing the too-big-to-fail problem. The same is true of
additional capital surcharges for this group, which are intended to form part of an even larger
buffer, but also to help reduce the size-related funding advantage of these institutions.
Admittedly, the crisis showed that monitoring the stability of individual financial institutions does
not suffice when it comes to safeguarding a stable financial system. Anyone who thinks financial
stability can be preserved in this way can't see the forest for the trees. Or, as Janet Yellen once
put it: before the crisis, "we looked closely at the trees and not as intently as we should have at
the forest".
The approach of looking at "the forest" in the sense of financial stability has come to be termed
"macroprudential" - in contrast to "microprudential" supervision, which looks specifically at the
individual trees.
And with regard to the macroprudential approach, considerable progress has since been made
here, too. Institutions that have analytical capabilities and are designed to identify risks to financial
stability have been set up at the global, European and national level. Moreover, special tools were
created, such as borrowing limits for real estate loans.
Yet the interactions in which microprudential and macroprudential instruments intervene are
always complex, and good intentions do not always produce good results, as history has shown
with the cobra effect.
The concept is named after a British governor's failed attempt to tackle a plague of cobras in
India. Because of the bounty for each dead cobra, the Indian population began to breed and kill
cobras in order to cash in on the reward. And after the bounty was scrapped, the remaining
captive cobras were released, so that in the end there were even more cobras than there had
been originally.
Or, to put a less dramatic and more nuanced spin on it, you could say that every measure can of
course have side effects alongside the intended effects. At the end of the day, the costs and
benefits of regulation have to be analysed and the efficacy of the measures already implemented
needs to be evaluated. This is precisely what we have agreed upon as part of our ongoing G20
presidency and we have entrusted the Financial Stability Board with the related tasks.
Aside from the creation of the banking union and macroprudential supervision, there have been
other institutional reforms in the euro area aimed at making the monetary union more
crisisresistant.
The Stability and Growth Pact was reformed, for instance, and a fiscal compact was agreed.
This should facilitate the more automatic enforcement of sanctions when the deficit and debt
limits are breached. After all, sound government finances are the best protection against the risk
of a sovereign debt crisis.
Because experience showed that undercompetitiveness can also lead to crises, a
macroeconomic imbalance procedure was also established, which looks at current account
developments in the individual countries, for example.
Furthermore, the ESM stands at the ready as a permanent crisis resolution mechanism that can
ward off threats to the euro area as a whole. It is important, though, that the ESM is not misused
as a means of circumventing the no-bailout clause. If crisis-hit countries look unlikely to be able
to repay their financial aid, the ESM is not permitted to grant assistance loans. In addition,
assistance can only be paid out - as I mentioned - subject to strict fiscal and economic
conditionality.
That was the legal situation.
In practice, however, this is still a challenge, for reasons of political expediency and due to
concerns about remaining contagion effects, but also because differentiating between liquidity
and solvency problems in real time is not a trivial matter.
One thing can be said for certain, though: the assistance loans have paved the way for the
required adjustment programmes in the recipient countries. Without them, a much more abrupt
adjustment would have been needed.
And in actual fact, the countries that were especially hard hit by the crisis have made noticeable
progress in dismantling macroeconomic imbalances over the past few years. Current account
deficits have shrunk significantly and have even turned into surpluses in most countries.
In the five countries that have received fiscal assistance, unit labour costs have fallen since
2010, making these economies more competitive. Additionally, labour market reforms and other
structural reforms, some of them extensive, were undertaken. And as the World Bank's Doing
Business report shows, the business environment has also seen a marked improvement.
The interim conclusion we can make, therefore, is this: extensive measures have already been
taken in the wake of the financial and debt crisis, most of which have suitable potential to restore
greater validity to the liability principle.
5. What remains to be done
But is everything thus resolved? I would argue: no, not yet.
To return immediately to my last point: the extensive reform efforts in the former crisis-hit
countries mustn't obscure the fact that local conditions in those places should be improved
further.
The fact that youth unemployment is still very high in a number of countries, say, highlights the
need to continue dismantling barriers to employment. Low productivity in many countries is also
an argument to invest more in education and training. And public administration and the legal
system must become more efficient in some countries.
It certainly is not as if all other countries still have homework to do while we in Germany can just
lean back and rest on the laurels of the successful labour market and social reforms
implemented in the first half of the last decade. These measures helped Germany - christened
the "sick man of Europe" by the Economist back in 1999 - to now post one of the lowest
unemployment rates in the euro area.
The Eurogroup President Jeroen Dijsselbloem hit the nail on the head when he said, "Structural
reform isn't something that is undertaken every ten or twenty years".
OECD forecasts predict that, of all 42 OECD countries, Germany will see the second-slowest
growth rate up to 2030 and the slowest until 2060. The reason for these weak growth prospects
is unfavourable demographic developments, which will squeeze the potential labour force
considerably in the coming years.
Added to this are other challenges, such as providing a speedy digital infrastructure and
affordable energy given a changed energy mix, and integrating refugees into the labour market.
So there is a need for economic policy action here in Germany, too. We have to invest more in
education and training so that the opportunities presented by globalisation and technological
progress can be better harnessed for all.
Ladies and gentlemen
The principle of individual national responsibility and the liability principle are enshrined in the
framework of the monetary union. Member states have retained responsibility for their fiscal and
economic policy.
But as I have already noted, for all practical purposes elements of joint liability were established
while we were combatting the crisis. And many additional reform proposals boil down to
extending joint liability, for example by way of a European unemployment insurance fund, a
European deposit protection scheme, or by introducing Eurobonds. What most of these kinds of
proposals have in common is that they do not envisage a material transfer of sovereignty to the
European Union level.
That's not surprising given that most countries hav