Axel A Weber: Strong, sustainable and balanced growth - the
contribution of financial market regulation
Speech by Professor Axel A Weber, President of the Deutsche Bundesbank, at the
11th WHU New Year's Conference, Vallendar, Rhineland-Palatinate, 14 January 2011.
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1. Introduction
Ladies and gentlemen
Thank you for the invitation to be keynote speaker at your 11th New Year's Conference. It is
a pleasure to be here once again. The beginning of a new year lends itself to looking back
and reflecting on the past year which turned out satisfactory - all the more so as the
economic outlook has brightened considerably.
This is not just true for Germany but also for the euro area in general. Hence, even though
for the euro area risks for the economic outlook are still tilted slightly to the downside, the
recovery should continue. Against this background, the recent increase of inflation in the
euro area above 2% has attracted some attention. Whilst this is largely the result of
shortterm upward pressure on prices, mainly owing to energy prices, inflationary pressures over
the policy-relevant medium term are expected to remain contained and in line with price
stability. Therefore, the Governing Council yesterday confirmed that the current key interest
rates still remain appropriate. Nevertheless, risks to the medium term outlook for inflation
which are so far still broadly balanced could well move to the upside. Thus, price
developments have to be monitored very closely.
In spite of the favourable economic outlook, the financial and economic crisis is not over yet,
and even though Germany fared much better during the crisis than many other advanced
economies, the welfare losses have been huge. Thus, one of our top concerns must be to
ensure that measures are taken to prevent the occurrence of another crisis of this scale. But
first, I would like to address the issue of regulatory reform on financial markets. So let us take
a look back and cast a look at the interlinkages between the real economy and the financial
system and at how the crisis originated.
2. The financial system - driver of growth, but also the origin of the worst crisis
in the post-war period
The state of the real economy and economic well-being are usually measured in terms of
economic growth. As you will probably recall from your macroeconomic courses, simple
textbook models basically identify three determining factors of economic growth: capital,
labour and technological progress. Of those three, the one most obviously affected by the
financial sphere is the first - capital. Considered on its own, the financial sector not only
plays a crucial role in capital accumulation but is also a part of the economy with a distinct
value added that contributes to an economy's growth. Beyond that, however, the financial
system performs another very important task with regard to economic growth: it not only
funds innovations but also helps in identifying them. The financial system therefore helps to
further the state of know-how and promotes technological progress. Sound economic growth
relies upon an efficient financial system. With each advancing stage of economic
development, the financial system also refines and increases its complexity together with
advancements in the real economy.
The massive repercussions and enormous costs for the real economy during the current
crisis have demonstrated impressively how important financial stability is for economic
performance and welfare: The second phase of the crisis, that is after the Lehman Brothers
insolvency in September 2008, not only marked the point of conversion to a systemic crisis,
causing transactions on the interbank market to virtually ground to a halt, stock prices to
plummet and investors to flee to the safety of government bonds. The disruptions of the
financial system were also passed on to the real economy. Financing conditions for
enterprises and households tightened, and as consumers and firms feared what was still to
come, expectations in the private sector as well as the outlook for the world economy
deteriorated sharply. As a result, manufacturing and trade were at the heart of the crisis and
suffered globally, and particularly in the advanced economies, output dropped at rates
hitherto unseen in the post-war period.
Financial stability has therefore rightly become a top priority on the policy agenda, and the
increasing role of the G20 testifies to the global dimension of this task. Yet the objective is
not to avoid financial crises completely. Historically, these crises have occurred regularly
over time and can be viewed as an element of market economies. In this context, attempts to
increase financial market stability should therefore not be understood as an attempt to avoid
crises altogether, but as an attempt to increase the system's resilience and, by doing so, to
limit the dire consequences.
The usual fear is that stricter regulation may introduce additional frictions and hamper
economic growth. The challenge policy makers face when reforming the regulatory
framework of financial markets lies in striking the right balance between the stability of the
financial system and its efficiency. Luckily, both intentions are to a significant degree
complementary, and the context is not that of a zero-sum game. Well-designed regulatory
reform can make the financial system more stable without cutting into sustainable growth. In
order to construct regulation wisely, it is first necessary to understand the underlying reasons
for the current crisis. Otherwise regulation runs the risk of curing the symptoms but not the
cause.
Prior to the crisis, the global economy grew at a rapid pace. The integration of rapidly
catching-up emerging markets contributed largely to this significant upturn. The labour
potential, that is the number of people who are readily available to the labour market,
increased greatly in these economies and they presented plenty of high-yielding investment
opportunities. Both led to a significant growth in per capita income. However, the phase
before the crisis was also characterised by extremely favourable financing conditions and a
high propensity to take risks. As a result, capital was not always channelled into its most
productive use, and in various countries this fostered an unsustainable asset price increase
that led to high private-sector debt and excess domestic demand; the housing markets in
several advanced economies are a prominent example. These undesirable developments
were further encouraged by loopholes and weaknesses in the regulatory framework.
Eventually, the underlying imbalances erupted and came to the surface; we still have to deal
with those consequences.
The deficiencies of the financial system that reinforced the unhealthy development were
many and encompassed the microeconomic as well as the macroeconomic level. On the
microeconomic level the factors that led to the financial crisis were a lack of transparency,
insufficient capital buffers, the unhampered development of a scarcely regulated shadow
banking system and moral hazard, for example in the form of ill-designed remuneration
schemes or an insufficient risk and liquidity management at the level of individual institutions,
to name but a few. Furthermore, the systematic importance of certain agents, ie their crucial
role they played for whole financial market segments, had been underestimated for too long.
3. Regulatory reform as a lesson to be learned from the crisis
Where the causes are multilayered, multilayered regulation is the appropriate measure. As a
first line of defence, the microprudential level of regulation will be strengthened. The
measures that policy-makers set up in September 2010 and agreed on at the G20 summit in
Seoul, commonly termed "Basel III", comprise higher capital and liquidity requirements which
are intended to enable an institution to better cope with losses itself and thus lower the
probability of it's insolvency. In this context, higher capital requirements mean both, a higher
quantity of capital as well as a higher quality. Particularly, the minimum core capital
requirements will rise from currently 2% to then 4.5%, plus an extra 2.5% that will be
introduced in stages from 2016 on. Tier 1 capital requirements will increase from currently
4% to then 8.5%. Furthermore, a stricter definition of core capital is to be implemented.
Yet, this first line of defence is not sufficient and needs to be supplemented. In market-based
economies the failure of individual enterprises, including banks, should not be ruled out a
priori. Thus, a second line of defence will be drawn, on the macroprudential level, which will
only come into play if an institution breaks the first line of defence and becomes insolvent. Its
aim will be to curtail the impact of individual insolvencies on the financial system as a whole
and to increase the financial system's transparency. The European Union only recently
established an institution for macroprudential analysis and monitoring in order to recognise
systemic risks early on, the European Systemic Risk Board (ESRB). Germany passed a law
on the restructuring of insolvent financial institutions last autumn, which is certainly a step to
be welcomed. However, the various national restructuring mechanisms will only be fully
effective if they are mutually compatible. As in other areas of regulation, this requires an
internationally coordinated approach.
Additionally, measures of macroprudential oversight are currently being developed and
implemented also to address systemic risk. Dealing with systemic risk is complex and
requires a multi-faceted approach. It should encompass systemically relevant financial
institutions, markets and infrastructures, while transparency is crucial.
Topics that either still need further discussion or at least ratification include, for example, the
question of how exactly to deal with institutions that are "too big to fail". Stricter regulation
and more intense supervision lead, not least, to the internalisation of otherwise negative
external effects of these institutions. The improvement of corporate governance, not least the
implementation of the FSB's international compensation standards, is also the subject of
debate. Further topics on the agenda are the mandatory registration of institutions that
currently operate in the shadow banking system, and the standardisation of contracts and
handling of derivatives. All these topics need to be concretised further. Once implemented,
these measures will have a profound impact on the financial system. They will increase the
system's resilience and, with that, its stability.
Especially with Basel III there have been concerns that the increased capital requirements
will have a potentially negative impact on economic performance. However, studies have
revealed that these fears are not well-founded. In anticipation of the new rules banks have
already started to increase their capital. Additionally, the transition period before the new
requirements fully enter into force has been set with a long horizon. These are clear signs
that policy-makers have found the right balance between regulation for stability and ensuring
strong and sustainable growth. In fact, there is no inherent conflict between the
G20 agenda's objectives of a more stable financial system and of strong, sustainable and
balanced growth.
What we have to be careful with is public debt. The (sadly) new feature of the current crisis
has been its third phase, the debt crisis, which hit us hard in May 2010. Towards the end of
2009, investors and rating agencies were increasingly turning their attention to the financial
risks that the government sector worldwide had already incurred or was likely to incur. The
default risk of these countries' government debt securities had until then been considered
safe. However, with deteriorating public debt through fiscal programmes and guarantees to
financial institutions in particular as rescue measures, the default risk was revalued on a
more differentiated basis. As a result, intra-euro-area yield spreads widened significantly
- especially to the detriment, above all, of periphery countries like Greece, Ireland and
Portugal. Although this third phase of the crisis has so far not impacted significantly on
euroarea economic developments, and financial markets have continued to recover, too, the
sovereign debt crisis still poses a serious challenge for the euro area as a whole that needs
to be resolved before it potentially becomes a more serious threat to the recovery.
Policymakers have already taken important first steps in this regard, both to embark on ambitious
and timely consolidation as well as to strengthen the institutional framework within the EU.
Keywords in this context are a strengthened Stability and Growth Pact, better enforcement
measures to correct excessive macroeconomic imbalances and a crisis resolution
mechanism that helps to deal with future crises but does not undermine the incentives to rein
in public deficits.
4. Conclusion
Ladies and gentlemen, the major drivers of growth for the world economy have not been
impaired by the financial crisis. Emerging markets are still undertaking great efforts to catch
up, and technological progress will continue. As I pointed out, even the regulatory measures
already implemented, as well those measures that will be implemented once the discussion
process has come to an end, will not hamper fundamental economic growth. The crisis has
warned us of the risks of exaggerated growth and has painfully demonstrated some major
weaknesses of the regulatory system. But the crisis does not mark the end of the world as
we know it. If we manage to improve the regulatory framework for the financial system and
maintain well-disciplined government budgets, we will be well on the way towards strong,
sustainable and balanced growth in the future.
Thank you for your attention.