andreas dombret : challenges for financial stability – policy and academic aspects dinner speech by dr andreas dombret, member of the executive board of the deutsche bundesbank, at the joint conference of the deutsche bundesbank, the technical university dresden and the journal of financial stability, dresden, 17 january 2013. * * * 2012 : an “ annus horribilis ” or an “ annus mirabilis ” or neither? your magnificence professor muller - steinhagen, mister state minister doctor beermann, ladies and gentlemen : the turn of the year gives me the chance to relate my discussion of some of the future challenges for financial stability to a resume of the previous year. please allow me to do this from a european perspective and let me start with a seemingly innocent question : will 2012 go down in history as an “ annus horribilis ” or rather as an “ annus mirabilis ”, or neither? the answer to this question is less trivial than it appears at first. let ’ s look to the origins of the words “ annus horribilis ” and “ annus mirabilis ”. to see this please note that the originator of the “ annus horribilis ”, queen elizabeth, used it to describe her feelings about the year 1992. at the time, her majesty was talking about, among others, the fire at windsor castle, but one might also read it as a comment about what happened in the financial sector in 1992 when the markets forced the uk to leave the european exchange rate mechanism. more recently, the queen ’ s remarks sound as a comment about the financial and economic development of 2012. please also note that many people use the metaphor of a large - scale fire to explain the economic term of a “ systemic ” event. thus her majesty is worth quoting in more length : “ 1992 is not a year on which i shall look with undiluted pleasure. in the words of one of my more sympathetic commentators it has turned to be an ‘ annus horribilis ’. i suspect that i am not alone in thinking it so. indeed i suspect that there are very few people or institutions unaffected by the last months of worldwide turmoil and uncertainty. ” according to various measures 2012 was a year of considerable systemic tensions. indeed, the indicators were approaching – but did not quite reach – the sad levels seen in the second half of 2008 and in the first half of 2009 – which was without doubts a very difficult period in the

, moral suasion, the endeavour to stabilise their own respective sovereigns or simply strategic considerations. in an economy in which the sovereign defaults, banks are likely to default, too. thus, the domestic banks have an incentive to invest in sovereign ’ s bonds and earn the yield mark - up if things go well. what happens in the event of a joint sovereign - bank default is not relevant for them. this undermines market discipline for governments and reduces their incentive to carry out necessary structural reforms. on the other hand, banks, which can obtain unlimited cash against sovereign collateral from the central bank, are protected from discipline from investors who provide funding. large sovereign bond exposures might also harm the real economy. rises in sovereign risk are transmitted into reduced bank lending. banks that were highly exposed to strained european sovereign debt have reduced their lending to the private sector. bis central bankers ’ speeches thus, the current regulatory treatment is incompatible with the principle of individual responsibility ; the market interest rate no longer reflects the riskiness of the investment. i am aware that banks as well as governments are afraid of rising funding costs as a result of ending the regulatory privileges afforded to sovereigns. the argument goes, moreover, that such a regulatory move risks considerable market turmoil. i do not think that this argument should keep us from doing the right thing. no market participant would judge a french bond to be as risky as a greek one : the riskiness of each is reflected in their prices. investors believe that sovereigns differ in terms of riskiness. so no one should be surprised when the regulatory treatment accommodates this fact. if additional capital requirements for european banks were imposed to cover sovereign exposures, the extra capital would be almost negligible on aggregate – albeit with substantial differences between banks. other measures, such as the inclusion of sovereigns in the large exposures regime might lead to more substantial repercussions, but these would be manageable if introduced over a transition period – which undoubtedly has to be granted. when it comes to funding costs for governments, a healthier banking system with better diversification would pose less of a burden on states. the contingent liabilities of the government would shrink which – all other things being equal – would reduce the risk of investing in sovereigns and, eventually lower the sovereign bond yields. the current regulation ’ s assumption that government bonds are risk - free has been dismissed by recent experience. the time is ripe to address the regulatory treatment of sovereign exposures.