Financial crises are costly – output and
financial wealth are lost, unemployment increases, and social
gaps widen. The costs may be prolonged, and they may become
chronic. The global financial crisis that began ten years ago
with the liquidity squeeze on global financial markets in
August 2007 is still casting long shadows.
Global debt levels remain elevated. Debt levels of the
non-financial sector relative to GDP stood at 220% by the end
of 2016 compared with 179% a decade earlier (BIS 2017). In
the aftermath of the financial crisis, risks were shifted from
the private to the public sector (Figure 1). In the euro area,
government debt due to the support for financial institutions
went up by €488 billion, or 4.5% of GDP, between 2007 and
2016 (Eurostat 2017a). Today, in the euro area, government debt
relative to GDP is about 24 percentage points higher than it
was prior to the crisis (Eurostat 2017b).
The global financial crisis has had a significant impact on
economic growth and unemployment. The estimated median loss
varies between 4% and 9 % (Ball 2014, Mourougane 2017, Ollivaud
and Turner 2014). Such output losses have also had social
consequences. In the euro area, the unemployment rate went up
from 9.2% in 2005 to 11.2% in 2015 (Eurostat 2017c).
Answering the question of how economies can be protected
from financial crisis is thus a key challenge for policymakers.
Complete "protection" against fluctuations on financial markets
is not possible and would impair critical functions of markets
in terms of the allocation of resources. But reducing excessive
risk-taking, making crises less likely and reducing their costs
should be the ambition of policymakers. In this note, I want to
highlight three elements of a strategy for making future
First, agreed financial sector reforms need to be
implemented. Enhancing the resilience of the financial system
and improving buffers against unexpected shocks has been a key
goal of post-crisis financial sector reforms. High levels of
debt can increase the fragility of finance, make financial
crisis more likely, and be an impediment to growth. In response
to the global financial crisis, governments have thus set out
to tackle the underlying causes of the kind of financial
distress that can seriously harm the economy. Regulations have
been amended in order to strengthen the financial system's
capacity to buffer shocks and to promote strong, sustainable,
balanced, and inclusive growth.
Second, complementary reforms can make the reform agenda
fully effective. In Europe, the Capital Markets Union is such a
complementary project. Implementing the Capital Markets Union
can represent a major step forward towards achieving a more
resilient financial system and putting in place improved
mechanisms of cross-border risk sharing in Europe.
Third, effects of post-crisis reforms need to be evaluated.
Full implementation of post-crisis financial sector reforms
should be followed by a structured evaluation of the effects of
reforms. A structured evaluation is needed in order to assess
the impact and the effectiveness of the reforms implemented and
to study potential unintended consequences.
|Figure 1: Public and private
As a percentage of GDP
|Source: BIS. 1 Including non-profit
institutions serving households. Deutsche Bundesbank
What are the drivers and costs of financial
Financial crises have been a recurrent theme in economic
history. Reinhart and Rogoff (2008b) have put together a large
historical database covering eight centuries and 66 countries
in Africa, Asia, Europe, Latin America, North America, and
Oceania. These countries represent about 90% of world GDP. The
database comprises information on a large set of economic
indicators as well as indicators of crisis episodes (0/1
indicators), including external and domestic defaults, banking
crises, currency crashes, and inflation outbursts. Analysing
these data, the authors conclude:
"Capital flow/default cycles have been around since at least
1800 – if not before. Technology has changed, the
height of humans has changed, and fashions have changed. Yet
the ability of governments and investors to delude themselves,
giving rise to periodic bouts of euphoria that usually end in
tears, seems to have remained a constant" (Reinhardt and Rogoff
2008b, p. 53).
While fluctuations on financial markets are part of regular
market processes, making crises less likely and less costly
should be a key goal of economic policy. After the crisis,
macroprudential policy has thus become established as a new
policy area. A stable financial system fulfils its core
macroeconomic functions smoothly and at all times. These
functions include the efficient allocation of financial
resources, the provision of risk-sharing mechanisms, and the
provision of an efficient and secure financial infrastructure,
including the payments system.
Yet, financial stability can be threatened if the distress
of one institution or a group of financial institutions can
"infect" the entire system. Channels of infection can be direct
contagion through financial linkages or indirect contagion
through asymmetries of information, panics, or fire sales.
Through such channels, decisions by individual market
participants can have external effects on the functioning of
the financial system. Such "externalities" are all the greater,
depending on how pronounced the risk-taking incentives are, how
high the leverage of individual market participants is, how
large the institutions are ("too big to fail"), how connected
they are ("too connected to fail"), and how high common
exposures to similar risks are ("too many to fail"). The real
economy can be affected through a credit crunch when banks are
forced to reduce their lending activities in response to the
crisis (Brunnermeier 2009, Brunnermeier and Oehmke 2013).
One key factor that affects the stability of the financial
system is the structure of finance (Bernanke, Gertler and
Gilchrist 1996; Gambacorta, Yang, and Tsatsaronis 2014). The
larger the share of debt finance is, the larger the "financial
accelerator" effects can be – seemingly small shocks
can then have large and systemic implications. Economic
fluctuations may become magnified and threaten the stability of
the entire financial system. The channel of transmission
between debt and output fluctuations can run through
consumption or investment (Cecchetti, Mohanty, and Zampolli
2011, Sutherland and Hoeller 2012):
High levels of household debt can affect the stability of
the real economy through the adjustment of consumption.
Evidence for the US shows that, during the crisis, households
with high levels of real estate debt cut down consumption in
response to shocks to asset prices, thus amplifying the cycle
(King 1994; Mian and Sufi 2014, Jordà, Schularick and
Taylor 2015; Mian, Sufi and Verner forthcoming). Similar
effects have been documented for other countries: The loss in
consumption during the financial crisis was particularly severe
in economies that experienced a large run-up of household debt
prior to the crisis. And these same countries experienced the
fastest increases in house prices in the pre-crisis period
(Glick and Lansing 2010, Leigh et al. 2012).
High levels of debt may also impair the ability of firms to
smooth employment and investment when an adverse shock hits.
High leverage has, for example, been shown to have negative
effects on the performance of firms as a consequence of
industry downturns (González 2013).
High levels of public sector debt can be destabilising.
Strained government finances may, for example, weaken the
ability to ensure financial stability (Das et al. 2010, Davies
and Ng 2011). Furthermore, high levels of public sector debt
may amplify under some conditions the effects of cyclical
shocks due to raising sovereign risk (Corsetti et al.
Given the importance of the banking sector for the
allocation of resources across all sectors of the economy,
excessive leverage in the financial sector can be particularly
harmful for the real economy. An insufficiently capitalised
financial sector or banking system is thus a threat to
financial stability. Adverse shocks can then set in motion a
downward spiral of asset valuations and prices that ultimately
threatens the solvency of financial institutions.
The destabilising effects of debt arise from its contractual
features. Standard debt contracts are insensitive to the
borrower's situation. An adjustment to idiosyncratic shocks can
occur only through new lending or through haircuts on existing
loans after risks have materialised. In contrast, the value of
equity adjusts if the borrower's situation changes. In this
sense, equity provides an ex ante risk-sharing mechanism. In
other words, equity as a claim on real assets has stabilising
features compared with debt as a claim on nominal assets.
Empirical studies do indeed show that excessive private (and
public) sector indebtedness, asset price misalignments,
international linkages of banks, and high external imbalances
are drivers of financial crisis (Borio and Drehmann 2009).
Furthermore, banking crises have often been preceded by real
estate price booms (Reinhart and Rogoff 2008a, 2008b). This was
the case in the 2008 global financial crisis, but it is also
true of earlier crises in the 1970s to 1990s in, for example,
Spain, Sweden, Norway, and Finland. Asset price booms are
particularly harmful if they are debt-financed (Jordà,
Schularick and Taylor 2015). Consequently, measures of private
sector indebtedness, such as credit relative to GDP, have been
identified as predictors of banking crises (Detken et al. 2014,
Drehmann and Juselius 2014, Laeven and Valencia 2012).
Moreover, asset price booms may be fuelled by increasing
capital inflows from abroad with the potential for severe
negative consequences when these capital flows stop (Kaminsky
and Reinhart 1999).
Financial sector reforms – where
do we stand?
In response to the crisis, the G20 countries have agreed on
a large set of financial sector reforms with four core
- building resilient financial
- ending too-big-to-fail
- making derivatives markets safer, and
- transforming shadow banking into resilient
Progress in the implementation of reforms has been steady
but uneven across the core areas of reforms. Several reforms of
the Basel III package still need to be fully implemented, more
work is required to improve the framework for the resolution of
global systemically important banks, implementation of
over-the-counter derivative reforms has progressed relatively
far, and the implementation of reforms in the regulation and
oversight of shadow banks is still at an early stage (Financial
Stability Board 2016).
From Implementation to Evaluation
Many of the reforms have ventured into uncharted territory.
Assessing the effects of financial sector reforms in a
structured way is thus crucial. Evaluation of reforms needs to
take into account how the macroeconomic environment has
changed, what the short- and the long-term effects of reforms
are, and how reform effects differ across countries.
One key challenge for evaluation is that many of the costs
of financial reforms borne by financial participants –
such as enhanced reporting costs – tend to be felt
immediately and are often observable. The benefits to broader
society, in contrast, can be reaped only over the longer term
and are difficult to quantify: What is the probability that
financial crises will occur in the future? And how devastating
would their effects be? Addressing such questions, let alone
providing quantitative answers to them, poses a number of
challenges. Also, resources that are needed for policy
evaluation. Evaluations require good data and the labour input
of skilled individuals to perform them.
Facing up to such challenges is unavoidable if the effects
of reforms are to be understood. A structured evaluation
process is critical to managing them. Policy evaluation means
being transparent about what policy was intended to do in the
first place and what it has achieved.
Policy evaluations follow procedures that have many
similarities with drug tests in medical science. "What are the
effects of regulations on the stability of the financial
system?" is like asking "How does this drug affect the
patient's health?" In either case, the purpose of the question
is to find out whether the treatment cures the disease
– or merely alleviates the symptoms. Besides this,
potential side effects can be revealed. A structured evaluation
framework allows disentangling the many different factors that
may have affected the "patient".
Good evaluations provide answers to three questions:
Did the reform "cause" an outcome? Much has changed since
the crisis: the competitive environment in which banks find
themselves has changed, economic recovery has been slow, and
other policies areas such as monetary policy have responded as
well. Thus, even in the absence of regulatory reforms, banks
would be in a different situation now than before the
Have the reforms had similar effects across markets or
jurisdictions? Lessons learned from one market or country may
not apply to another. In some countries, (non-financial) firms
finance the bulk of their investments through capital and debt
markets, in others, they rely more heavily on bank credit.
Legal and institutional settings differ across countries. Such
differences need to be taken into account.
Have the reforms achieved their overall objectives?
Ultimately, one needs to look at the benefits of reforms to
society as a whole. Disentangling the costs and benefits of
regulation is the crucial point of any evaluation. Financial
reforms generate direct compliance costs for market
participants, such as the costs of reporting requirements, and
these costs tend to be recognised immediately. The benefits of
a more stable and resilient financial system, by contrast, can
be reaped only over the longer term and are more difficult to
Direct costs of compliance need to be distinguished from the
costs of crises that are borne by market participants. The
bailout of banks during the crisis shifted private costs to
taxpayers and raised levels of public debt worldwide. Reforms
thus seek to realign incentives by withdrawing implicit public
guarantees. As a result, risk taking on the part of banks may
decline, allocation of credit may change, and costs of debt may
increase, because creditors cannot rely on bailouts and thus
demand higher risk premia. Profits in the financial sector may
decline as a consequence of reforms.
Taken together, costs are shifted from the public sector to
the (private) financial sector. One example from environmental
policy may serve to illustrate the point. A Pigovian tax on
chemical producers that pollute a river internalises the
externalities of polluting the river by aligning private and
social costs, thereby realigning the incentives to pollute. The
direct result of this policy is lower production of chemicals,
as pollution of the river is now part of the private sector's
costs, and lower sectoral profits. However, these are not the
costs of the reform, but rather the intended consequence.
Fortunately, a robust, evidence-based policy evaluation
process does not have to be designed from scratch. Many
jurisdictions already have explicit frameworks for the
evaluation of financial sector policies (Financial Stability
Board 2017, Annex A). In many policy areas, structured
evaluations are routinely applied. Labour market reforms are
being evaluated in many countries, educational programmes are
often implemented only following a testing phase, and policy
evaluations are commonly applied in the area of development
policies. There has been a profound improvement in economic
analysis, and this forms part of the infrastructure needed to
perform evaluations. Policy evaluation can thus rely on a rich
infrastructure of data, methodologies, and – not least
– skilled personnel.
Because regulatory reforms have a global dimension, it is
important to speak a common language when looking at the
effects of reforms. Setting standards, learning from good
practices, and international coordination are thus vitally
important. The Financial Stability Board has developed a
framework for the post-implementation evaluation of the effects
of the Group of 20 (G20) financial regulatory reforms
(Financial Stability Board 2017).
The Role of the Capital Markets Union
Complementary reforms can further strengthen the
international reform agenda. The European Capital Markets Union
provides an opportunity to deepen financial market integration
and to enhance the resilience of the European financial system
(European Commission 2015, 2017; Deutsche Bundesbank 2015a).
Cross-border debt flows tend to be more stable than equity
flows and in particular foreign direct investment.
Well-developed and integrated capital markets can thus
facilitate risk sharing among investors, with the accompanying
potential for generating welfare gains. In integrated markets,
local risks can be shared among investors from different
regions. Similarly, individual investors can protect themselves
against local income shocks by diversifying their investments
across borders. Increased reliance on equity finance would be
particularly beneficial in the European Monetary Union, where
exchange rates cannot adjust to cope with regional
macroeconomic shocks and where cross-border fiscal risk-sharing
mechanisms are limited.
Cross-border risk sharing, however, is constrained if the
integration of capital markets is tilted towards debt finance.
In fact, private sector mechanisms for cross-border
risk-sharing remain underdeveloped in Europe (ECB 2017). The
development and integration of European equity markets can thus
play a vital role in strengthening cross-border risk sharing in
Europe and should remain a goal of the Capital Markets Union.
Despite the freedom of mobility of cross-border capital flows
in Europe, many implicit barriers to the cross-border movement
of equity capital and the development of equity markets remain
in place. Examples include the development and integration of
European venture capital markets and the removal of tax
incentives that favour debt over equity financing (Deutsche
Bundesbank 2015b). One major achievement of the Capital Markets
Union could thus be the removal of impediments to efficient,
non-distorted cross-border capital flows.
Aggregates cover G20 and other major economies and are based
on a conversion to US dollars at purchasing power exchange
Based on a speech given by Prof Claudia Buch in a panel
debate at the Rencontres Economiques d'Aix-en-Provence, July 8
2017. The full speech can be freely accessed at www.bundesbank.de.