The importance of confidence and trust
The scale and the trans-national scope of the current financial crisis, according to Ingves, define its unique character. All crises share similar causes and common remedies but they also have many differences. When confidence is lost the taxpayer becomes the lender of last resort and the government becomes the owner of last resort!
The remedy involves regaining confidence to resolve a crisis and preserving confidence to avert further problems. The international dimension of the current crisis requires the establishment of trust across national borders trust and between authorities to strengthen cross-border crisis management.
Banks are both central to all economic activity, due to their role in the payment system, but they are also inherently unstable, due to the maturity mismatch from borrowing short and lending long. Their relatively low capital base is another potentially destabilising feature of the fractional reserve banking system.
To avoid a run, a bank must maintain the confidence of depositors and market participants. If a bank loses the confidence of its customers, it faces problems. If confidence for the entire banking sector disappears, a financial crisis is a fact. That occurs when people are unable to make solid judgements; when they fail to understand the true quality or location of assets.
Confidence is the core ingredient of a sound bank. Confidence is essential to prevent and to resolve financial crises.
When a crisis occurs the first step is to acknowledge its implications. Losses will not disappear and bad assets must be dealt with.
Liquidity and capital regulation need to be reformed to avert a recurrence of a banking crisis and restore trust. However, other commentators argue convincingly that regulation alone will not prevent bank failures and Dr Ingves counterpart, the Governor of the Bank of England is one of those. Good business succeed; bad businesses fail. Many of the current crop of failures arose as a consequences of losses in activities that were not core to the business. Irish Nationwide Building Society and EBS in Ireland, for example, was set up to provide residential mortgages but lost the plot when it funded speculative, commercial developments.
Get the Lemons!
Ingves advocate that to regain confidence in the short term it is vital to get the lemons!
Banks create confidence by telling good and credible stories about the future, stories about why stakeholders will get your money back. When these stories fail to create confidence, the markets will dry up. This is basically an example of the well-known lemon problem.
The US subprime market was the catalyst of the international dimension of the current crisis although it was only coincidental to the self-inflicted fatal wounds the Irish banks inflicted on the country. The repackaging and sale of assets backed by subprime loans meant that the crisis, at its outset, had already started to impact banks internationally. Bankers exposed to subprime assets began to find it increasingly difficult to tell convincing stories. Banks and market agents became less willing to trade and to lend to each other. Rating downgrades and more bad news kept arriving and the crisis started to spread geographically and to affect more markets. Banks experienced serious funding problems.
Confidence simply disappeared and liquidity evaporated. A melt-down of the financial system was prevented by a massive intervention by central banks and governments worldwide.
A loss of confidence is the driver of a liquidity crunch, but the lemon problem explains the mechanics of a market breakdown. A lemon is an asset of bad quality, originally referring to poor quality cars. In short, the lemon problem arises when sellers know whether or not their asset is a lemon, but potential buyers cannot tell the difference. The risk of purchasing a lemon will lower the price buyers are willing to pay for any asset and, because market prices are depressed, owners of non-lemon assets will be unwilling to put them up for sale.
In normal times, banks can obtain short-term finance by borrowing on the interbank market and by selling assets. When it became apparent that some assets had turned sour – that they were lemons – confidence in the strength of individual banks’ balance sheets evaporates. Confidence in the banking sector as a whole was eroded, because people were uncertain as to where the bad assets were actually located and the fear one bank could adversely impact another bank. Such uncertainty over the extent and location of lemons, coupled with a fear of contagion, are normal features of any crisis. However, the opacity of some of the new financial products and the increased interconnectedness of the financial system inflated the degree of uncertainty.
Weakened confidence between the banks led to the breakdown of interbank markets. At the same time, previously liquid asset markets completely dried up, due to the lemon problem. As a consequence, banks found it costly – or even impossible – to obtain liquidity by selling assets.
When there are lemons out and about, bankers cannot tell credible stories that inspire confidence in the future.
A precondition for the return to normal conditions, that is, to a situation where banks do not depend on central banks for liquidity, is that confidence is restored.
Central banks have been injecting liquidity for two years , but still the underlying problem – the lack of confidence – has not been fully solved. Normality and stability will not return until the impaired assets are dealt with.
To do that is both messy and costly. A difference to previous crises is the new financial products that have turned sour. It will be difficult to deal with these opaque and complicated new breeds of lemon. However, this does not make it less important to get the lemons – rather the contrary. There are no shortcuts in dealing with bad assets. The losses must be recognised. A loss is a loss. The costs involved may make it tempting to sugar-coat the lemons by letting the bad assets be valued above market value, but this will only postpone the recovery.
It is crucial for investors to realise that the bottom has been reached if confidence is to return The catalyst for this can only be achieved by a realistic and transparent valuation of assets. If the bottom is in fact reached, people will start to listen to good stories about the future again. Risk appetite will return and market activity will recover.
A lack of confidence in the banks’ balance sheets cannot be improved by creating opaque accounting rules. The book value of a bank will increase if they assign book values above market value, but will it restore confidence? The balance sheets of banks should reflect realistic values if confidence is to be inspired.
Accounting rules should force banks to disclose what their assets are worth and not allow problems to be hidden. Lack of confidence arises over concerns about a bank’s actual financial situation. If market participants have to recalculate reported valuations, then the return of confidence will be more difficult to achieve. It is therefore important that accounting is transparent and internationally harmonised. Accounting rules are not only about preserving financial stability in the short run. Changing the accounting rules could make communication more uncertain and less transparent.
Another tool for telling stories about the future is stress testing. Stress testing can thus be a very valuable and effective tool in restoring confidence. A track record of reasonable stress tests, will enhance the credibility of the methodology and the results has continued to increase during the crisis.
Liquidity and Capital Regulation
The financial crisis of the past two years has been very costly and must not recur. Lawmakers, central banks and financial regulators have a daunting task ahead of them. Regulatory and supervisory reform is needed.
Liquidity or, rather, illiquidity has been in the centre of this crisis. Banks will always be exposed to liquidity risk due to the maturity mismatch, as this is a central feature of banking. However, in the run up to the crisis, this maturity mismatch increased too much. Banks relied on the misguided perception that short-term financing would be available from liquid markets. A key lesson from the crisis is that a liquid market can very quickly become illiquid.
The conclusion is that liquidity must be regulated more appropriately. Banks need to hold a buffer of liquid assets large enough to allow them to weather a liquidity shock. However, the definition of this liquidity buffer, as well as what type of assets should be viewed as liquid, requires careful thought. We should keep in mind the lesson that market liquidity can vanish quickly and be extremely cautious about what securities we consider to be liquid. Furthermore, the power to dictate the type of assets a bank must hold will have an impact on asset markets. We must ensure that this power is not misused.
From a central banker’s perspective, Ingves argues that the content of the liquidity buffer has a bearing on the central bank’s policy on what assets to accept as collateral. In a crisis, it is the central bank’s decision on which securities to accept that defines liquid and illiquid assets – at least in the local currency. Therefore, the interplay of liquidity regulation and the central banks’ collateral requirements also warrants considerable reflection.
Finally, liquidity regulation will make maturity transformation more costly. More regulation is needed today but, in casting additional regulation, costs have also to be considered. Too strict regulation would stifle competition, make financial services more expensive and, in the long run, hamper economic growth. On the other hand, too loose regulation would inspire speculation with taxpayers’ money and also reduce economic growth. Thus, the extent of financial regulation is – at least partly – a question of society’s risk tolerance.
Liquidity buffers will create a cushion. However, the root of a liquidity crunch is a lack of confidence. A major aim of regulatory reform should thus be to ensure that trust does not dissipate so rapidly and completely again. In order to do this capital requirements need to be increased, both in terms of the quality of capital and the amount of capital.
Increasing the quality and amount of capital will increase the resilience of individual banks. In addition, strengthening the ability of banks to absorb losses – therefore more and better capital will also strengthen the resilience of the system.
In Ingves view, the important part of capital is loss-absorbing common equity. In addition, other forms of capital are needed to protect the state. If a bank defaults, capital typically evaporates very quickly. I have seen many examples of banks that have defaulted because they did not meet the capital adequacy rules. I
Building trust to enhance
cross-border crisis management
A financial crisis is costly to resolve. The crisis in Indonesia cost the equivalent of 50% of its GDP. Growth is stymied for years.
The potential costs are so large that only the nation state, through its power to tax, can shoulder the costs. This makes the state the only ultimate and credible guarantor of financial stability.
Option #1
Today, there is a mismatch between the geographical reach of the only party that can guarantee financial stability – the state – and the international financial system. The logical solutions to this geographical mismatch are either to shrink the financial system back to within national borders or to create an international institution with a right to tax or a system of burden-sharing, so that confidence in an ultimate guarantor can be established on an international level.
The first solution would be too costly. Basically, it would imply rolling back decades of globalisation and financial integration. It would also mean a serious blow to the European single market. In a way, I find it puzzling that we are discussing the possibility of a single market for all kinds of goods and services except for the commodity most suited for free trade: money.
Option #2
The second solution would involve a possible European wide tax to pay when a major SNAFU occurs. But since taxes are determined at a national level there is no scope for pan-European taxes determined at an EU level.
Consequently, the geographical mismatch continues and, as a consequence, cross-border banks pose a real challenge to crisis management. To accommodate this mismatch, national authorities must cooperate more effectively. This is the only feasible option. In order to achieve efficient cooperation, it is vital to build trust between authorities, which explains my third ingredient.
Option #3
The third and only practical option is based on cross-border cooperation. But cooperation is required in good times as well as bad.
In the EU, there can be the home country principle as a fix for the geographical mismatch. But this involves a partial loss of sovereignty at national level to achieve this compromise.
However, the home country principle does not solve the dilemma of international banks and national authorities. Tension arises because the home country is responsible for the supervision of branches but the host country is responsible for the financial stability of the country. This tension also persists if the foreign bank operates through subsidiaries. Many cross-border banks centralise different parts of management. There are good economic reasons for such centralisation. However, the implication is that the home supervisor, as the consolidating supervisor, has the overall picture, while the host country has the responsibility.
The capacity to respond to cross-border crisis management is impeded by a lack of mutual trust. In bad times, trust is essential for sharing information. Reaching a joint assessment and making efficient decisions often require frank and open-hearted discussions. Such discussions will not take place if the parties do not trust each other.
Nordic approach to trust building
The Governors of the Nordic countries have built trust for a long time. This building of trust dates back to the 19th century. Although it is not very widely known, in 1873, Sweden, Denmark and Norway formed a monetary union based on the gold standard. This union was eventually dissolved in 1924. However, I believe that one legacy of the union has been that the Governors of the Nordic Central Banks – adding Iceland and Finland to the group – have continued to meet regularly since then. This tradition of regular meetings has built trust. It has taken some time, but today the trust is there.
The Nordic example shows that trust between authorities can be achieved, but that trust takes time to build – so patience is warranted. At the same time, we need to start getting this process going immediately.
Financial stability ultimately depends on taxpayers. Bank defaults are rare but there is still a low frequency of them arising and these are uninsurable events. The costs arise in direct support and the lost opportunity to achieve economic growth.
Inges 6-year term as Governor began in January 2006. Dr Ingves is a member of the ECB General Council and a member of the Board of Directors of the Bank for International Settlements (BIS). He is also Sweden’s governor in the International Monetary Fund.
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