Is Bigger Really Better? Moral Hazard Issues in Expanding Financial Safety NetsGlobal Solutions SummitBerlin 18-19 March 2010

Peter BofingerUniversität Würzburg and CEPR

Topics

Ten years after: Where do we stand?

Small is beautiful: The German „Three Pillar System“

Moral hazard and safety nets: Better inventives for bank managers

What has changed since 2007? Private sector deleveraging, high public deficits

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2007 2018

Private net financial balances = Current account minus Fiscal balance (Source: IMF)

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Fiscal balances (% of GDP)

2007 2018

Bank lending stagnant with the exception of China

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Bank lending to private non-banks (percent of GDP)

Emerging markets All countries Advanced economies China G20 Euro area United States

Source: BIS

Business models have become more conservative

2 The height of each bar shows the aggregated capital shortfall considering requirements for each tier (ie CET1, Additional Tier 1 and Tier 2) of capital for the major internationally active banks monitored by the BCBS (BCBS (2018)).Source: BIS Annual Report 2018

NPL declining, but still high in Southern Europa

Source: ECB, Financial Stability Review November 2018

Expanding Safety Nets?

• Lender of Last Resort is already unlimited for countries indebted in their own currency

• Global dimension: Presentation by Helene Schuberth• Considerable progress in extending the safety nets of the euro area:• ELA (Emergency liquidity) : Country specific lender of last resort• European Stability Mechanism (500 billion Euro): Lender of last resort for

member state governments indebted in a „foreign currency“.

• Single Resolution Mechanism (SRM), backed by Single Resolution Fund (SRF). ESM serves as backstop for SRF

• Work in progress: European Deposit Insurance Scheme (EDIS) with a targetsize 0.8 percent of deposits is grossly overrated

Small is beautiful: Germany‘s

„3 Pillar System“

Is bigger better? The German „Three pillar system“

23%

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10%16%

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16%3%

Total Assets

Big Banks

Regional Banks

Landesbanken

Sparkassen

Credit cooperatives

Mortgage Banks

Foreign Banks

Banks with specialpurposes

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15%

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24%

17%

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8% 3%

Loans to non-banks

Big Banks

Regional Banks

Landesbanken

Sparkassen

Credit cooperatives

Mortgage Banks

Foreign Banks

Banks with specialpurposes

Source: Deutsche Bundesbank

Smaller is more profitable

Advantages of the smaller banksØLong-term orientation due to

independence from capitalmarkets

ØLocal anchoring combined withcentralized service centers

ØSupport of social and culturalactivities at the local level

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9.18 9.3910.13

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Return on equity (2017)

Who is saved by financial safety nets?

Source: Presentation Edward J. Kane

Profits private, losses social?

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Stock prices of German Banks and DAX (14 May 2007=100)

DEUTSCHE BANK COMMERZBANK HYPO REAL ESTATE HLDG. DEAD - 14/10/09 DAX 30 PERFORMANCE - PRICE INDEX

Setting the right inventives for bank mangers(Dudley-Proposal)

Compensation

ImmediatelyDeferred

(5-10 years)

Equity Debt

Unsecured Debt

Performance bonds:

Security deposit for

fines

William C. Dudley: Enhancing Stability by Improving Culture in the Financial Services Industry, New York, October 2014

Summary

The world has changed dramatically since 2007

• Net private lending has almost vanished (China is the exception)• Bank business models have become more conservative• No obvious need for expanding safety nets

The German experience: Diversified banking systems (“Three Pillar”) with small banks provide stability and to low costs for customers (=low profitability of banks)

The problem is not that banks were safed, but that themanagers were not held responsible for their mistakes

• Share holders made huge losses• Instead of increasing capital requirements to prohibitive levels,

change the compensation of bank managers (Dudley Proposal)• Responsible divers are better than more and speed limits

Why we need strong banks