Transcript Claudia Buch: Too big to fail: lessons from a decade of financial sector reforms

00:00:00,000 –> 00:00:09,00 It was a manic Monday in the financial market. The collapse of Lehman Brothers set off a wave of panic on Wall Street.

00:00:09,000 –> 00:00:18,00 The global financial crisis was an important reminder how costly it can be if the financial system does not function well.

00:00:18,000 –> 00:00:30,00 The costs of the crisis were large in terms of the fiscal expenses, but the cost of the crisis were also very real and very important in terms of the social cost.

00:00:30,000 –> 00:00:36,00 What happened during the crisis?

00:00:39,000 –> 00:00:51,00 As we all know, the fall of Lehman Brothers was an important trigger of the financial crisis. So what was this bank, Lehman Brothers? Was it so large relative to the financial system?

00:00:51,000 –> 00:01:11,00 Well, it wasn’t necessarily so large, but it was very connected to the financial system and its failure was a signal taken by markets that other banks might be in trouble. So, really, if we talk about too big to fail, what we mean is too systemic to fail, too connected to fail.

00:01:11,00 –> 00:01:31,00 Governments basically took two lessons from that situation. The first was that they wouldn’t let other large banks fail other banks that have been in distress. So the governments engaged in crisis management and they spent quite a bit of money to rescue failing banks.

00:01:31,00 –> 00:01:39,00 Governments also took a second lesson from the crisis and that has far longer term implications also for the financial system today.

00:01:39,00 –> 00:01:59,00 Leaders of the G20 states decided to end too big to fail. What they said in the summit declaration, is that they want to make sure that the large and the systemic banks take the negative implications that their failure can have for the financial system into account in their decisions.

00:01:59,00 –> 00:02:10,00 So in the words of economists, they wanted to internalise the systemic risk externality that these banks impose on the financial system.

00:02:10,00 –> 00:02:21,00 So let me explain in a bit more detail of what this implicit funding subsidies are and how they’re related to systemic risk externalities.

00:02:23,00 –> 00:02:42,00 Let’s start with the individual bank, with the management of the bank, with the equity owners of these banks. They have to take decisions on how large the bank is, what the activities are, how risky the activities are. But these decisions also have implications for the losses that a bank would incur in case of failure.

00:02:42,00 –> 00:02:52,00 Now, these implications in particular, if we talk about the larger bank, are not only relevant for the individual bank, but they’re also relevant for the government and for the system as a whole.

00:02:53,00 –> 00:03:30,00 So if one of these banks runs into difficulties and may be insolvent, then the government has to decide, ‘What should I do? Should I bail out the creditors of this bank or should I send this bank into, what is called, recovery and resolution?’ How the government chooses has implications for the funding costs of the banks. So if there’s an implicit guarantee for the liabilities of this bank, then the bank has a funding cost advantage compared to other banks in the system, and that in turn might affect the decisions taken up front at the bank level.

00:03:30,00 –> 00:03:45,00 So understanding this mechanism, government said, ‘Well, let’s reform the regulation of large financial institutions and make sure that this implicit funding subsidy is reduced and thereby the systemic risk externality is reduced.’

00:03:45,00 –> 00:03:58,00 So what did they do? Basically, three sets of reforms. The first was to increase the capital requirement for larger financial institutions.

00:03:58,00 –> 00:04:17,00 All banks have to meet capital requirements and those were also raised after the global financial crisis. But there’s a surcharge for the systemic financial institutions. The idea was to internalise negative implications for the financial system to make the larger banks more resilient.

00:04:17,00 –> 00:04:34,00 The second reform was about resolution reforms. Because you can’t just send a systemic bank into insolvency, new rules, new institutions, new tools are now in place to restructure and resolve large financial institutions.

00:04:34,00 –> 00:04:51,00 And the third part was enhanced supervision. So has all this worked? Has too big to fail ended? One indicator is the capitalisation of the banks. So the larger banks are now better capitalised, which makes them more resilient.

00:04:51,00 –> 00:05:11,00 It’s interesting to see that the larger banks have restructured their portfolios and they have reduced their market shares but this hasn’t come at the expense of lending overall. So there’s still sufficient funding for the real economy, partly also because other banks have picked up the activities.

00:05:11,00 –> 00:05:29,00 Does it mean that we have solved too big to fail, that the problem has disappeared? Big progress that has been made in terms implementation of resolution reforms. But there are still gaps with regard to specific reforms in specific countries. So these gaps clearly need to be closed.

00:05:29,00 –> 00:05:51,00 There’s still a lot of work we need to do in terms of assessing systemic risk and the effect on the overall financial system. Non-bank financial intermediaries, they’re sometimes called shadow banks, have become more important. So clearly, these are also risks that have to be monitored and action has to be taken in case new systemic risks are appearing.

00:05:51,00 –> 00:06:08,00 So a lot of progress has been made in terms of addressing too big to fail but it’s certainly also an issue that will remain with us and it’s important to keep monitoring and to keep also ensuring that the reforms are fully implemented.