The
Bank for International Settlements (BIS) is an international
organization that serves central banks and financial authorities.
According to its mission statement, it
- promotes monetary and financial stability,
- provides a forum for discussion and cooperation, and
- acts as a bank for its members.
At
first glance, one would expect the annual report of such an
organization being rather dry and technical. I have read the 83rd
annual report, published on June 14, 2013, and definitely confirm
that this first impression is wrong.
As
a matter of fact, the report contains a good summary and outlook of
the current international financial situation as well as many
interesting ideas and recommendations. I was also positively
surprised by the blunt language. Finally, BIS presents a good mix of
numerical information and material arguments. All this makes the
report interesting to read.
The
paper starts off with a summary of what happened in 2012, from a
macro-economic perspective. I will not expand on this here. More
interesting are BIS’ recommendations for the future. They relate to
four issues:
- Roadblocks to growth
- Fiscal sustainability
- Resilience of the banking and overall financial sector
- Monetary policies
Roadblocks
to growth
Creative
destruction
BIS
holds that rigid labor and product markets hinder long-term economic
health. The reason is that people cannot move across sectors if
markets are not flexible.
“Rigidities
in labor and product markets are among the most important obstacles
standing the way of long-term economic health.”
More
specifically, the service and construction sector have shrunk
substantially during the financial crisis and, today, offer less
opportunities for workers. As a consequence, governments should
ensure that
- shrinking sectors can let people go, e.g. fire workers and
- high-productivity sectors can develop (through abolishing entry barriers) and then hire people more easily.
“Still
existing misallocation of resources among sectors of the economy must
be corrected.”
“High
employment protection is associated with lower employment.”
This
above described reallocation process is usually called “creative
destruction”.
“In
the longer run, growth tends to come from new goods and services as
well as innovative ways of producing and delivering them.”
Political
reality
If
the above process of creative destruction is so obvious – why do
governments not act accordingly? BIS gives two reasons:
- Reforms will hurt well-established people and businesses and confront them with higher competition. To be precise, BIS is actually more polite: “Reforms produce losers as well as winners.”
- In the short run, reforms can make things worse. Indeed, it usually takes many years for reforms to be successful.
“Rather,
it seems, policymakers act only when their hand is forced.”
“Politicians
hope that if they wait, incomes and profits will start to grow again,
making the reform of labor and product markets less urgent. But
waiting will not make things any easier, particularly as public
support and patience erode.”
Fiscal
sustainability
Government
debt levels
BIS
says that, generally speaking, public debt in member states is too
high. What’s more, increasing age-related spending will further
question fiscal sustainability of government debt levels.
“Six
years after the onset of the global financial crisis, public debt in
most advanced economies has reached levels unprecedented in
peacetime. And, worryingly, it continues to rise.”
But
why specifically are high government debt levels bad? According to
BIS, they hinder growth because
- higher government debt means higher interest payments means higher taxes and lower productive government spending;
- higher government debt means rising sovereign risk premia;
- higher government debt means public authorities loosing flexibility to employ countercyclical policies.
Another
argument is somewhat surprising: “With low
levels of debt, governments will again have the capacity to respond
when the next financial or economic crisis inevitably hits.”
This might be right, but, to remain politically correct, isn’t the
whole work of BIS about avoiding future financial crisis?
“Finding
the way to medium- and long-term fiscal sustainability remains a key
challenge.”
So,
which government debt thresholds are suited? According to BIS,
advanced economies are safe up to 60 % of GDP; emerging market
economies should not go beyond 40 % of GDP.
“Structural
fiscal problems have to be tackled early. Doing so means avoiding
much more pain later.”
Quality
of fiscal adjustment
Quality
of the fiscal adjustment also matters: Pursuant to BIS, government
spending cuts are more successful than tax increases. One, spending
cuts have larger fiscal multipliers. Two, it is more difficult for
politicians to reverse spending cuts than to overturn tax increases.
Finally,
the bank insists on the urgency for carrying out reforms: Reform
fatigue might lead to politicians abandoning essential reforms.
Resilience
of the banking and overall financial sector
BIS
touches upon all of the current hot reform topics, i.e.:
- High quality capital buffers to protect banks against losses;
- Sufficient liquidity buffers to protect banks from sudden collapses in market confidence;
- Resolution regimes to make it possible for large and complex institutions to fail in an orderly way;
- Bank structure regulation, i.e. the separation of commercial and investment banking activities.
Capital
buffers and internal risk models
On
the first topic, BIS discusses namely internal risk models. The bank
recognizes that they can be highly variable from one bank to the
next, in particular due to
- what internal risk models actually measure (Is the capacity of the borrower measured on the basis of the prevailing macroeconomic environment or the entire business cycle? Are prevailing or stressed market conditions assumed?);
- differences in the fundamental structure of the business models;
- estimation noise (Differences in data sets lead to different statistical outcomes.);
- differences in bankers’ incentives which usually favor optimistic views on risk and low regulatory capital;
- national supervisors’ scope of intervention in setting specific model attributes.
In
view of these shortcomings, risk-weighted capital ratio and liquidity
ratio are complementary:
“Together,
they [risk-weighted capital ratio and liquidity ratio] reinforce
each-other, generate more information on the riskiness of the
business of the bank, and are more difficult to be manipulated.”
In
the same vein, capital adequacy and leverage ratio should, in BIS’
opinion, work together.
“Harnessing
the complementary strengths of the two ratios [capital adequacy and
leverage] provides an effective response to the practical and
theoretical shortcomings in risk measurement.”
Another
way to address the above deficiencies is improving outsiders’
understanding of risk weight calculations through
- greater transparency regarding the characteristics of internal models;
- greater comparability in the disclosures that banks make about the structure and performance of their internal models;
- greater standardization of information to allow outsiders to better compare model performance.
Bank
structure regulation
With
regard to bank structure regulation, BIS approves the goals of risk
isolation and reduction of moral hazard. However, the bank seems
rather critical, pointing to the danger of unintentional shift of
financial intermediation activities outside the perimeter of
consolidated supervision and to unclear interaction with other
regulatory reform projects.
Reform
process for the financial sector
More
generally speaking, BIS defends the complexity of financial reforms,
saying that “details are enforceable,
principles are not”. This
is actually one of the few statements in the report that I don’t
agree with. In my view, the opposite is true: It’s only when you
get the principles right that you can enforce details. The reason is
that, in real life, the details are unfortunately never the same
details that you predicted beforehand.
Related
to complexity is BIS’ call for a genuine increase in loss
absorption capacity as opposed to mere optimization of risk-weighted
assets through redesigning transactions (“window
dressing” – to use the terms of BIS). I think that, de
facto, both are linked: The more complex you make it the more
loopholes you will create. It’s more difficult to escape from
guiding principles.
“With
many elements of the new standards [of reforms of the financial
sector] already in place, emphasis is gradually shifting to
monitoring the pace of implementation.”
Monetary
policies
“Monetary
policy has fallen short of original expectations.”
“The
longer the current accommodative conditions persist, the bigger the
exit challenges become.”
“We
are past the height of the crisis, and the goal of policy today is to
return to strong and sustainable growth.”
As
central banks’ balance sheets have grown massively, both in
absolute terms (worldwide 20 trillion USD) and in terms of percentage
of GDP (worldwide 30 % of GDP), BIS focuses on how central banks
should exit from accommodative monetary policies. The challenge will
be to strike a balance between the risk of exiting prematurely and
the risk of exiting belatedly. Beyond timing, communication will be
another key aspect to make the exit as smooth as possible.
Central
Banks vs. Governments
In
BIS’ view, two elements characterize the relationship between
central banks and governments:
First,
independence of central banks is key:
“History
has shown that monetary policy decisions are best when insulated from
short-term political expediency considerations, hence the importance
of operational autonomy.”
Second,
central banks can only influence on the framework of economies; they
cannot, however, change the fundamentals.
“With
monetary policies remaining very accommodative globally, central
banks continue to borrow time for others to act.”
“Central
banks’ accommodations have borrowed time. However, central banks
cannot
- repair the balance sheets of households and financial institutions;
- ensure the sustainability of fiscal finances;
- enact the structural economic and financial reforms needed to return economies to real growth paths.“
“Our
message is simple: authorities need to hasten labor and product
market reforms to boost productivity and unlock growth; the private
sector must deleverage and the public sector needs to ensure fiscal
sustainability; risks in the financial system need to be managed; and
the expectation that monetary policy can solve these problems is a
recipe for failure.”
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