Viv Davies: Hello and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from the Centre for Economic Policy Research. It's the 27th of October, 2011 and I'm speaking to Thorsten Beck, Professor of Economics and chairman of the European Banking Center at Tilburg University, about the recently published Vox eBook on "The Future of Banking".

The eBook presents a collection of essays by leading European and US economists that provide solutions to the financial crisis and proposals for medium to long term regulatory reforms. Beck and the authors of the eBook call for a forceful and swift resolution of the Eurozone crisis. They call for more incentive for banks to internalize risk, and a more credible bank resolution regime.

I began the interview by pointing out that a lot of people thought that the banking crisis had been resolved two years ago, but that now banking was back at centre stage. I asked Thorsten to explain what went wrong.

Thorsten Beck: Well, the mix of bank recapitalization, fiscal stimulus packages to avoid further deepening of the recession, and the low growth that we experienced in many developed economies all contributed to an increase in fiscal deficit and therefore ultimately the debt to GDP ratios. And this, of course, comes on top of ongoing structural challenges for the fiscal positions of many developed countries due to demographic changes.

In many cases, these additional debts to GDP basically pushed some countries’ fiscal position towards an unsustainable territory. On the one side, in many cases there was simply not sufficient repair of balance sheets and recapitalization and, on the other hand, the stress test that many European banks went through were painting simply too rosy of a picture, partly related to the fact that there was obviously assumptions of zero risk for the government debt that they were holding.

So the situations of both government and banks were already somewhat fragile. Then there came the external shock of the Greek sovereign debt crisis in late 2009. And, maybe not by itself but by the lack of a proper policy reaction to it, basically this exacerbated the crisis and pushed Europe back into a recession due to the policy uncertainty and also affected the banking sector.

Now, you can also look at it from a different side. That is the losses that were incurred in the 2008 crisis have not really been allocated yet. They have been delayed into the future by just, again, increasing the fiscal deficit and the debt to GDP ratios.

Again, given the additional geographic challenges that Europe faces, basically we are living the Day of Reckoning where we have to make the painful structural adjustments to an earlier date, basically to today.

Viv: Perhaps you could outline some of the main messages and recommendations from the book?

Thorsten: First of all, let me mention that I'm actually not the author, I'm the editor of the book. There were many eminent authors from both sides of the Atlantic that have contributed to this book. It's difficult to outline all of the different policy measures that are mentioned here but let me just highlight a few recommendations.

One important message relates to the whole debate on Eurobonds. Several groups of economists have come out with an alternative proposal to Eurobonds as a fiscal policy, but rather recognizing that there is a need for a large pool of safe assets.

There's the suggestion to create somewhat a mutual debt structure where existing government debts are being securitized into what is called a “European safe bond” that then would substitute a large pool of safe assets and can address then both the liquidity and the solvency problems within the European banking system, but most critically actually help to distinguish between the two which also allows the European Central Bank to focus again on the liquidity provision to the banking sector, instead of worrying which of the government debt is not sustainable.

Another very important message that comes out is that, while there has been progress on capital and liquidity requirement, there is much more to do in, for example, determining the risk weights that are assigned to different assets when calculating the risk weighted capital asset ratio. But also looking beyond the issue of whether certain activities should be ring-fenced, but also looking with the ring of how risky a bank's activities are.

And finally the very important message is we need to further move to create a European-level regulatory framework that can address the weaknesses of cross border banks in Europe. So match the geographic parameter of the European banking system with a corresponding regulatory parameter.

Viv: In your introduction to the book, you suggested rather than privatizing profits and nationalizing losses, it would be better to privatize both profits and losses. This suggests that you wouldn't be in favor of government bailouts for banks in future, which I guess effectively means the end of the idea of "too big to fail." Could you comment on that perhaps?

Thorsten: It's a very tricky issue, but let me start with a very almost provocative or cynical statement. For European leaders to have to beg banks to please accept the 50 percent haircut on Greek debt just in order to avoid contagion, you can almost call it blackmail. I would have expected a much more forceful standing on that, even if such a haircut would then trigger the all-feared credit default event.

Similarly, what I mean by this is we will need another round of bank recapitalization, probably with support from the government, but it should not be, as in 2008/2009, just a free for all recapitalization round but it may have to lead to some restructuring or the resolution or the exit of some of the weaker banks.

Now this is for the short term. In the medium to long term we have to develop a resolution regime that helps move away from simple bailouts to alternative solutions that wipe out the claims of equity holders and of junior debt holders - the people who take the risk decision and others who support it - while, at the same time, protecting critical financial services such as payment services or savings of broad population and minimizing negative repercussions on the rest of the financial system and the economy at large.

Living wills that allow, for example, the resolution and part liquidation of large banks are certainly a very important step in this direction. There are no perfect solutions, but I think we have to move by bailing in equity holders instead of bailing them out.

Viv: In the last few years we've witnessed a whole raft of regulatory measures and rules in relation to the amount of equity and liquidity banks should hold, and particularly in relation to banks' capital ratios and their equity as a proportion of risk-weighted assets, et cetera. Would you agree that, as a result of all this, the banking system is actually safer today than it was a few years ago?

Thorsten: First of all, many of these measures are actually being phased in so they're not in place yet, which also might actually be good, given the current economic circumstances. So we would expect to see some of the affects later. However, the bigger concern is that some of these reform measures are rather mechanical, the increase in the capital ratios for example.

Of course, the capital efficiency ratio is a ratio so it has a numerator and denominator. The focus has been on the numerator rather than the denominator, which are the risk weighted assets. And here, most importantly, and that's all that comes out in several chapters of the book, is the way the risk weights are being calculated and that they're actually not necessarily static so stable over time, but the behavior of banks might also drive the risk weights that are being attached to certain assets.

Also, the codependence of financial institutions from each other might also, again, influence how risky the assets are that banks are holding. That's being lost in the current policy discussion.

Viv: Do you think there's a case for more coordination and joined up thinking in regulatory frameworks? For example, we've had in recent years the Dodd Frank Act, Basel reforms, Basel III most recently, European directives, the Vicker's report of the Independent Banking Commission here in the UK. Are all of these frameworks compatible?

Thorsten: First of all, bank regulation is primarily national. So it’s adequate that many of these issues are first being addressed at the national level, although one size does not fit all. It is natural, again, that many of these debates are being held on the national level, but, of course, close coordination is necessary.
Let me just highlight two areas where this is very important. One is the large, global, cross border banks where, again, a better resolution regime has to be put in place in order to avoid this too big or too complex or too important to fail phenomenon. Again, living wills that I mentioned earlier are a certainly an important look, if not even preservable, step in the right direction.

And here also agreements for expansion and burden sharing agreements might also be important. The second important area for coordination is, of course, within the European Union and, more importantly, within the Eurozone. Given the interaction between sovereign debt and the banking crisis, and here, having a regulatory framework and having also not only a resolution framework but even a resolution authority with the necessary firepower is critical.

Viv: One of the things you point out in your book is the importance of banks for the real economy. How do we get banks to lend to businesses when regulation enforces what many consider to be excessive capital requirements?

Thorsten: First of all, let me say there will be some downscaling in lending. I think that's almost unavoidable and of course some of this might also be driven by demand. It is certainly an important concern. I think here is where we have to point to the need for pro cyclical regulation in the sense that lower capital requirements during a downturn, higher capital requirements during an upturn or during boom periods, which can help mitigate the impact of financial cycles on the real economy.

The other area is to make lending to the private sector more attractive relative to other activities. Again, here the ring-fencing idea comes out where certain risky activities where it's doubtful how much benefit for the real economy really comes in are being associated with higher capital requirements. Similarly, the zero risk weight for government bonds certainly has to go away as this gives an unfair advantage for government debt compared to private sector lending.

Viv: In summary, Thorsten, what would be your key messages for European leaders and policymakers in relation to a safe future for banking?

Thorsten: First, we need a forceful and swift resolution of the Eurozone crisis without further half baked packages as we've seen them over the last two years now. For this to happen, the sovereign debt crisis and the banking crisis that are intertwined must be addressed with separate policy tools. The uncertainty must be removed, which then will also help the funding for the banks and ultimately will help the banks start relending again.

The second main message that comes through in most of the chapters, it's not so much about a mechanical solution that creates certain repercussion or restrictions or prohibitions. It's about the incentive for banks. Again, this is about proper risk weights for capital, for liquidity requirement. That is about taxation, for example. A financial transaction tax doesn't really affect the risk taking incentives for banks. There are better options, as outlined in the book.

Finally, it's about the end game. It's about the expectations that bankers have of what will happen to them if they really fail. Will they lose their claims or will they be bailed out? Ultimately, if we can construct a regime where we privatize these losses where equity holders’, junior debt holders’ claims are being wiped out in the case of a bank failure, then I think the relationship between banks on the one side and regulators on the other side will certainly be redefined to the benefit for the real economy.

Viv: Thorsten Beck, thank you for taking the time to talk to us today.

Thorsten: Thank you.