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University of Amsterdam and CEPR. The repeated bursts of financial distress in Europe in 2011-13 reflect vulnerabilities built up in the previous decade and are germane to the roots of the




The repeated bursts of financial distress in Europe in 2011-13 reflect vulnerabilities built up in the previous decade and are germane to the roots of the credit crisis. Abundant global liquidity relaxed funding constraints for banks and their borrowers, whether governments, firms, or consumers. Private and public debt grew faster than domestic savings as they were funded externally, by wholesale funding. Such funding is cheap because it is short-term, uninsured, and uninformed, and therefore prone to runs. This classic problem of ‘hot money’ for developing countries has now reached developed economies, since they have become large net borrowers. Credit grew fastest in the Eurozone’s periphery, where the stability induced by the euro eased historical concerns about private productivity or fiscal laxness. Banks abandoned organic growth on local business credit, and escalated lending to unsustainable real estate booms and excess public consumption. As this balance-sheet expansion was built on a very unstable funding structure, Eurozone banks are now visibly over-reliant on jittery wholesale credit flows. A radical new architecture is needed to restore proper credit incentives and strengthen resilience, moving banks away from a failed business model. Central to this transformation is to steer a desirable structure of bank funding. A banking system based on more stable funding (retail deposits and informed, long-term investors) would also promote a focus on local business credit opportunities, moving away from the oversized carry trades, investing in risky global assets and funding it with unstable global liquidity.

How, then, can regulators introduce prudential measures on liquidity risk that will be effective but not too onerous? The measures must also be introduced earlier than 2019 without disruption to be politically feasible. A concrete solution, based on broad academic consensus, would be as follows. Central banks have, during two years of Basel III negotiation, defined desirable liquidity positions in terms of standard ratios. These may be introduced as long-term targets, next to less demanding standards to be implemented immediately. Banks may choose not to comply with the (higher) desirable standards because of individual circumstances or business model choices. In that case, they would be charged ‘prudential risk surcharges’ on the difference between the desirable and the actual ratios. Risk charges may start quite low, certainly in a confidence crisis. These fees would not reflect a direct insurance promise, but reflect the risk externality caused by individual bank strategies on systemic liquidity risk. As such, they represent a non-fiscal form of ‘bank taxation’ which targets risk creation, rather than transaction volumes. The banks which would be more affected are those with the lowest retail deposits, which have expanded their balance sheets by relying on wholesale funding. This would rebalance the current bias where non-deposit funding is de facto insured but evades insurance charges. The critical feature of ratios is that they may be adjusted countercyclically to stem excess growth of unstable funding. Raising charges would be much easier than adjusting ratios, as they have lower adjustment and disruption costs than quantity adjustments (which as a result are usually delayed for years).

 


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