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Symposium 2011

Proposal - Consistent macroeconomic policies that eliminate negative real interest rates and unsustainable debts are a precondition for a stable financial system

The Challenge

The global financial crisis has revealed how systemic risk in the banking system can lead to huge economic downturns. Many of the problems leading to the crisis have been discussed and many suspects h ...

The global financial crisis has revealed how systemic risk in the banking system can lead to huge economic downturns. Many of the problems leading to the crisis have been discussed and many suspects have been identified (including investment banks, central banks, rating agencies, regulators and the economics profession).

  • It is well known that the banking system, by its nature, is particularly vulnerable to economic crisis;
  • It is naive, however, to attribute these vulnerabilities solely to a lack of a more consistent regulatory framework. There were important gaps: insufficient capital of poor quality, “shadow” institutions out of the reach of supervision, a remuneration structure that creates incentives to arbitrage and opacity in key financial vehicles. The main failure, however, has been the effective implementation of existing requirements and standards;
  • What it is at stake is the quality and efficiency of Banking Supervision, particularly among industrialized countries;
  • The focus should be on the improvement of access to critical leading indicators, such as excess of credit and too much leverage;
  • Proposed solutions must be gradual and not radical: the Basel III framework presented by the BIS seems to address key issues, such as capital requirements, risk coverage of innovative products (securitization, derivatives), leverage ratios, global liquidity standards and capital buffers. However, the proposed time for implementation (up to 10 years) seems too long, particularly in face of growing tensions in the world markets;
  • How to deal with global banks (SIFIs – systematically important financial institutions) is particularly challenging: during a crisis, they are the main contagion channel spreading uncertainty among diverse markets. In this case, minimum international standards must be imposed with higher capital requirements. Since they are “too big to fail” close monitoring is needed and crucial information shared among Central Banks which should act in a coordinated fashion;
  • Another critical element to minimize systemic crisis is to avoid the disruption of interbank lines, which usually requires direct and pre-emptive intervention by Central Banks;
  • Over and above these prudential measures is the consistency of macroeconomic policies. Excess of liquidity and too low interest rates feed speculative bubbles, which will inevitable jeopardize the stability of the financial system;
  • Neither the more complex and sophisticated regulatory framework can work efficiently on an unstable economic environment. We have made little or no progress in attacking global imbalances which are the real sources of the banking problems;
  • Cases of prolonged negative real interest rates are “poising pills” which generates serious allocative distortions penalizing savings and stimulating dangerous speculative movements in asset prices;
  • Their outright prohibition – unless in extreme cases of a serious recession - would be a major step to avoid economic crisis and to assure financial stability;
  • By the same token, an international law of fiscal responsibility is needed to avoid unsustainable path of public debt / GDP ratio. The potential destabilizing effect of the Euro Zone debt crisis on the banking sector is an striking example;
  • The world is experimenting a curious paradox where emerging countries – such as Brazil - have set macroeconomic fundamentals which are sounder that most developed countries: lower public deficits supported by a fiscal responsibility law, positive and high real interest rates, larger compulsory deposits and a consolidated supervision embracing all kind of financial institutions - commercial and investment banks, brokerage houses, asset managements, hedge funds and financial houses;
  • Brazil is also an interesting example of an orderly banking consolidation (PROER, 1995 / 1997) while the economy was expanding. The social and economic costs were relatively low, quite different from the chaotic process in the 2008 crises in the USA and Europe which resulted in massive injection of public funds and, in some cases, extreme measures of Statization;
  • In short, what has been described as a market failure looks more and more as an institutional failure - distorted economic policies and poor banking supervision - difficult to understand given the power of independent Central Banks;
  • It is time to resist the fatal attraction of radical reforms such as the creation of new institutions: we have already enough with mostly independent Central Banks, the BIS not to mention the slow and bureaucratic IMF;
  • Brazil should be looked as an important benchmark in the growth and development of a sounder financial sector with its unusual blend of private and public banks, supported by a conservative Central Bank. It has passed by the tough stress test of recent crisis: there was no panic or lack of confidence in sharp contrast with the developed world;
  • There is no magical formula: the optimal level of intervention is a learning by doing process. The decision to find a market solution (voluntary or compulsory), to support or close down a financial institution will always be a discretionary one and have to be decided on a case by case basis.
  • The final objective is to minimize (not avoid entirely) systemic risks without constraining the incentives to financial innovation, an important source of long-term growth.

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