The financial crisis of 2007 sent shockwaves through the world economy. Banking expert Steven Ongena’s research focuses on how such catastrophes can be prevented in the future – for example by limiting the amount of debt banks are allowed to carry.
The odd casualty is unavoidable when it comes to the economy. Falling share prices or businesses going bust might not be pretty, but they’re par for the course of any market economy, says Steven Ongena. The UZH professor of banking researches how financial crises develop and how they can be prevented or mitigated.
Does this mean that we have to accept that financial crises will continue to occur, such as the one in 2007, the aftermath of which is still felt today? Ongena shakes his head. “Major crises where taxpayers lose a lot of money to save systemically important banks can definitely be avoided.”
Financial crises can be caused by a number of factors (see box), and the suggested solutions to prevent them are just as varied. One of the few things that specialists agree on is that this can’t be achieved without regulation of the financial system. “But it’s not easy to find the right balance,” says Ongena. In other words, as little regulation as needed to allow the economy to thrive, but as much as needed to make sure the system won’t teeter on the brink of disaster again.
After the last financial crisis, many countries tightened their regulations for the banking industry, including stricter requirements when it comes to equity and maximum debt levels. These are considerable improvements, says Ongena. “The banks’ capitalization is significantly better than before the crisis.” Moreover, regulatory authorities have also implemented what are called macroprudential measures. This somewhat cryptic term refers to the idea that rules and regulations should be considered in terms of their impact on the system as a whole rather than on the individual financial institutions.
Building up reserves
Ongena’s research largely supports the measures that have been taken. Together with research colleagues, he has examined the effects of countercyclical capital buffers, for example, which are also part of the new regulations. The seemingly complicated term actually refers to a simple idea: Banks should be made to build up capital reserves during an economic boom, which will help them overcome difficult times. The scientists analyzed microdata from Spain, where the instrument had already been applied on a trial basis before the crisis.
The results show that the measures are effective, especially in difficult times: Banks that had built up a capital buffer granted significantly more loans during the crisis than their competitors. As a result of this, the clients of these banks were also better off – they employed more staff and fewer of them went bankrupt. Banks that had set aside capital reserves during boom phases thus contributed to softening the crisis. In Switzerland, such countercyclical capital buffers have been mandatory for banks since a decision by the Federal Council of 2013.
Tax on outside capital
Ongena has a new suggestion on how regulation of the banking sector could be improved: By levying taxes on outside capital. This would create an incentive for banks to keep their debt at a low level. The current practice of forcing banks to hold a minimum level of equity is unpopular. It has put a brake on the number loans being handed out and is hampering overall economic growth.
Taxes on borrowed capital, however, would mean that banks hold higher levels of equity – without any of the unwanted side effects. Put simply: If borrowing cash becomes expensive, banks are more likely to keep their own cash, which is also safer. The work of the researchers, who analyzed tax reforms in several European countries since the mid-1990s, suggests that this measure could actually be effective. In countries that had introduced reforms to make holding outside capital more expensive, banks’ equity was significantly higher. Yet they didn’t grant fewer loans, nor did they take more risks.
The last financial crisis raised awareness of the system’s vulnerabilities – not only in academia but in politics, too. Did the reforms solve all of the problems? “No,” says Ongena, “it’s a very complex and dynamic environment, which will therefore always have its risks.” The banking specialist considers the inflated balance sheets of central banks to be one of the most significant risks in the next few years. In response to the ongoing financial crisis, the central banks didn’t only lower their key interest rates, but also purchased various securities from private banks. This increased the financial institutions’ liquidity and had a positive effect on the entire economy. Now, however, the central banks risk that the sale of these securities will have the opposite effect – and that we will slide into the next recession.
How Financial Crises Develop: Lax Controls, Risky Loans
The causes of financial crises are varied. Major recessions are often preceded by credit booms and an inflated real estate market, with banks playing a key role. Technological innovations in the financial industry can also exacerbate a crisis. In the run-up to the last crisis, for example, banks had outsourced various tasks to external agencies. These agencies failed to adequately assess the creditworthiness of debtors.
Central banks can also contribute to a financial crisis through their fiscal policies. The situation gets dangerous if they keep the key interest rate low over a longer period, as was the case between 2002 and 2005. The banks will then hand out more loans for projects where the involved businesses have only a slim margin of profit. When interest rates later go up again, these projects are no longer profitable, the loans are no longer secured, and they become “bad”. Steven Ongena, professor of banking at UZH, analyzed microdata taken from the Spanish credit register to show that banks indeed hand out more and above all riskier loans in a low interest rate environment.
For a few years now, lax financial regulations have also increasingly been discussed as a possible cause of financial crises. Ongena’s research suggests that the crisis of 2007 also has its roots in the deregulation of the banking sector that took place in the 1970s and 1980s, when a number of private banks sprung up as a result of decreasing government regulations for banks. For companies, this new choice of potential lenders meant it became easier to borrow capital. As the banks faced increased competition for debtors, they expanded their lending volume and thus took on debt. During the crisis, many of them were then no longer able to service these debts.