The world is becoming more and more leveraged
Deeper integration coupled with sustained financial market growth was the means of choice to make the economy more stable after the 2007/2008 financial crisis. Only this promise has not been kept. In the current global economic environment, which is characterized by several crises at the same time, visibly growing debt levels are calling financial stability into question. What are the consequences for markets and their participants?
This was the central question of a policy discussion with experts from academia and the European Central Bank, jointly organized by the Leibniz Institute for Financial Research SAFE, the Institute for Banking and Financial History, the Center for Financial Studies, and the House of Finance at Goethe University Frankfurt on 30 November 2022. The starting point for the debate under the title “Leveraged – financial stability in a high debt world” was the anthology of the same name edited by economist Moritz Schularick from the University of Bonn.
“The idea is to bring together a new generation of researchers to synthesize the decade since the Global Financial Crisis in individual contributions for a broader audience,” Schularick prefaced the debate. “We are looking at the bigger picture and beyond technical debates.” Thus, he said, the goal is to explore what makes the financial industry so crisis-prone time and again, how large the sector should be, and how tightly knit the public safety net should be. “In their contributions to this book, young researchers have taken new directions in economic thinking,” Schularick said, handing over to one of the book’s co-authors, Kaspar Zimmermann.
The SAFE researcher singled out biased expectations as a risk factor for financial markets. “Credit cycles are sentiment-driven, and this affects not only low-income households but also the middle class in particular,” Zimmermann explained. For example, he said, misleading house price forecasts are associated with biased beliefs of credit cycles. “These beliefs determine both the demand for credit and the supply of credit,” the SAFE researcher noted. Based on real estate loans to borrowers with low credit ratings, which led to the subprime crisis in the U.S. at the time before the global financial crisis ensued, Zimmermann noted, the key in a crisis is to avoid amplification.
A look-back-bias is also observed by Daniel Dieckelmann from the ECB's Directorate General Macroprudential Policy and Financial Stability: “There is no precise definition of what a banking crisis is and what distinguishes it,” noted the economist, who is also one of the authors of the book presented by Schularick. Instead, he said, we would rely on recognizing banking crises “when we see them.” Such shocks would be viewed as binary events instead of using continuous measure. His current work, based on quantitative data on historical banking crises, aims at such measures.
“Only 35 percent of all banking crises are credit booms gone bust, but about 25 percent are due to financial interconnectedness, such as in Germany in 2008,” Dieckelmann elaborated. In comparison, some countries such as Canada, Australia, and New Zealand proved to be more financially stable than others. Overall, Dieckelmann found that banking systems have become more resilient to real shocks because policymakers now have the appropriate tools at their disposal. “But the flip side is that crises with financial origins have become more prevalent.”
In the panel discussion that followed the presentation of the book contributions, Loriana Pelizzon, Director of SAFE’s Financial Markets Research Department, emphasized in response to Schularick’s question about the size, role, and importance of financial markets today: “The world is becoming more and more leveraged.” Two aspects in particular need to be questioned, she said: why we have this type of structure and what incentives can be put in place to shrink the size of the financial sector. In addition, she said, it is important to critically evaluate the role of central banks not only as lenders of last resort, but also as market makers of last resort. “Central banks should intervene, but we need to make it clear from the beginning that this will not become normal,” Pelizzon said. In this context, refinancing should be backed by equity and not by higher debt levels.
Macroprudential regulation could help contain the size of the financial sector, the SAFE researcher added. But there is a strong incentive for market participants to circumvent these rules, she said. “We need to figure out a mechanism to avoid moral hazard.” High penalties and quick action are imperative in this regard, she said.
Crises require quick reactions
Moral hazard cannot be completely mitigated, argued Isabel Vansteenkiste. “When the financial sector is getting bigger, policymakers also have to react,” said the ECB’s Director General International and European Relations. In the event of an acute crisis, such as the outbreak of the Corona pandemic, she said, a quick response is needed; there is no time to spend months analyzing first. “Our initial response in this crisis was important and good,” Vansteenkiste affirmed.
When asked about the drivers of crises, the ECB representative noted that short-term thinking in particular would further fuel crises. In the view of Lena Tonzer, who conducts research at the Vrije Universiteit Amsterdam and heads a research group at the Leibniz Institute for Economic Research in Halle, herding is more likely to be responsible. Following up on Daniel Dieckelmann’s remarks, Tonzer held that it is important to differentiate what kind of crisis we are dealing with: “Lessons learned from the banking sector don’t have to apply to other sectors.” Crises with excessively high unemployment figures and sharp fluctuations in gross domestic product are particularly devastating, she said, and should be avoided.