The previous chapter examined the advantages and disadvantages of the sovereign money system. Although we do not argue to move towards such a system, the problems raised by the advocates of sovereign money are real and urgent. Their plans moreover provide a solid basis for measures that could be usefully introduced into the current system.
In Chap. 4 we identified two challenges: we need a more balanced and controlled growth of money and debt as well as a better balance between public and private interests. This chapter focuses on the steps that can be taken to bring this about. We discuss both measures taken since the crisis and measures that have been proposed but were not implemented.
Anzeige
7.1 Taming the Money and Debt Cycle
The first challenge is taming the money and debt cycle. The balanced growth of money and debt matters not only for the stability of the financial system but for maximizing its contributions to the economy. As we saw in Chap. 3, finding the right balance between flexibility and rigour is a perennial challenge. If the monetary system is too strictly regulated – for example when currency was strictly tied to gold – this ultimately creates problems for economic growth and exacerbates crises. Flexibility in money creation and lending is necessary to anticipate cyclical fluctuations. On the other hand, a too-flexible monetary system leads to speculative bubbles and/or high inflation. Self-fulfilling effects can arise, where credit and money creation and rising financial asset prices all reinforce each other.
The decades leading up to the last financial crisis witnessed a trend towards greater flexibility. Numerous constraints on lending were removed while the money creating role of banks grew due to the increasing dominance of deposit money. Public policies also encouraged private debt growth.1 This flexibility led to historically high levels of debt as well as greater volatility in lending and hence in the economy at large. We discussed the downsides of this in Chap. 4: excessive credit growth heightens the probability of financial crises, while high levels of debt can undermine economic development and lead to the unfair allocation of costs and benefits in society.
This section discusses the main policy initiatives and suggestions to achieve a more balanced growth of money and debt. These are: (1) better curbs on and elimination of incentives for the growth of debt; (2) policy coherence and the structure of the financial sector; and (3) measures to cushion financial crises.
7.1.1 Curbing the Growth of Debt
In the wake of the crisis, macroprudential policy emerged as the main method to counter the excessive growth of debt. Initial steps have also been taken to eliminate tax incentives for debt finance.
Anzeige
7.1.1.1 Macroprudential Policy
Macroprudential policy focuses specifically on countering systemic risks, defined as “the risk of developments that threaten the system as a whole and ultimately cause severe damage to the economy”.2 To gauge such risks, analysts assess the emergence of imbalances (such as high debts and the growth of bubbles) and the structure of the financial sector (high concentration and interdependencies).3
Macroprudential policy makes use of the same instruments as banking supervision (also referred to as microprudential policy) such as capital and liquidity requirements. The main difference is the purpose for which the instrument is deployed: reducing risks to individual institutions (microprudential) or to the financial system as a whole (macroprudential). The macroprudential framework offers various possibilities for national supervisors to impose additional requirements to counter systemic risks (see Box 7.1).
Box 7.1 Macroprudential Policy
The main macroprudential instruments are included in the European Capital Requirements Directive and Regulation, known as the CRD IV package.4 Based largely on international agreements in the Basel III framework, the main instruments are additional capital buffers on top of microprudential requirements. An example is the countercyclical capital buffer. In good times, when lending grows too rapidly, the national supervisor (DNB in the case of the Netherlands) can impose on banks an additional capital requirement of 2.5%, which can be drawn upon in bad times. National supervisors can also (temporarily) increase the minimum risk weighting for mortgage loans if they believe the housing market is overheating. Systemically important institutions face additional capital requirements. National supervisors can also tighten other parts of the capital framework if they can demonstrate the remaining instruments are insufficient. This is referred to as the flexibility package (see Table 7.1). The CRD V package (2019) modified several aspects of these rules (mainly activation requirements and buffer limits) but did not change their essence, nor did it introduce additional instruments.
Table 7.1
Overview of macroprudential instruments in the CRD IV package
Brief Description | Legal Basis | |
|---|---|---|
Countercyclical capital buffer | A capital surcharge (ranging from 0% to 2.5%, possibly higher) to counter risks of the financial cycle. If a country introduces this surcharge, it also applies to credit granted by other European banks in the country. | Articles 130 and 135-140 of CRD IV |
Systemic buffer | A capital surcharge for one or more systemically important banks. | Articles 133-134 of CRD IV |
G-SII/O-SII buffer | A capital surcharge for ‘global systemically important institutions’ or ‘other systemically important institutions’. | Article 131 of CRD IV |
Sectoral risk weights | The risk weighting for mortgage loans can be increased to counter systemic risks. | Article 124 and Article 164 of the Capital Requirements Regulation (CRR) |
Flexibility package | Various measures (including an increase in liquidity requirements or risk weightings) if other macroprudential instruments are insufficient. | Article 458 of the CRR |
Alongside this European macroprudential framework, many countries have requirements on mortgage loans. In the Netherlands, for example, there is a maximum loan-to-value ratio of 100%, which means the loan cannot exceed the appraised value of the home.
Responsibility for macroprudential policy is shared by a range of organizations. A distinction can be drawn between: (1) the detection and reporting of systemic risks, and (2) the activation of instruments. The first is carried out at the European level by the European Systemic Risk Board (ESRB), which is part of the European Central Bank. In the Netherlands this responsibility rests with DNB and the Financial Stability Committee, comprising representatives of DNB, the Ministry of Finance and the Authority for Financial Markets.5 Primarily a national matter, the activation of instruments is the responsibility of DNB, while mortgage loan limits are the responsibility of the Ministry of Finance. To activate certain instruments, DNB must obtain approval from European organizations such as the ESRB and the European Banking Authority. The advent of the European banking union has also given the ECB specific macroprudential responsibilities: it can activate the CRD IV instruments implemented by national member states or increase their stringency if it deems this necessary to counter systemic risks.
One of the main issues is how to measure systemic risks.6 Deviation in the growth trend of credit is a key indicator when deciding to apply the countercyclical capital buffer (CCB). The question is whether the Netherlands should rely on this indicator as the ‘baseline’ is very high; since lending rose so rapidly in the run-up to the crisis, it would take extreme credit growth to turn this warning light red. While DNB has thus far concluded that there is no reason to activate the CCB in the Netherlands, other indicators suggest serious grounds for concern.7 Precisely because one indicator alone does not reliably point to the build-up of systemic risks, the ESRB recommends activating the buffer on the basis of multiple indicators.8 Sweden notably applied the buffer in March 2017 although according to the standard indicator (growth trend of credit) it was not required to do so.9
A crucial follow-up question is how far these instruments can actually curb the risks. While macroprudential instruments have thus far been a part of capital regulation, capital requirements are primarily meant to make banks more shock-resistant to potential problems, not to curb the growth of debt. BIS economist Claudio Borio, one of the developers of the CCB, argues that it is not suited to curbing credit growth and that the relationship between risk-weighted capital requirements and lending is too indirect to serve as an effective brake.10 One of the reasons for this is that, particularly in good times, the risks to banks’ assets (such as outstanding loans) are underestimated.11
This raises the question of whether macroprudential policy needs to be broadened. The countercyclical raising of liquidity requirements is highly complex in the existing framework and can only be implemented through the flexibility package, which is not easy to deploy (see Table 7.1).12 Furthermore, the non-bank financial sector mostly falls outside the purview of macroprudential policy. The current framework’s exclusion of shadow banks – financial institutions that strongly resemble banks as they issue short-term debt to fund long-term loans – is a particular ground for concern. The crisis was largely caused by ballooning credit growth among financial institutions that subsequently proved untenable. Nevertheless, these institutions largely remain outside of the scope of macroprudential policy.13
Macroprudential instruments not only target financial institutions but also specific loans. A key macroprudential instrument is the maximum loan-to-value (LTV) ratio: the maximum loan that can be granted relative to the value of collateral. In the Netherlands the maximum permitted LTV ratio for mortgage loans has been reduced in stages since 2012; since 1 January 2018, the maximum is 100%. Various institutions are calling for a further reduction of the LTV ratio to 90% or even 80%.14 On the other hand, the Netherlands Bureau for Economic Policy Analysis (CPB) warns against the high social costs associated with further reducing the LTV ratio, particularly for first-time buyers in the housing market.15
Although capping the LTV ratio curbs lending, it is not an absolute ceiling. So long as the value of homes continues to rise and market prices are used to determine value in the LTV ratio, more credit can be granted. This in turn can further inflate house prices. A loan-to-income (LTI) ratio that ties the amount of the loan to the applicant’s income is in theory a stronger curb on lending. While the Netherlands has no direct LTI limits, there are limits on financing costs. One’s income and the interest rate determine the maximum that can be spent on a mortgage (about which NIBUD, the National Institute for Family Finance Information, issues an annual recommendation). This constitutes a loan ceiling although the lender may apply a different limit if it can be justified.
7.1.1.2 Tax Incentives
A second strategy to limit private debt growth is the reduction of tax incentives to incur debt. The tax treatment of debt makes it more advantageous for households, businesses and banks to use debt rather than equity finance. Households and businesses can deduct interest payments from their taxable income. Cautious steps have been taken since the crisis. The maximum mortgage interest deduction was reduced from 52% in 2014 to 49.5% in 2018; it will fall further to 37% by 2023. Steps have also been taken to limit interest deductions for private equity operators. The Dutch government also intends to set an upper limit for deductible interest expenses (interest ceilings) for banks and insurance companies. Tax benefits of so-called cocos – special debt instruments issued by banks – have been abolished in 2019.16
Some countries have tried to tackle the unequal tax treatment of debt and equity by introducing deductibility for equity. Belgium, for example, introduced a notional interest deduction in 2006 (see Box 7.2). Other countries such as Cyprus, Italy, Croatia, Latvia, Liechtenstein, Austria and Turkey have also introduced equity deductibility in recent years. The relevant base (all equity or only new equity) and the notional interest rate differ from country to country.
Box 7.2 Equity Deductibility in Belgium
In 2006 Belgium introduced the deductibility of equity costs for business. This ‘deduction for risk capital’ means a notional interest rate can be deducted from adjusted equity; in the 2015 assessment year this notional rate stood at 2.63%.17 Since the deduction did not apply to the equity of subsidiaries, the European Commission and the European Court of Justice ruled that it violated the free movement of capital within the EU.18 Belgium accordingly amended the law. Now the deduction is only permitted on the increase in equity over the average of the previous five years. While this measure primarily focuses on ‘ordinary’ businesses, Schepens shows that this measure has also contributed to an increase in the equity of Belgian banks.19 A major criticism of the measure is that it facilitates international tax arbitrage by multinationals.20
In general, it is desirable for different types of funding to be treated equally in order to combat avoidance behaviour; this is provided for in the deductibility of equity. Limits on the tax deductibility of interest expenses implies that unequal treatment between debt and equity is not eliminated, which may have undesirable consequences. Nevertheless, it does meet the desired objective of discouraging excessive reliance on debt finance.21
Although attention since the crisis has focused on the preferential tax treatment of debt, there have been few concrete steps to address the problem. Whereas the gradual reduction of mortgage interest deductibility has been successful, the tax advantage for businesses has only been partially addressed. Given the free movement of capital within the European Union, the equal tax treatment of equity and debt requires coordination at the European level to prevent tax arbitrage. For banks the situation is more complex since debt finance (and its associated interest expenses) is at the core of the business model (lending by means of money creation). The question is whether this core includes all forms of bank’s debt finance (such as short-term market funding) and whether more differentiated interest deduction would be appropriate.
7.1.2 Policy Coherence and the Structure of the Financial Sector
Policy reforms since the crisis have focused on the constraints and incentives for the growth of debt. Less attention has been devoted to policy coherence and the structure of the financial sector.
7.1.2.1 Policy Coherence
The macroprudential policy framework is now largely an independent policy area with its own instruments and responsible organizations.22 The question is whether this demarcation acknowledges the many factors that play a role in the boom-bust dynamics of lending. Here it is particularly important to examine the relationships between macroprudential policy, banking supervision (microprudential policy), monetary policy and socioeconomic policy.
Macroprudential policy largely uses the same type of instruments as banking supervision, particularly capital requirements. At the same time, macroprudential policy has been set up as a separate policy area with its own objectives and framework. One of the founders of the macroprudential framework, Claudio Borio of the Bank for International Settlements, nevertheless believes it is mistaken to speak of two separate policy areas. It is more a case of different perspectives: one focused on the stability of individual banks (micro perspective) and one focused on system stability (macro perspective).23 This implies that the distinction between banking supervision and macroprudential policy is fluid and complex. Particularly in the field of risk weightings, microprudential logic may clash with macroprudential logic (see Box 7.3).24
Box 7.3 Procyclical Effects of Risk Weightings
Bank capital requirements look at the size of the bank’s risk-weighted assets to determine the required equity level. Although risk weightings may appear rational from the perspective of an individual bank (having few risky loans such as mortgages means less need for equity), they may be imprudent from the macro and long-term perspective.
The first international capital framework, the Basel I Accord of 1988, used a system of broad categories to determine risk weightings. Over time, both banks and supervisors became dissatisfied with what they considered imprecise measures of risk. Basel II of 2004 gave banks with approved risk management systems more latitude to assess the riskiness of their assets. Risk assessments issued by credit rating agencies were also given more prominence. Policymakers hoped that this would better align capital requirements with the actual risks that banks faced. In addition, they expected that banks would put their risk management in order and engage in less rule-avoiding behaviour.
One of the disadvantages of the Basel II approach is that it can reinforce procyclical effects. Banks’ risk models often have short-term horizons. In good times with few bankruptcies, the models report low risk, encouraging banks to grant more loans. During a crisis, all signals suddenly turn red, prompting banks to hit the brake. A similar dynamic is found in credit ratings. At the aggregate level, this can strengthen the cycle of boom and bust.
Limited changes have been made in this area since the crisis. Policymakers require banks to apply longer time horizons in their risk models and to factor in worst-case scenarios. There are also lower limits for risk weighting and banks must no longer place blind trust in credit assessments. The Basel III Accord (2010) and the recent Basel IV Accord (2017) nevertheless continue to rely on both risk models and credit ratings.25
As an adjacent policy area, monetary policy merits greater attention in light of the debt problem. In its current form, monetary policy is primarily aimed at stabilizing the value of money, which in many countries is construed as limited inflation for goods and services. The price of houses and financial assets falls outside its direct purview. Critics believe this narrow focus contributed to the financial crisis, with central banks in Europe and the United States keeping their interest rates low, thereby contributing to the growth of credit bubbles.26 In the wake of the crisis, critics charged that the policy of low interest rates and quantitative easing was again contributing to excessive debt. This raises the question of whether monetary policy should also explicitly address financial stability.
There are two reasons to keep monetary policy separate from other policy areas. First is the question of whether the principal instrument of monetary policy, the interest rate, is an appropriate means of countering credit bubbles. It is doubtful that raising interest rates is on its own sufficient to counter excessive credit growth, while doing so can cause serious damage to the rest of the economy.27 Second, monetary policy’s exclusive focus on price stability gives the central bank a clear objective, making it easier to argue that it should be independent from politics. In addition, pursuing a single goal also improves oversight by and accountability to politicians. Financial stability is a vaguer concept and more difficult to measure and account for.
On the other hand, there are good arguments for monetary policy to focus more on financial stability. Although the interest rate may be too blunt an instrument to tackle credit bubbles, this does not mean that central banks should ignore sharp rises in lending when deciding on interest rates. The interest rate instrument is so powerful that other instruments alone will probably be insufficient to curb excessive credit growth.28 Since the crisis, the ECB has started to interpret its mandate more broadly while Banking Union has given the ECB a key role in supervision. The time thus seems opportune to reflect more broadly on the relationship between monetary and financial stability policy and its associated instruments.
Finally, socioeconomic policy fields such as housing, pensions and tax policy affect the volume of debt in society. High mortgage debts in the Netherlands cannot be viewed apart from broader housing market policy, where a stagnant rental market and the deductibility of mortgage interest render home ownership attractive. Likewise, the pension system mandating employees to save significant portions of their salaries contributes to long balance sheets where high debts are combined with high, but mostly inaccessible savings. Countering our dependence on debt requires a broader strategy than just macroprudential policy. Brakes such as the loan-to-value ratio will be more effective if they are tied to the elimination of incentives to borrow rooted in socioeconomic policy.29
7.1.2.2 Structural Measures
Post-crisis deliberations on how to constrain credit growth have devoted less attention to the structure of the banking sector. The current Dutch banking landscape with its three large universal banks is liable to encourage money creation and credit growth. As the big three are relatively certain that newly created bank deposits will remain available to them as a source of funding, they face less constraints in credit creation. A more diverse banking sector in which newly created money does not automatically remain within the big three banks may indirectly constrain money creation; as was the case, for example, in the 1960s and 1970s (see Chap. 3). Greater diversity in the banking landscape, as advocated by proponents of the sovereign money system, would help. Some of their ideas can be pursued without switching fully to the alternative system. Two recent proposals are particularly noteworthy: (1) the introduction of a central bank digital currency; and (2) the formation of a bank focused primarily on payments and savings.
There have been ongoing discussions about whether the central bank should allow citizens and businesses to hold payment accounts at the central bank.30 In the debate this is referred to as the introduction of central bank digital currency (CBDC). In the current system, only commercial banks and a number of other financial institutions have access to digital accounts at the central bank. Since these deposits do not count as part of the money supply, these are called central bank reserves rather than central bank money. While citizens and businesses can access central bank money in the form of cash (coins and banknotes), for digital money they can only rely on commercial banks. The question is whether a digital, public means of payment should be developed, allowing households, businesses and other financial institutions to save directly with and make payments through the central bank. As a public alternative to payment accounts at commercial banks, it could be organized as a relatively independent payments system that can provide a back-up in the event of disruptions to the private payments system.31
The debate on CBDC mostly focuses on financial stability issues. In the current system, citizens can either convert their bank deposits into cash or transfer them to another bank. The introduction of a central bank digital currency would enable this money to be transferred to the central bank. Critics fear that this possibility would increase instability as warning clouds on the horizon may prompt citizens to transfer their balances en masse to the central bank, thereby triggering a bank run across the entire commercial banking sector.32 This would then require the central bank to rescue the commercial banks, with a substantial expansion of its role as lender of last resort.33
Proponents argue that there are ways to mitigate such problems, for example by limiting the convertibility of bank deposits into central bank digital currency and capping the amount allowed to be held on the central bank account.34 Additionally, the deposit guarantee system would continue to discourage bank runs. It is also possible that digital public money will result in more diversity in the financial system, helping to curb systemic risks. If a full-fledged alternative to bank deposits is available, this would put a stronger brake on money creation than our current homogenous system. In Chap. 4 we pointed out that the forerunners of the Postbank (PCGD and Rijkspostspaarbank) fulfilled such a function for decades.35 In short, the diversity introduced by central bank digital currency may have a disciplining effect on banks. Finally, the fact that a safe haven could destabilize the current system points to flaws in our current system rather than shortcomings of CBDC. After all, the forerunners of the Postbank did not cause instability.
Another possibility would be granting licences to banks whose only assets are central bank reserves, thereby giving citizens indirect access to ‘secure’ money. But financial stability would remain a concern as this variant also provides a safe haven for bank deposits, potentially exacerbating the risk of a systemic bank run. But as with central bank digital currency, greater diversity in the sector may have positive effects on stability. In the Netherlands, such a deposit bank has been proposed by the Full Reserve Foundation (see Box 7.4).
Box 7.4 A Deposit Bank
The Full Reserve Foundation’s plans for a deposit bank focus less on volatile lending than on ensuring that “taking risk becomes a choice”. The foundation seeks to “reduce and ultimately abolish” the deposit guarantee system so that “banks can once again fail without the payment system coming to a standstill”.36 To date, no such deposit bank has materialized.
The Full Reserve Foundation applied for a licence for a deposit bank, i.e. a bank whose sole assets comprise central bank reserves. The idea was that citizens would have a secure option for payments and savings with a bank that incurs no financial risks. The finance minister, however, ruled that no such banking licence could be issued. The discussion largely focused on participation in the deposit guarantee scheme.
The Full Reserve Foundation wanted the deposit bank to have access to target2, the interbank payment system. But the minister ruled that access to target2 would require participation in the deposit guarantee scheme.37 The Full Reserve Foundation did not believe the deposit bank should shoulder the costs of other banks’ riskier activities; the deposit guarantee scheme is, after all, a mutual insurance which would put the deposit bank in difficulty should other banks collapse. Other solutions to cover this risk, such as insuring the deposits through a private insurer, were deemed unacceptable.
DNB proposed organizing the deposit bank as a money market fund so it would not have to participate in the deposit guarantee scheme.38 This was unacceptable for the Full Reserve Foundation as it would mean exclusion from the payment system (a money market fund does not have access to target2). These obstacles ultimately led to the entire plan being abandoned.
The idea that greater diversity in the commercial banking sector can limit excessive debt growth has received scant attention since the crisis. Of course, there have been debates about the importance of greater diversity.39 But concentration in the sector has only increased since the crisis. The share of the three major banks grew from 71% in 2006 to 75% in 2016 (measured by balance sheet size), while that of the five largest banks grew from 84% to 89%.40 New supervision requirements were a factor in Rabobank’s decision to centralize its operations, with its local branches giving up their own banking licences. In short, in many ways, diversity seems to have decreased.
7.1.3 Preparedness for the Next Financial Crisis
In addition to limiting excessive debt growth, it is also important to prevent financial collapse once problems materialize. The first step is to prevent a shock from immediately becoming a crisis. Tightening banking requirements have been key in this respect. If a crisis nevertheless arises, we need to ensure that money and credit do not enter a downward spiral. Here we discuss how to deal with banks that are in distress and the tools available for monetary policy to combat the next crisis.41
7.1.3.1 Tightening of Banking Supervision
Bank regulation and supervision have been tightened since the crisis, with the Basel III Accord (2010) and its implementation in European laws and regulations introducing tighter capital requirements as well as rules for liquidity.
Capital requirements have been strengthened in different ways. The requirements for the risk-weighted capital ratio have been increased. As the crisis revealed deficiencies in this area, policymakers have made further adjustments, gradually reducing banks’ room for manoeuvre in weighting risks. Capital requirements have also been strengthened by introducing an unweighted capital requirement (the leverage ratio). This is intended as a backstop for the risk-weighted capital ratio, not as a replacement. Banks’ equity must be at least 3% of the total size of the balance sheet (EU rules: CRR II). In the Netherlands, the current requirement is 4% for systemic banks. This requirement will be aligned with European requirements once these enter into force (June 2021).42
Liquidity rules help ensure that banks have sufficient liquid assets and stable sources of funding. Up until the 2007-2009 crisis, policy in this area was developed at the national level but was of marginal importance compared to capital regulation. The crisis showed this to be a blind spot. Basel III therefore introduced liquidity rules. The liquidity coverage ratio (LCR) states that banks must have sufficient liquid assets to deal with short-term stress. The net stable funding ratio (NSFR) states that banks must have appropriate financing sources for long-term liabilities.
Although these steps go in the right direction, we should not overstate the nature of the changes. Risk weighting still plays a central role in capital requirements, but during booms risk models indicate that risk is low.43 The danger remains that banks will not have access to equity if they need it to absorb shocks. While the introduction of the leverage ratio is an improvement, many believe the 3% minimum is too low to absorb significant setbacks.44 Liquidity requirements also remain rather insignificant in practice. Since its introduction in 2010, the LCR was eased first by the Basel Committee itself and then implemented in the EU in a more flexible form due to fears that banks would otherwise be hit too hard.45 The same applies to the NSFR: its implementation has been postponed in the EU with policymakers fearing it would impede economic recovery. It will now become operational in June 2021, more than 11 years after the Basel Committee first proposed this measure.46
7.1.3.2 Problem Banks
The 2007-9 crisis revealed policy frameworks for dealing with failing banks to be insufficient; there were few if any emergency plans in place and it was unclear which bodies were responsible (particularly in the case of cross-border banks) and what powers they had.47 There were few options besides nationalizing banks, granting them large loans or buying up their shares, which meant taxpayers ended up meeting a large part of the costs.
Much has changed since then. First of all, banks are obliged to have recovery plans in place to tackle any eventualities. These include, for example, possibilities for recapitalization, access to emergency funding, and the sale of assets or specific parts of the business. The recovery plan is part of a broader policy framework for dealing with problem banks. The European Single Resolution Mechanism (SRM) has been in force since 2015 as part of the Banking Union. This framework sets out the various options available to supervisors if a bank encounters solvency problems. It comprises the national resolution authorities (in the Netherlands: DNB) and a European body, the Single Resolution Board (SRB), which plays a leading role for banks supervised by the ECB.
These authorities draw up a resolution plan for each bank. Resolution means “a controlled and careful means of winding up a bank threatened by collapse”.48 They have various options. They can: (1) pass on the losses to the shareholders and creditors (bail-in); (2) sell parts of the bank, without the shareholders’ approval; (3) transfer the essential parts of a bank to a public ‘bridge bank’, in which the bad parts are allowed to fail; and (4) transfer the bad parts to a separate vehicle (a bad bank) that will then be gradually liquidated. The authority can also choose to allow the bank as a whole to fail.49
Although the single resolution mechanism is an important step forward, it has barely been tested in practice. We should not have undue expectations of the bail-in in the event of a major crisis. Although it may work for an individual bank or a number of small banks, whether it will also work in a systemic crisis is highly questionable.
Alongside the immediate challenges of absorbing the 2007-9 crash, the EU has had particular problems with the prolonged negative effects of the weakened banking sectors. After the crisis, some EU countries were very slow to recognize problem loans. Many banks actually needed capital injections and a writing off of bad loans to strengthen their financial positions, but many governments were reluctant to enforce this. There are good reasons for being reticent about writing off loans: it is quite possible that the economy will revive and reduce the volume of problem loans.50 The writing off of problem loans leads to losses for the bank and a deterioration in its equity position; if there is no simultaneous plan for recapitalization, early loan write-downs may exacerbate the crisis.
Yet delaying writing off problem loans may also result in ‘muddling through’, with the wait-and-see attitude impeding recovery. If problem loans remain on bank balance sheets, banks remain financially unhealthy, potentially reinforcing the downward spiral. Recapitalization plans are required to avoid this. Recapitalization based on retained earnings always takes longer than recapitalization with new shares (which existing shareholders will oppose). Policymakers in the United States have tackled this issue by demanding that banks recapitalize during the 2007-9 crisis, with the government acting as a backstop if they fail to raise enough capital. American banks thus improved their financial positions faster and resumed lending sooner. In Europe policymakers were much more reticent; the result was that the recovery took much longer.51 Bail-in rules mean that banks must be recapitalized in the event of problems, but these rules are aimed at individual banks. European rules do not currently provide a means to force a group of banks – including banks that are not in acute difficulties – to recapitalize during a crisis.
7.1.3.3 Monetary Policy in the Next Crisis
During the 2007-9 financial crisis, central banks sought to support vital markets and lower interest rates. The US and the UK resorted fairly quickly to quantitative easing, which had long been used in Japan. Quantitative easing involves the central bank buying up government and corporate bonds. The European Central Bank chose this path in 2015 as the threat of deflation loomed in the wake of the euro crisis. Combined with low (even negative) interest rates, the ECB sought to encourage borrowing in the hope that this would boost the economy and bring inflation to the desired level. Monetary policy thus moved into unfamiliar terrain.
Another crucial question is what instruments governments have at their disposal to revive the economy in a forthcoming crisis. Many governments have very high levels of debt. Even higher public debt in a subsequent crisis could fuel investor mistrust, which in turn could lead to a new debt crisis. What additional room for manoeuvre would governments have then?52
Public money creation through monetary financing is one option.53 In monetary financing, the central bank creates new money without any corresponding debt. There are various ways in which this money can be brought into the economy, including through government spending or the central bank transferring money directly to citizens (‘helicopter money’). Monetary financing is the standard way to create new money in the sovereign money system. Could it be an option in the current system in case of an emergency?
The main objection is that monetary financing can spiral out of control, even leading to hyperinflation (see Chap. 6). Having this option may also make governments less inclined to control public spending. It is also doubtful whether many countries would actually need to resort to monetary financing in a future crisis: some governments, including those of the Netherlands and Germany, would be able to implement generous countercyclical fiscal policies in the event of a crisis.
Although the monetary financing of government spending is now rare, it used to be quite common, including in Western countries. The historical experience is thus not as clear-cut as opponents would have us believe. Although monetary financing has the potential to spiral out of control, it has often proved to be effective.54 Some observers believe the policy of quantitative easing already has characteristics of monetary financing, particularly when the ECB buys up newly issued government bonds and it remains unclear whether it will ultimately sell them.
Monetary financing is currently prohibited in Europe under the Treaty on the Functioning of the European Union (Article 123 TFEU). It is therefore generally assumed that monetary financing would require an amendment to this treaty. Saravelos et al. argue that although monetary financing through government expenditure is prohibited in the EU, it is unclear whether this would apply if the ECB opted to transfer newly created money directly to citizens.55
7.1.3.4 Interim Conclusion
Macroprudential policy has been the main post-crisis initiative to manage the growth of debt. Additionally, small steps have been taken to eliminate fiscal incentives to accumulate debt. Despite these measures, in the Netherlands the level of private debt as a percentage of GDP is no lower than before the crisis (see Fig. 4.3). It is thus uncertain whether the range of instruments to limit debt growth are a match for all the forces that still encourage it. These include tax and other incentives, the structure of the financial sector, and lenient monetary policies.
7.2 Balance Between Public and Private Interests
The second major challenge is restoring the balance between public and private interests. As we discussed in Chap. 4, crucial public interests are at stake in the financial sector. The payment infrastructure has the characteristics of a public good while lending has significant positive and negative external effects. That public interests are at stake implies that the government needs to take responsibility for these issues. This of course does not mean that the government will completely take over the provision of these services itself. In many public-interest services such as energy, food supplies and healthcare, private parties play an important role in promoting public interests.56 Likewise, in the financial sector both public and private actors have a responsibility to contribute to the public interest.
The public-private relationship has changed over the past decades. Fifty years ago, payments and savings in the Netherlands were primarily ‘public’: people used cash for most payments and mostly relied on the publicly owned predecessors of the Postbank for non-cash payments. Financing, on the other hand, was more often the domain of private institutions although the government had an important role through public investment banks. Since then, commercial banks have expanded to serve households while the public banks have been privatized. With the shift to deposit money, society now largely depends on private banks for payments and savings.
The financial crisis reminded us how dependent society has become on financial institutions, particularly the major commercial banks. Since their operation has a direct impact on important public functions, public and private interests are interwoven. Commercial banks cannot be seen as purely private institutions. Indeed, their public dimension came to the fore in the dispute over a pay raise for ING’s chief executive in 2018. According to Dutch Prime Minister Rutte, banks do not have the same freedom as other companies to set their chief executive’s pay as they are “semi-public institutions”.57
Since the crisis, various steps have been taken to strike a better balance between public and private interests in the financial sector. Attempts have been made to: (1) draw a clearer boundary between public and private interests and institutions, and (2) to embed public interests more firmly in the banking sector.
7.2.1 A Clearer Boundary Between Public and Private Interests
Since the crisis, efforts have been made to better balance public and private interests in the financial sector. The first step was to draw a clearer boundary between the two. Attention has been paid to whether banks’ more public activities can be separated from their more private activities. Efforts have also been made to limit the public guarantee for the financial sector.
7.2.1.1 The Ring-Fencing of Public Activities
Following the crisis, a great deal of attention was devoted to the need to separate banks’ public activities from their riskier private endeavours. Critics claimed that by pursuing risky activities such as trading in complex financial instruments, large banks had jeopardized their ‘public functions’. Institutions had become so large and complex that governments felt obliged to rescue the entire bank to safeguard its public functions. A clear separation of activities would ensure that public activities were protected and that governments would not have to bail out the entire bank in the event of a crisis.
A range of proposals – some of them implemented – were advanced to introduce such a separation.58 How this separation would work differed between the proposals. Broadly speaking, there were two options which could be combined if necessary: (1) prohibiting banks that perform utility functions from pursuing certain risky activities; and (2) obliging banks to ‘ring-fence’ certain activities within the bank. In the case of ring-fencing, the bank would not be prohibited from pursuing riskier activities, but would have to ensure that specific business units are independent in their operations and their funding basis.
The United States chose the first option: the Volcker Rule (adopted and gradually introduced in 2012) states that banks offering payment and savings accounts are not allowed to pursue certain activities such as trading on own account (so not on behalf of customers). In the United Kingdom banks have been required to ring-fence their domestic retail activities since 2019 so that these can operate independently; other activities must be kept outside of the ring-fenced entity (Vickers Rule). In the EU, the European Commission presented a plan to keep certain trading activities separate, on the advice of the Liikanen Committee,59 combined with a variation of the American Volcker Rule. But the Commission withdrew this plan in 2017.
No separation measures have been implemented in the Netherlands although the subject has arisen in social and political debates. The De Wit Committee called for ‘utility bank activities’ (payments, savings and loans) to be ring-fenced from more speculative activities.60 But the government found such a separation difficult to achieve in practice and feared negative consequences for the Dutch economy.61 As the debate persisted, the government appointed a separate committee to investigate whether structural measures were required. The committee (chaired by Herman Wijffels) counselled adopting the Liikanen proposal on the ring-fencing of trading activities and, if necessary, prohibiting banks from own-account trading.62 The government, however, decided to await European regulations, which to date have not materialized.63
7.2.1.2 Reducing the Public Guarantee
Realization of the scale of the government’s guarantees to the major banks led to a public outcry. Following the crisis, European policymakers set up a recovery and resolution framework and a European authority to respond to bank failures. Policymakers also sought to reduce the public guarantee by making professional investors in banks bear more of the financial risk and having banks contribute to the deposit guarantee scheme in advance.
The main way in which professional investors can contribute financially in a crisis is through the ‘bail-in’. If a bank gets into difficulty, its shareholders, bondholders and other creditors (if they are not covered by the deposit guarantee system) must meet the costs. It is hoped that this will reduce the public costs of bailing out failing banks and lead to less risky bank behaviour. Laudable though this measure is, we should not have overly high expectations. Particularly in the event of a systemic crisis, a bail-in can reinforce panic and hence exacerbate the crisis.64 In such cases, the government must stand ready to intervene and offer guarantees.
Changes have also been made to the deposit guarantee scheme. Although it is primarily a safety net between banks, it is publicly enforced and the government is required to intervene in emergencies. During the crisis, European countries increased the guaranteed amount to €100,000. Whereas banks previously had to contribute when another bank collapsed, in the Netherlands a fund was created in 2015 requiring pre-financing by banks. By 2024 this fund will amount to 0.8% of all guaranteed deposits, with the bank’s mandatory contribution largely depending on its risk profile.65 This fund, however, is insufficient to repay the guaranteed deposits should one of the large Dutch banks collapse; in this case the government would have to step in. The relevance of the deposit guarantee system is thus questionable, in any event for the large banks. If a systemic bank is on the brink of collapse, the deposit guarantee system would not be called upon; rather, a solution would be sought for the entire bank instead.
7.2.1.3 Better Representation of Public Interests in the Banking Sector
The clearer separation is one way to achieve a healthier balance between public and private interests. Another is to ensure the better representation of public interests in the banking sector.
7.2.1.4 Greater Awareness of Public Duty
Measures have been implemented since the crisis to better represent public interests within banks. Employees in the financial sector must now swear an oath. This was first inserted into the Dutch Banking Code, which banks implement on a ‘comply-or-explain principle’.66 The code was later incorporated into the Financial Supervision Act and thus extended to the entire financial sector (although reference is still made to the ‘banker’s oath’). The oath must now be sworn by all executive and supervisory board members, customer-facing staff and employees able to influence the institution’s operations. In the oath, the person promises to act honestly, to consider the interests of all stakeholders when taking decisions, and to keep the interests of the customer central. Breaches lead to disciplinary consequences.
Further rules of conduct have been added to the banker’s oath. The banking sector now pledges to work in the interests of society and to consider the interests of all stakeholders. Individual banks have also sought ways to ensure that the interests of different stakeholders are protected (see Box 7.5).
Box 7.5 Balance Between Different Stakeholders
De Volksbank (formerly SNS Bank, nationalized in 2013) has an internal agreement stating that decisions must consider the interests not only of shareholders but those of customers, employees and society at large. Solutions must be sought that balance these interests. For example, De Volksbank now waits longer before engaging bailiffs and debt collection agencies in cases of default. The customer is first approached by the bank itself. A bailiff is only used if the debtor is able but unwilling to pay.67
Rules for remuneration have been introduced to counter excessive pay and perverse incentives. That the bonuses paid to bankers in good times could not be clawed back when governments had to incur the bail out costs were perceived by many people to be grossly unfair. Critics also claimed bonuses reward misconduct, namely pursuing short-term profit at the expense of long-term stability.68 Recent European rules limit bonuses for bank executives to 100% of their annual salary, while unjustified bonuses can be reclaimed. The Netherlands now has stricter rules for all financial employees, capping their bonuses at 20% of their annual salary.
While clear steps have been taken, cultural changes do not happen overnight; these measures must prove themselves over the longer term. A crucial question is whether these initiatives are enough to counter the forces within banks that lead to their purely commercial focus.69 One may legitimately ask whether organizational changes within banks are required.
7.2.1.5 Position of the Citizen
Other efforts to change bank behaviour have focused on providing greater counterweight to powerful commercial interests in the financial sector. The crisis showed that banks had previously encountered little resistance to their activities, in large part due to the massive informational advantages they enjoyed over their customers, shareholders and financiers.
Consumers were in particularly weak positions.70 Although pre-crisis policies required financial institutions to offer sufficient and factually accurate information, this often led to information overload where customers could no longer see the forest for the trees.71 Information alone is insufficient; behavioural research shows that consumers, contrary to the assumptions of rational choice theory, sometimes take excessive risks.72
Since the crisis, policies have sought to strengthen the position of consumers. Since 2014, banks have a statutory duty of care towards customers.73 The Netherlands Authority for Financial Markets has the power to ensure that customer interests are sufficiently heeded when financial institutions develop new, potentially risky products. The position of consumers has also been strengthened by the creation of a complaints office, while the government has strengthened its commitment to mandatory financial information. The Money Wise Platform (Wijzer in Geldzaken), established in 2013, seeks to encourage responsible financial behaviour through better information. A similar initiative, the National Financing Guide (Nationale Financieringswijzer), addresses businesses.74
Other factors have weakened the position of consumers. Standard products have not been developed to give consumers greater certainty about the suitability of financial products. The process of switching banks also remains complex, rendering the exit option less practical for account holders (see Box 7.6).
Box 7.6 Exit Option for Account Holders
Europe uses an account number system, the International Bank Account Number (IBAN), to simplify international transfers. The disadvantage of this system is that account numbers are linked directly to banks, rendering number portability impossible. If account holders wish to change banks, they are issued a new account number. This is an obstacle even if a switching scheme is in place.
Discussions have been under way for many years, including in the Dutch Lower House, on ways to introduce number portability into the IBAN system. DNB has concluded it will be difficult, requiring technical adjustments at both the national and European levels. “It appears technically possible to allow switching in the current infrastructure while retaining the NL IBAN. However, in view of the expected complexity of the introduction in terms of technology, operations and processes, and the consequences for banks and processors, including outside the Netherlands, it is not recommended”.75 But this has not silenced the discussion. A motion was adopted in parliament on 4 April 2018 to embed number portability in the Banking Act. Minister Hoekstra has promised to study other options (Handelingen II, 2017/18, 69, item 10, p. 37).
One possibility is to use aliases in the payment system. The National Forum on the Payment System recently stated: “To give a real boost to bank account switching, a new type of alias is required: a standardized, self-checking number that preferably belongs to consumers and businesses and can be used throughout the euro area […]. Given the need for a solution at the European level, the MOB will share these findings with the European Commission as input for the cost benefit analysis for European number portability that the Commission will institute in 2019”.76
A better exit option may strengthen the position of consumers vis-à-vis banks, but a genuine dialogue between consumers and financial institutions would require consumers to be involved in other ways. Here there is an interesting parallel with the position of citizens in the healthcare system (see Box 7.7).
Box 7.7 Position of Citizens in the Healthcare System
Like the financial system, healthcare in the Netherlands is a mixed public-private system. The position of the citizen is guaranteed in a number of ways, vis-à-vis both care institutions and insurance companies. Some care institutions are required to establish client advisory boards. Health insurers are required to guarantee in their articles of association that they give policyholders reasonable influence over company policies (Article 28 (1) (b) of the Healthcare Insurance Act).
This influence was deemed insufficient. Two motions were adopted in the Lower House in 2014 requiring policyholders to be given more influence over health insurers.77 The Council for Public Health and Healthcare (2014) recommended giving citizens greater say to improve the legitimacy of the system. The 2017 coalition agreement stated: “legal provisions will be adopted giving policyholders, patients and clients a greater say on the policy of their health insurer and care provider.”
There are currently two bills pending. The new Care Institutions Client Participation Act (2018) mandates the establishment of a client advisory board in all care institutions with more than 10 care providers (this obligation previously applied only to publicly financed care institutions). Whereas the previous law contained the right of consultation in decisions affecting clients, the new act contains the right to consent to these decisions.78
A further bill has been tabled to strengthen the position of policyholders vis-à-vis health insurance companies (Act on Influence of Policyholders under the Healthcare Insurance Act). The government believes the opinions and wishes of policyholders must carry more weight in the health insurer’s decision-making.79 Minimum requirements must be drawn up, giving individual policyholders a say and guaranteeing their permanent advisory representation. This can take the form of a members’ council, but the insurer can also use alternative means.
People must deal with the financial sector not only as consumers but also as citizens. Here, the voice of citizens is interpreted in the first place by parliament. Financial regulation has received much more attention since the crisis, with elected representatives being much more engaged with financial laws and regulations. A meaningful representation of the public voice in the financial sector also requires public organizations to be more informed about societal wishes, a requirement the United Kingdom is seeking to meet in an innovative way (see Box 7.8). Finally, there is greater recognition of the importance of ‘watchdogs’. An example is Finance Watch, an NGO operating as a counter-lobbying organization, established following the crisis.
Box 7.8 Involving Citizens in Financial Regulation
According to Andrew Haldane, Chief Economist at the Bank of England (BoE), central banks have a twin deficit problem: citizens have insufficient understanding of economics and there is a lack of public trust. To address both of these deficits, the BoE announced in March 2018 that it was setting up regional citizen panels. According to Haldane, the aim is to initiate a structured and systematic dialogue between the BoE and citizens on the economy, the financial system and monetary policy. The aim is not only to ensure that citizens are better informed, but to learn from them.80 Actively informing and consulting citizens is part of a broader approach to involve them more in the Bank of England’s policy. This includes a layered communications strategy that involves communicating in a language free of financial jargon, a national education programme and regional tours.
7.2.2 Interim Conclusion
The Dutch government ultimately decided not to separate the activities of commercial universal banks. Nor has such a measure been implemented at the European level, although individual countries (including the UK) have advanced a number of initiatives. Governments have taken steps to prepare themselves for the next banking crisis. Key among these are bail-in measures to pass on the costs of a bail-out to the bank’s financiers. It nevertheless remains unclear how these measures will operate during a major crisis.
That universal banks have numerous public utility functions implies that they are semi-public institutions. Banks have been more aware of this since the crisis, evidenced by initiatives such as the Banking Code and the banker’s oath. Whether such initiatives within the sector’s sphere of influence will lead to actual change remains uncertain, raising the question of whether greater attention should be devoted both to the organization of banking and how to increase the influence of certain stakeholders. When considering the balance between public and private interests, we cannot forget the need for greater diversity and competition in banking.
7.3 Conclusion
Two important challenges must be addressed to arrive at a more stable, fairer and legitimate financial monetary system: the more balanced growth of money and debt and a better balance between public and private interests. This chapter has considered the extent to which such steps have been taken in the current system and what further possibilities exist, partly inspired by plans for a sovereign money system.
Although measures have been taken to achieve a more balanced growth of money and debt, they have not been robust enough to reduce the current mountain of debt. This means further attention is required for incentives to borrow and lend, policy coherence and the structure of the financial sector.
Regarding the balance between public and private interests, we first considered the possibilities of separating the financial system’s public and private functions. Attempts to achieve a clear boundary have foundered for various reasons. Since the major universal banks have public utility functions, they have become de facto semi-public institutions. It is thus particularly important to assess how public interests are safeguarded in these institutions. The organizational structure of banks can also be assessed in this light.
Open Access This chapter is licensed under the terms of the Creative Commons Attribution 4.0 International License (http://creativecommons.org/licenses/by/4.0/), which permits use, sharing, adaptation, distribution and reproduction in any medium or format, as long as you give appropriate credit to the original author(s) and the source, provide a link to the Creative Commons license and indicate if changes were made.
The images or other third party material in this chapter are included in the chapter’s Creative Commons license, unless indicated otherwise in a credit line to the material. If material is not included in the chapter’s Creative Commons license and your intended use is not permitted by statutory regulation or exceeds the permitted use, you will need to obtain permission directly from the copyright holder.