The International Banking Crisis: Lessons and EU Reforms

The key dynamics of the transatlantic banking crisis are analyzed - with emphasis on the fact that the banking disaster of 2007/08 was not really a surprise -, and the five key requirements for restoring stability and efficiency in the EU/OECD banking sector are highlighted: Hedge funds should be regulated and be required to register with the Bank of International Settlements, which should have the right to tighten equity capital requirements if deemed necessary. The quality and comprehensiveness of banks- balance sheets must be radically improved and all off-balance sheet activities must be included in future total balance sheets (TBS). Securitization is a useful financial innovation, yet asset backed securities (ABS) should become more standardized and every bank selling ABS should declare its willingness to buy back this package at any point of time at a minimum of 50% of the initial transaction price. All credit default swaps (CDS) must be registered in a global database, and future transaction should go through a clearing house. Previous CDS transactions must also be recorded, since a critical veil of ignorance of counterparty risk would otherwise continue and hence the uncertainty about the valuation of large portfolio positions of banks, funds and insurance companies would continue. Financing of rating should be indirect, namely every country or company planning to place bonds in the market should pay fees into a pool, and this pool then finances the respective rating on a competitive basis. This two-stage approach of financing ratings would most likely eliminate the existing conflicts of interest in the present regime. Most important, however, is the introduction of a new tax regime designed to encourage bankers to take a more long term time horizon in decision-making and to reduce excessive risk-taking. Banks and funds should be taxed not only on the basis of profits but also on the basis of the variability - read variance - of the rate of return on equity: the higher the variability over time the higher the tax to be paid (a simple calculation for Germany shows that based on historical data the large private banks would have paid the highest overall tax rate). As regards Basel III one should note that Basel I/II rules are flawed in the sense that raising the equity-loan ratio is assumed - in the logic of the existing Basel arrangements - to create a better cushion against risk and adverse shocks to profitability, respectively. However, theoretical analysis clearly shows that raising the equity ratio implies in an aggregate perspective that the (relative) credit multiplier is increased which in turn could bring about a rise of vola-tility and risk, respectively.