Viv Davies: Hello and welcome to "Vox Talks," a series of audio interviews with leading economists from around the world. I'm Viv Davies from CEPR. It's the second of June 2011; and I'm in London, talking to Professor Viral Acharya of the New York University Stern School of Business about measuring systemic risk, Basel III and capital requirements. Professor Acharya describes the Stern systemic risk rankings of US financial institutions and what he considers to be the failure of the Basel III capital requirements in addressing systemic risk. He discusses shadow banking, and also how banking and sovereign risks are becoming intertwined.

I began the interview by asking Professor Acharya to explain how systemic risk arises in the first place.

Professor Viral Acharya: I would say; in order to give a very short but maybe useful definition, systemic risk arises when a significant part of the financial sector gets under capitalized all at once. Another way of saying it would be that, a common shock hits a large part of the financial sector that's being funded with short term debt. Different crises have either more emphasis on the shock, sometimes the emphasis is more on the short term debt aspects of it. But I think the key factor is that it has to hit a large part of the financial sector all at once, so that there is some loss of intermediation.

And through the loss of intermediation, there is either a credit crunch for the real sector, there's a reduction in debt for the household sector, capital markets could freeze up all at once. In the extreme, payment and settlement systems could collapse altogether so that there could even be loss of trade globally as a consequence.

Viv: So systemic risk is one of the main reasons why regulation of financial institutions is so important, yet there has never been a formal or organized method, established by regulators, to measure or quantify systemic risk. Why do you think that is?

Prof. Acharya: It's partly because regulators very often follow the letter of the law that's laid out. And unfortunately, most regulation - at least the way it was formerly written down - had always been about what I would call micro-prudential regulation; focused on supervision of individual banks, ensuring that they don't fail, ensuring that there's no sort of fraud in the accounting, that they're rightly recognizing losses in due course of time, and so on. Systemic risk was often justified as a reason for regulating banks. But as you put it, there hadn't been a good formal attempt to measure or quantify systemic risk in an interesting way.

In the Western economies, I would say there hadn't been an episode of a fully blown banking crisis. Scandinavia had one in early '90s. You could argue savings and loans crisis in the United States was also a systemic crisis in the sense that it cost the taxpayer a lot. A big part of the mortgage industry was at risk at that point.

But I think it was partly really because the Great Depression was followed by a suite of regulations, like the Deposit Insurance, the SEC, the Glass Steagall Act, which seemed to have contained banking crises for a while, until these regulations became anachronistic in one way or the other, so that the government guarantees remained in place, but all the restrictions to ring fence its users became weak over time. Amd then gradually the seeds of a full blown systemic crisis were sown in the Western economies.

Viv: Maybe you could explain for us what you and your colleagues at the NYU Stern School of Business have been doing in relation to measuring systemic risk.

Prof. Acharya: Our measurement of systemic risk is based on publicly available data. It's very close to the definition of systemic risk that I made earlier, which is that systemic risk arises when a big part of the financial sector gets under capitalized all at once. As you can see from this definition, the key ingredients are: first what's the leverage of an institution? Second what is its exposure to some sorts of common shocks out there in the economy? And three its size is going to be important because the larger it is, the greater is going to be its share in the overall under capitalization of the system.

At NYU, we have an academic paper on this. I've co authored this paper with Lasse Pedersen, Thomas Philippon and Matt Richardson. My colleague Rob Engel then has an econometric implementation in there with Christian Brownlees. But as a result of this collaboration ended in a website which is called Vlab - Volatility Lab - something that Rob Engel maintains on his Volatility Institute website.

Here, on a weekly basis, we update our ranking of the systemic risk contributions of the top 100 financial firms in the United States. Now, the idea is not to say that systemic risk contributions change on a week to week basis, but it helps you understand why these measures are moving.

Put simply, what our measure does is the following. It says that “I'm going to define a stress scenario for the economy as a 40% crash in the aggregate market, per se. S&P 500, for example”. Why such a simple scenario? Because we don't have the advantage that regulators have of knowing every single asset that banks are sitting on what's currently the most important asset class.

But by and large, in every crisis, if it is systemically important, you would expect a pretty large correction to the stock market, of the economy as a whole, because a systemic crisis should be something that actually spins over to the real economy to households and so on.

Our criterion is…the question we want to ask is: will firms be well capitalized when there is a large common shock to the economy as a whole? So, the question would be, for example, will Bank of America have a capitalization of not more than $8 of assets per dollar of equity? Conversely, which means its leverage should not exceed 12.5 to 1 in this stress scenario.

Therefore, we are not talking about current leverage. We are talking about leverage in a potentially severe stress scenario down the road. So we need to be able to project, given its current leverage, and given its current equity capitalization, how much of their equity capitalization will erode in a 40% correction to the market?

In a simple sort of market language, this is a concept of what is the downside beta of Bank of America? Beta is more of a linear concept. Probably risk increases somewhat more exponentially on the downside, so we do a more sophisticated estimation of this downside risk.

But we basically come up with a measure, which we call MES, or marginal expected shortfall, which is “what your expected shortfall, or loss, when the market is in a bad scenario this 40% shock?”

For example, if Bank of America's shortfall against market, on a per dollar basis, is, say, two, it means that when market loses 40% of its equity capitalization, Bank of America is going to lose 80% of its market capitalization.

Now, therefore, if I know this downside risk measure, the MES, I can project how much equity Bank of America is going to be left with in the scenario. I know what the liabilities of Bank of America are, based on its current balance sheet. I can project its leverage ratio, therefore, in that systemic stress scenario, and now, most likely, it's going to be short of being at the leverage of 12.5 to 1.

So I can calculate by how many dollars is its equity short of ensuring that its leverage doesn't exceed 12.5 to 1. This we call the capital shortfall of each firm in this case Bank of America. I can repeat this exercise for J P Morgan, for Citigroup, for Goldman Sachs. We do this for the top 100 financial firms.

The important thing is we are subjecting them not to what they believe is their own stress scenario, which is usually different across different players. We are subjecting all of them to a common shock, because we are really interested in the system as whole becoming under capitalized at the same time.

So now we can add up the capital shortfalls of each of these firms, and then the proportion or the percentage of that which Bank of America contributes is its own systemic risk contribution. If Bank of America's capital shortfall is $35 billion, the overall shortfall is $75 billion, then Bank of America's systemic risk contribution in the U.S. economy is about 45%, as per our measure.

We update this measure on an ongoing basis, so it reflects changes in assets that these banks might be undertaking, it reflects changes in their leverage, it reflects changes in market volatility, and so on. Potentially, we could even reflect changes in how likely the scenario is, where the market actually gets a 40% correction in the first place.

Viv: So you update weekly, or monthly?

Prof. Acharya: We update it weekly. I would say it's more interesting to study a long time series than try and understand when big changes take place, and try to add some economic meaning to what really happened around those times. One thing I should stress is, as I said we are not in the regulatory shoes; we can't have the supervisory intelligence that they have on specific assets that they have. So our approach to systemic risk is very top down. We are coming up with a measure of systemic risk at the level of an institution itself, whereas the current regulatory approaches are more bottom up. They try to get a more granular knowledge about their assets. In some sense, for example, the Basel requirements attach risk rates to each asset. They add those up, and then they try to come up with a capital requirement.

Viv: So, would this mean that it could become easier now to design efficient regulation that discourages the build up of excessive risk?

Prof. Acharya: In principle, yes. Let's suppose, for the time being, that our measure has some economically sound properties in reflecting systemic risk. You could think about several ways we could easily transform our measure into a capital requirement, because I'm actually telling you how much short you're going to be in a systemic crisis and that therefore tells me how much capital you need to raise today to ensure that you will not exceed a 12.5 to 1 leverage in a systemic risk scenario. You could even, in principle, design a levy or a surcharge that's based on this contribution. Clearly, there will be something that's about the level of regulation that needs to be decided as to how high the surcharge or the levy is going to be. Or, in principle, regulators could even just ensure that the systemically most important institutions are being supervised better, try and ensure that the resolution authority…whether they have sufficient knowledge of what's going to happen when they need to wind them down, are their living wills good enough in prescribing what set of actions need to get triggered, etc.

Viv: So, to what extent have the Basel III capital requirements been successful, or not, in helping to mitigate systemic risk?

Prof. Acharya: I have mixed feelings about Basel III capital requirements, in the following sense. Clearly, it's reasonable to think about capital requirement as a response to dealing with systemic risk. And this is because, by and large, systemic risk arises when there's loss of intermediation. Loss of intermediation generally happens when there is something like a bank run, or at least significant draw down on liabilities of a bank or a bank like institution. Where I think Basel capital requirements have failed and I would say have failed, in some sense, quite royally is in, really, their approach, which is really this bottom up approach of assigning risk weights to each asset class and then aggregating it up. As we've been discussing, what you really care about is whether the system is resilient to a large, common shock. But, what the Basel risk weights are based on is the individual historical risk profile of asset by asset. What you really want to know is the risk of mortgages is in a recession? What you really want to know is the risk of a corporate loan is in a recession? What is the risk of a credit card receivable in a recession? That common conditioning on a recession or a large financial sector crisis is what the risk weights should be based on. Instead, the risk weights are based on individual assessments of risk of different asset classes, but they are not aggregated upon.
So there are several problems with this, I would say at least three. One you are looking at individual risk of assets rather than their systemic risk. So because you have ignored systemic risk, implicitly, systemically-risky assets are being subsidized relative to their risks that they impose on the system.

Two the risk weights are often historical looking, they're backward looking in their risk assessments. And so, because the Basel risk weights don't change that frequently, they completely miss any dynamic aspects of risk taking in the economy. They miss the fact that an asset class could be emerging to be a systemically important asset class, like mortgages were in the last decade, whereas prior to that they had been, historically, the most stable asset class. And I would argue that, taking my first point, because we gave a lower capital requirement to mortgage backed securities in Basel capital requirements, in one form or the other, implicitly we are subsidizing this asset class by saying, "No, if you want to go and lend more on this asset class, please go and do it."

And that brings me to the third point which is that because you are not conditioning on a common shock, there's no sense in which the Basel risk weights are capturing a risk of build up of concentrated, common exposure across balance sheets of institutions. So, historically, mortgages have been a stable asset class; they weren't as dramatically large part of bank balance sheets as they became in the last decade. But during 2003, 2004, 2005, 2006, this was the biggest source of credit creation that banks were engaged in, either as direct mortgage origination or as holdings of mortgage backed securities or the other.

So Basel risk weights were telling you that, oh, banking sector is extremely safe because its risk weighted assets were very small, because they were loading up on an asset class that had historically been very stable. But of course, because they were loading up so dramatically on one asset class, there was lending down the quality curve; there was a common factor exposure that was building up. And add to all of this that Basel capital requirements don't really distinguish that much between short term debt, long term debt, even though Basel III proposes some liquidity capital requirements to get around it.

So I would say the broad approach of Basel capital requirements is problematic because of risk weights. Risk weights are not inherently about systemic risk, the way I see them.

Basel III, in contrast, put simply, is some liquidity requirements, which I think is going to deal with short term debt issues a little better than it has done in the past. But by and large, I'm not sure if Basel capital requirements are really what is needed to contain systemic risk in the economy. They are capital requirements, but unfortunately they are not capital requirements geared to deal with systemic risk.

Viv: And what about the shadow banking sector? There's been some criticism of Basel III in that, whilst it was designed to make the banking sector more resilient, it has perversely created new risks by favoring the development of the insufficiently regulated shadow banking system. Would you agree with that?

Prof. Acharya: I would say that's probably point number four against Basel capital requirements, but I would say this is actually a broader criticism of the regulation of financial sector in general, which is that it's often by form rather than function. So, for example; we regulate depository banks, but we were not regulating the investment banks, which, increasingly, after the repeal of Glass Steagall, started performing very similar functions under the same jurisdiction. One was under bank holding companies; the others were with SEC. Money market funds seem to be doing maturity transformations, just like depository banks do, but they are being treated sort of as a halfway between a mutual fund and a bank. So, I think there were these special purpose vehicles which were, again, doing maturity transformation, but because they were off balance sheet, they were not recognized as being part of the banking sector in one way or the other.

So there's a sense in which the letter of the law is important, which is that regulators often have a tendency to take what the law requires them to do and then go and then enforce those requirements. If the law doesn't allow them to do something, because unless the regulation is very principle based, they don't really go and actually exert their discretion or judgment about what they should be doing. They sort of tend to go in more of a box ticking approach.

So I think, in some sense, the only way around this is to regularly revisit the architecture of the financial system, see what new forms of financial firms are coming up, what their function is, and if their function is inherently looking to be the same as that of a regulated entity, both in what it does and what its capital structure is, I think there's no reason to call it something else, to just put it in sort of common parlance. I think, if a money market fund or a conduit faces a run, there is something about it which looks like a bank, and let's better regulate them, as we regulate banks.

Viv: Finally, what would be your strap line advice to the G20 with respect to regulatory reform in the banking sector?

Prof. Acharya: I would say ensure that regulation is addressing systemic risk, both in an ex ante sense in terms of charging more capital to those institutions that are likely to become under capitalized in a stress scenario. Ensure that those institutions, there is a good resolution authority for dealing with them when things go bad so that they don't become too big or too systemic to fail. And I think the last piece of advice I would give is that clearly sovereign credit risk is emerging as a big source of systemic risk in its own right. Banks own a big chunk of bonds of their own governments. Governments, when they are in fiscal difficulties, are known to push their debt onto the balance sheets of banks, either implicitly, through moral suasion, or explicitly, through higher statutory liquidity requirements.

Clearly, this means that the banking balance sheets and the sovereign balance sheets are getting quite intertwined. Ireland is a prime example. But to the extent that European banks are exposed to, say, debt of Greek banks, how safe Greek banks are depends upon how safe Greece is as a sovereign in its own right. These risks are becoming intertwined, and I think my bottom line on this would be that it's not clear that just macro prudential of private financial sector going forward is going to be sufficient for ensuring financial stability. We may have to think hard about fiscal prudence on part of the governments, to ensure that their problems don't spill over to the private financial sectors.

Viv: Viral Acharya, thanks very much for speaking to us today.

Prof. Acharya: Thank you, Viv.
 

Viv Davies interviews Viral Acharya for Vox

August 2010

Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/5424]

Viv Davies: Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from CEPR. It's the 17th of August, 2010, and I'm talking to Viral Acharya, Professor of Finance at the New York University, Stern School of Business, about his current work on financial reform, and in particular, capital requirements and measuring systemic risk.

I began by asking Professor Acharya how important the recent Dodd Frank Act is, in the context of reforming the American financial system, and what he thinks are its strengths and weaknesses.

Viral Acharya: I would say, by and large, this is clearly the biggest overhaul of financial reforms in the United States, at least since the Banking Act of 1934. There have been important changes along the way, but nothing where the policymakers, and to an extent, the industry, have made a concerted effort of this magnitude, to realize the law of the land, so to speak. On its strengths and weaknesses, it is perhaps not surprising that, given it was in the aftermath of the severe financial crisis we witnessed, it is focused on systemic risk. The risk that, in many institutions, faced together, it's hard to essentially let them fail, or the risk that, in a large institution, that is interconnected and is a critical player in the economic plumping, it's very difficult to have it fail.

So, on this front, I would say the Act is good in the sense that, perhaps for the first time, that it is explicitly recognized, and dealt with, in the financial reforms law, at least in the United States, that the purpose of the regulation is actually to deal with systemic risk.

So, in particular, it comes up with recommendations for how to designate an institution as a systemically important institution. It designs a systemic risk oversight council that's going to be in charge of its regulation of these institutions. And, by and large, proposes an array of requirements that these institutions have to meet, over and above what the provincial regulators might require of the small or medium size banks at large.

The other strength is that, in principle, the Act covers not just the traditional banks - I would say the commercial or the universal banks that are systemically important. But it also covers non-bank institutions, which are increasingly being called the "shadow banks", who have not been regulated as much. This would include, essentially, insurance companies, hedge funds, investment banks, which are now all merged, and so on.

In principle, if the systemic risk oversight council finds any of these to be also systemically important, they could bring them under the purview of the legislation, and the requirements that they subject systemically important institutions to.

I would say, in terms of weaknesses, they are primarily three weaknesses, in my view. Which is that, while the Act takes systemic risk on board, it doesn't quite go all the way in actually dealing with it then.

The first and foremost is that, it does not require that the systemically risky institutions essentially pay upfront for the fact that they are systemically important, and ex post there is the likelihood that they might receive more forbearance than the others.
Instead, what the Act says is that, in case they are to be failed, in case they get into trouble, they will have to be failed necessarily. Their creditors will be wiped out, shareholders will be wiped out, management will be replaced, etc. And, if at all there are any costs over and above this, they will actually be charged to other financial players in the system.

Now, an issue with systemic risk is that, one, there will be other costs, besides this player. And two, to charge this to other financial firms at that point, just seems a bad economic design.

It's basically, like, saying that when my neighbor's house goes on fire, I'm actually going to pay for the mess that it creates. And this is precisely the time that I might actually be more concerned about saving my own house, rather than actually paying the [inaudible 04:42] from cleaning up the mess in the neighboring house.

So, it just seems like postponing the problem to the next crisis, rather than actually requiring that systemically important institutions pay a penalty for actually being systemically important, they paid upfront so that the costs can actually reduce the burden later on. And also, they have lowered incentives to suffer these costs in the first place. I would say this, to us, has been at NYU Stern, in our book, "Regulating Wall Street", I would say, has been one of the first and foremost weaknesses.

The second weakness, I would say, is that, even though the Act proposes a resolution authority, which is going to be more in the FDIC style, resolution going forward. It actually leaves out how to deal with markets that are systemic, and not just institutions.

To give you an example, each money market fund in the grand scheme of things, is rather small, but after the collapse of Lehman Brothers, a large number of these funds were experiencing runs at the same time.

In fact, the run on the repo markets, which caused the instruments to fail, was also, essentially, not run off any one individual, these are not just runs on individual firms, they potentially, you run the risk that the entire market may freeze all at once.

And, essentially, the systemically important markets, the money markets, the deposits from money market funds, sale and repurchase agreements, which are now a very significant part of the plumping of the financial institution, it's not just taking retailer deposits anymore. These markets have their infrastructure, how to deal with a run in these markets, has not been appropriately dealt with.

I would say the third thing that's … these two are the most important. One, because it's about controlling systemic risk ex ante by making these systemically important firms to pay up front for it. And the second is ex post, which is, how do you deal with this kind of systemic risk when it actually arises? I would say that these two are the most important weaknesses.

The third, sort of minor weakness that I think you might attribute to the Act, this essentially concerns the fact that it completely omitted certain important parts of the financial sector altogether. In the United States, that would primarily include the government-sponsored enterprises, so Fannie Mae and Freddie Mac, which contributed in pretty significant measure, to the housing credit boom. They are in conservatorship right now; they already bled to about $150 billion dollars of taxpayer's money. More might be required.

To be fair, there is a summit, in fact today, as we speak, in the United States that the Obama administration is going to vein on certain proposals in discussions with certain industry experts, academics, and so on. And they plan to propose some reform proposals by January of 2011.

But I think, too, we need to, while it's important to think of them reforming them separately, I think there is a number of pieces in the Dodd Frank Act that should apply, also, to the government sponsored enterprises. It's time to remove from them the special status, which is that the law, somehow, works separately for government-sponsored entities than it does for these private institutions.

Viv: Viral, as you've suggested, it's widely accepted that systemic risk in the banking system needs to be contained. However, as you've noted in a recent paper, the systemic risk of an individual institution has not yet been measured or quantified by regulators in an organized way. Recent work that you've undertaken in this area has focused on criteria for determining systemic institutions and on measuring systemic risk. In particular, you've been looking at capital requirements and stress tests. Could you tell us some more about this?

Viral: Essentially, there are two ways to go as far as measurement of systemic risk goes. One way to think about systemic risk is to entirely rely on regulatory assessment, as was done through the stress test in the United States in summer of 2009, or spring of 2009, and in Europe very recently. In this kind of an approach, regulators basically subject the balance sheets of financial institutions to some macroeconomic or market-based stress scenarios. For example; 10% unemployment rate, contraction in GDP of a certain level, housing price declines of 20% all across the county. And then get a sense of... because these shocks are correlated across balance sheets of institutions, see which institutions are likely to become undercapitalized in these times.

And then, either, have a plan to basically close down on those who are going to be troubled in such times, if they already look pretty much close to insolvency. Or, essentially get them to be recapitalized. Either privately or impose some discipline on them by saying that if they don't raise the private capital themselves, the government will do it for them at the cost of diluting the management and the shareholders.

The alternative approach... so this relies heavily on design of the supervisory stress test, valuation of losses by, or estimates of bank loses by bankers, and then their agreement with what the regulators think are reasonable estimates.

In contrast, you could also rely on some market-based data in order to extract measures of systemic risks. This is something that we have been doing at NYU Stern. In fact, we have a website on Volatility Lab run by Robert Engle, the Nobel Laureate in econometrics in 2003. Essentially on this website, we provide a daily ranking of the systemic risk of US financial institutions based on market data until that date, but in a projected or a forecasting sense.

So let me explain simply what we do. If you didn't want to rely on a regulatory definition of stress test, you could say a stress test is a scenario, say, in which the aggregate market, the stock market or the economy, collapses by 40 or 50%. This is what has happened in the Great Depression and is what we witnessed in many countries in the Great Recession.

Then you could ask the question: In this kind of a scenario, which firms’ equity capital, which financial firms’ equity capital, is basically going to get wiped out the most? Because, that would be one way of knowing whether they get undercapitalized.

Now, intuitively, we know from the standard sort of finance paradigm, that firms that have high betas so whose assets or stock price fluctuations are very correlated with all of the market are going to be the ones who are going to tank when the market as a whole tanks as well.

Now, of course, the thing about systemic risk is that it's sort of a tail end. It's not just about smooth variations and so on. So you can refine this measure a little bit to calculate like a tail beta, or what the specific econometric measure we use is called as marginal expected shortfall, MES, which you can think out it as the mess produced by each financial firm.

And it basically tells you that when the market in it's worst outcomes, you econometrically estimate, using historical data and some projections based on it, which firms are going to suffer the most as far as equity losses are concerned.

Now equity losses are not enough because if the firm has very high leverage then a given equity loss is going to bring it down much closer to the brink of failure.

And so our measure essentially combines these pieces of information which is: How variable are you? How correlated are you with the market? How much therefore will you lose when the market as a whole suffers a dramatic downturn?. And is that capital loss that you suffer is going to be sufficiently large relative to your leverage let's say so that you don't have four percent tier capital requirement in that stress scenario.

Now, you can calculate this measure and then rank different firms based on this measure, you can in some sense see out of the total loss that is going to arise out of this scenario which firms are in fact contributing the most. The beauty of the measure in some sense lies in the fact that you can test it historically.

You can see, if you are sitting at the beginning of the crisis, which firm showed up as being systemically most important. If you were sitting as Lehman Brothers collapsed and wanted to do the US stress test going forward from that point, which are the firms that you should have looked at and expect it to fail the worst in the stress test?

What our research shows is that the measure does a remarkable job of actually picking who are the systemically most important firms. The largest commercial banks that got into trouble, especially Fannie and Freddie, all of these show up in the top ten to fifteen in the world ranking of US financial institutions. Because they have tail risk, they have high correlation with the market and these firms have extremely high leverages all factors that contribute to systemic risk.

I think going forward it's not that we need to make a choice between market based measures or supervisory tests. I think we need to go both. There is clearly a lot of information that supervisors can gather if they are systematic and thoughtful about it, relative to what the market already knows all has factored in.

But I think given that there is no way of knowing whether a stress test is being done rightly or wrongly or adequately. It will be useful for regulators to have some market signals that give them a sense of who should they be looking for. If they assess the firm not to be systemically risky, is that consistent with what the market data are telling them?

So I think it is very good to and fro discipline between market data and supervisory data which might make future assessments of systemic risk more stable.

Viv: To what extent, Viral, do your ideas and recommendations on risk in capital requirement etc. differ from what's contained in the proposed Basel III proposals?

Viral: I would say first and foremost, Basel III doesn't even have the strengths of the Dodd Frank Act in my view. The Basel capital requirements have not yet explicitly recognized that they should be about containing systemic risk of financial firms. The Basel requirements are still about increasing the capital buffers of each financial firm in isolation, ensuring that that firm doesn't fail on its own rather than trying to ensure that this firm has a sufficient buffer if it is more likely to fail then other firms get into trouble or the rest of the economy gets into trouble.

So I would say at the conceptual level, our measure of systemic risk and how it could be used to design capital requirements is very, very different. Of course, I think that not addressing systemic risks in anyway into the volume capital requirement makes them a very weak and potentially even a harmful tool in dealing with systemic risks. Because as we saw before the crisis, all institutions seemed extremely well capitalized from a regulatory standpoint. But clearly there were extremely correlated and very highly leverage.

So what happened? I think what happened is that the regulatory capital requirements were simply not capturing the fact that the system was extremely vulnerable at that point. The other thing I would caution about is that the Basel III approach seems to be of going for more and more and more capital.

Either now or five years down the road, more liquidity in one way or the other. I think as I said the key question is not whether you have more capital or more liquidity in an absolute sense. But, whether you have enough capital or enough liquidity to withstand stress scenarios of the economy when other firms are likely to get into trouble at the same time.

This latter question is never being asked. To just give a simple example the Basel capital rates give a one fifth capital charge to an AAA rated mortgage backed security compared to an AAA rated corporate loan.

Now historically up until this crisis, it seemed that mortgage default risk was smaller and therefore this might have been a reason to justify it. But the trouble is that once you do something like this, the entire financial sector starts digging at the AAA rated mortgage backed securities. Because now it has a one fifth capital charge, it offers a greater leverage.

Over time the share of the housing sector in the economy becomes larger than that of the corporate sector. Suddenly an asset that looked more stable in the past is actually now the most systemic asset in the economy. But the capital requirements remain somewhat naive or innocent about all of these things that are taking place in the background. And essentially year by year they start looking woefully inadequate as far as guarding against systemic risk is concerned.

Of course this is very familiar argument. I think Hyack was worried about this all the time. That regulation basically creates pockets of concentrated exposures of the financial sector. And so if you get something like an interest rate wrong altogether, it basically leads to a big mess. Similarly here if you essentially get the risk weight of an important asset like housing wrong - and in this case you're getting it wrong because you're not thinking about systemic risk or the collective risk of institution - then you basically get the entire financial sector digging at that particular aspect of regulation. And that is indeed where the crisis happens eventually.

Viv: You referred earlier to the stress tests that were undertaken in the US in the spring of 2009. How do you think the recent stress tests undertaken by the European banks compare with that exercise? Were the European tests robust enough in your opinion?

Viral: They seemed to have helped in the sense that... so I think they are probably better than the opaque scenario that we had before the stress tests were conducted. I know from the postings of Xavier Freixas on VoxEU that he thinks that this has actually been a good thing as far as understanding the stability of the Spanish cajas is concerned. But at least from someone who saw the stress test from outside, personally my assessment is that they could have been somewhat better. I liked the American model somewhat more for the following reason. One, the American stress test had a very clear recapitalization plan that was put in place along with the stress test. Which is the stress tests were a way of assessing the capital adequacy of an institution in a stress test. If they did not meet it, they were given a pre specified amount of time to raise the capital privately.

Failing which, the government would basically inject the capital at the cost of diluting the shareholders, firing the management et cetera, et cetera. Now both of these are very important. The reason why is the following. If you don't have a meaningful way of addressing the balance sheet of a weak institution, it almost becomes dangerous to go and announce in the market that, "Oh, this institution is in trouble. But we don't have any tools actually to fix its problem."

In that case you can see now that regulators might therefore be reticent about the true extent of risks in the first place. Now the markets again won't know who is where, who has made what kind of losses, or is likely to make what kind of losses in a systemic stress scenario. You get the sort of laws of confidence and the downward spiral of holding, not getting enough investments, banks not trusting each other, etc. happening as we have seen repeatedly in this crisis.

In contrast, if you have a credible plan to address the balance sheets of weak institutions now the regulator is exonerated from actually withholding the information. The regulator will say, "Yeah, I should go and give this information out. The firm is going to in fact give this information of any place to go and raise this capital. If they don't do it, I'm going to inject this capital into the firm anyway”

So, I would say it was decisive to have undertaken the stress test even if one year later than the American stress test, perhaps because the sovereign risk, targets showing up severe stress signs in the fall off of '09.

I think as far as addressing the balance sheets of financial firms is concerned, there has been a little bit lack of decisiveness in the European regulators. Perhaps the situation is very complicated right now with the kinds of holdings of sovereign bonds that may be out there.

And to sort of make a point on that for example it's not at all clear why the holdings of sovereign bonds on the banking side of the balance sheet were not… Essentially, efforts were given to these sovereign bonds holding on the trading book side.

But clearly, if you are holding things on your banking book you might make losses there too. It seemed as though effectively the stress tests were assuming that, "Oh, if you suffer losses from there they are only going to be mark to market losses. Because either we are not going to like this sovereign thing, or we are going to backstop your losses, or we'll allow you to readily swap these bonds into the central bank of the region for liquidity."

All of these seem to be essentially saying that we don't want to address the root causes of the problem. We are just going to tide them over. But yet we want to get some information to the market to make them feel a little better.

So I'm left with a feeling that they didn't go all the way.

Viv: How important is international coordination in banking regulation and financial reform? Are there fundamental differences, for example, between the US and Europe in terms of what is required going forward? And in this respect, do you think that European governments could be following the US lead in establishing laws for financial reform?

Viral: I would say that by and large, clearly, some forms of coordination are very important, and even though I'm myself somewhat critical of the current state of Basel capital requirements, I think the process of going through the financial stability board to actually agree on a capital regulation, the G20 where some of these issues get discussed in some detail. I think these are important forums which, even if sometimes not as well functioning as one would like, I think that we set the stage for achieving a certain amount of common ground in the regulation. I think some areas where they become especially important are areas such as derivatives. This is because derivatives have the somewhat off balance sheet nature, which is that most derivatives when they are created have zero value at inception. But of course the leverage can potentially be very high because when risk materializes, one party may be losing a lot of value to the other.

These are done across country borders. They have relatively been opaque so far. So this is one area I would say, I didn't mention this but the Dodd Frank Act actually does a reasonable job in trying to improve the infrastructure of the OTC derivatives market the over the counter relatively opaque, unregulated aspect of the derivatives market.

By trying to bring at least some of these back on to banking balance sheets, trying to ensure that the more opaque, exotic varieties are capitalized better. Having both public transparency of price and volumes of trading but also almost close to full transparency for regulators as to what kind of counter party exposures are getting built up in these markets.

There are some things that could have been done better, but at least the spirit of the reform of derivatives in the United States, I would say, is probably one of the best done aspects of the Dodd Frank Act.

Now, a really worry, though, is that if one of the other financial centers, in it's bid to actually attract more of derivatives business over to itself, starts lowering the standards, either in terms of disclosures or collateral requirements, or requirements that derivatives that are actually clear on centralized platforms. If one financial center essentially sees an opportunity and decides it's willing to take that risk, it could essentially completely unwind the... it could blunt the edge of the US reforms. Because, financial business, even if not fully mobile on an overnight basis, has had shifts in terms of moving from these regions and where the laws are the weakest.

And there is no doubt that if, say, one financial center in Europe provides weaker regulation of credit derivatives and it is going to be cheaper for financial firms to produce credit derivatives there, eventually that is where the trading will take place.

Fortunately, the central bankers are talking a lot about coordinating on derivatives reforms. I know the New York Fed, the European Commission, the ECB, etc. are in talks about these things, the Bank of England. And the hope is that they will not actually go for a race to the bottom, but instead actually ensure that a minimum standard is maintained.

Viv: Finally, Viral, before we wrap up, I'd like your take on a comment that was made recently in a speech at the Stern School of Business by the US Secretary of Treasury, Tim Geithner. He suggested that the recent reforms will fundamentally reshape the entire financial system. They'll require financial firms to change the way they do business, to change the way they treat customers, to change the way they manage risk and to change the way they reward their executives. Now that's quite a tall order. Do you think the banking system is really ready for such a significant cultural shift?

Viral: That's a good question. My sense is they have been getting ready for it. I think it was to be expected that business could not just go on as normal after a crisis of this sort. Initially, it seemed that, in fact, the Dodd Frank Act might even get watered down quite a bit due to the lobbying attempts. I would say the end effort has not been as diluted as one would have thought perhaps a year back. Culturally, it does require a shift, and I think that shift has happened. I think industry knows that they face a fair bit of regulatory uncertainty. And I use the word "uncertainty" because that is what might be the critical thing to worry about right now which is that one aspect of the Dodd Frank Act, including of it's strengths, such as the derivatives reform, is that a great deal of discretion has been left to prudential regulators.

Now to some extent, you don't want the Congress in the United States to be writing the details of every single law out there. But what this also means is that, over the next three to five years, a large amount of rule making is going to take place. And currently, there isn't full clarity on what's going to happen.

To give you an example: It's not clear which segments of derivatives are going to cleared on centralized platforms and which segments are not going to be cleared. But if you were a derivatives boutique firm or, say, a large bank with a significant presence in derivatives, you would want to prepare for something like this, but you actually don't know yet how to prepare fully because there's uncertainty as to what the exact rules are going to look like. So I would say that this uncertainty is what, in some sense, the banking sector needs to be able to deal with. Now, unfortunately, this kind of uncertainty is not something they can hedge very easily, because it's an uncertainty that affects every single firm out there. So most likely it might just produce a reduction in the risk taking. They might hedge their bets a bit by just holding back on their capital and liquidity.

And this may be a somewhat tricky situation in a time such as this one when you're actually trying to kick start lending and kick start investments in the real economy. Now having said that, there are some aspects I think which might fundamentally alter the way banks are operated. One of the things Timothy Geithner mentioned in his speech was that even though…has not yet footed this idea openly, that at least the United States is considering the possibility of a two tiered capital requirement.

One will be like a minimum capital requirement, which is for normal times. And then an additional buffer that financial firms especially the systemically important financial firms will have to hold for withholding stress in a systemic scenario. This actually comes out of good economic principles for regulating systemic risk. In some of my recent work with Hamid Mehran at New York Fed and Anjan Thakur at University of Washington, sorry, Washington University of St. Louis.

We do find that indeed if you had to regulate systemic risk, this is what you want to do because you want to have an additional buffer that firms would have to in some sense post. If they want to take on systemic risk where they're going to suffer a lot in the stress scenarios. I think an analogy would be that this is like a deductible on insurance. And the more risky the party that wants to be insured is, the higher will be the deductible that they'll have to put up.

And they will lose this deductible in case things go bad. That's the sense in which it's an extra buffer that they have to put over and above the price that you have to pay for buying insurance in the first place. Now these kinds of changes, I think, will require a much more fundamental shift in the banking sector. So far the banking sector has been very focused on looking at returns on equity.

Returns on equity invariably go up with leverage when some parts of your leverage costs are essentially implicitly subsidized by the government, as they are in the case of large financial firms. Now as you get more and more constraints on your leverage, this means that becomes not an easy way for the banking sector to generate their equity profits. Which is what they get compensated on, which is what their shareholders care about, even if it is mor,e in the short term, an accounting measure of performance.

So, now for the banking sector to generate value therefore they can't just use leverage. They will have to increasingly use the real fundamentally value of the balance sheet of the bank which we would call as return on assets. They just can't increase their value by simply increasing leverage as easily and by correlating with others, for example, because with they're going to be bailed out in such times.

They will have to instead increase their profitability in a fundamental sense. Maybe they should be looking more at expansions to emerging markets that the growth hedging currently seems to be lying. Whereas from 2003 to 2007 they seemed excessively focused on funding housing in the US sector - an extremely advanced part of the financial sector. and one where it's not clear what the economic returns on this activity might look like over the long run. Even though it seemed very easy to leverage on the US housing exposure because of the variety of regulations that were in place.

So I think these kinds of fundamental shifts are likely to take place. I think that they are going to be for the good overall. Clearly capital should be chasing the highest economic return activities rather than the highest return on capital, taking account of weaknesses of regulation out there. So if we are able to address the weaknesses some of these reforms are proposing, we might just get a more sensible allocation of capital and overall higher economic growth globally.

Viv: Viral, thanks very much for taking the time to talk to us today.

Viral: Thank you Viv. It's been a pleasure.

Viv Davies interviews Xavier Freixas for Vox

August 2010

Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/5401]

Viv Davies: Hello and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from CEPR. It's the fifth of August 2010 and I'm talking to Professor Xavier Freixas from the Universitat Pompeu Fabra in Barcelona about the outcome of recent stress tests imposed on European banks and, in particular, the impact of the tests on Spain. I began by asking Professor Freixas what he thought the main objectives of the stress tests were in the first place.

Professor Xavier Freixas: To answer that, I'd like to see it in the context. So, on the first in March, it was decided to have a stress test as the European community of banking supervisors have already done before. But then, with the Greek crisis, there was a theory that there was a lack of information and transparencies to the market that was hurting solvent, liquid, serious banking institutions. And so, there was a pressure by those banking institutions to have more transparency and this was, I think, the main driving force that has led to have such an exercise with the results being available and everyone being able to perform additional tests on the results.

I think that there were really two objectives that are different and, therefore, your perspectives on how good the stress test results are dependent on those issues. So first, there is one objective and that is to have more transparency in order to identify what are the fragile banks. And that's one thing.

So, to discriminate among the top, solvent, sound banks and those who are in bad shape: That was clearly one objective, obviously promoted by those banks that are successful in this crisis, so that's a relative thing.

But then, the second objective that is related to the strain on budgetary resources is to see whether if there are systemically important financial institutions at risk, whether the county has sufficient available resources to support and restructure these "too big to fail" institutions.

The stress test is great regarding the discrimination, but it's clear to see that there are banks that are really in good shape and others, several in particular, that need additional resources. That's one thing.

Then whether there are banks that need more resources whether governments in those countries are able to provide those resources. Then it depends on how you design the stress test. It's more sensitive to what you want to be assumptions of the stress test. If you have a catastrophic debt, then no government has sufficient resources to bail out the many banks in the country. So this is much more sensitive.

But the discriminating exercise is great because then we know, relatively to each other, how banks are performing.

Viv: The results of the stress tests show that only seven out of 91 banks failed to meet their capital requirements. Were you surprised by this? Many commentators are of the opinion that the tests weren't robust enough. They suggest, for example, that the capital adequacy requirement at six percent was too generous and that there were also significant discrepancies between the assumptions that we used in different countries. What's your opinion on the question of robustness? Did the tests ask the right questions or do you think that consistency and credibility were perhaps sacrificed?

Prof. Freixas: There is, of course, one interesting thing. Well, this is related to the previous question. If you prioritize the objective to discriminate among banks, then this is a minor criticism. If the key issue is whether Europe has sufficient budgetary resources to bail out the banks that are in trouble, then it's critical to have the right assumptions. My view is rather that the main exercises are to provide transparency to the market so that the solvent banks are able to borrow from the market more easily in spite of being located in such or such country, in countries that have budgetary restraints.

Now we go to the question, are the assumptions too soft? Well, I would tend to say that the starting point of the exercise is today's housing prices as they are. So, we're considering an additional fall in the prices, and we're picking up the starting point to-date prices so that the initial point is not taking into account the bubbles that were in the prices a few years ago. From that perspective, it's not having a reasonable drop is not a bad assumption.

Now, the exercise considered two scenarios: The benchmark, which is quite generous I think and the adverse scenario, which obviously is the interesting one. In the adverse scenario, I think the macroeconomic assumptions are rather optimistic, but on the outside, the risk assumptions are quite rigorous.

The adverse assumptions of 4.4 percent losses in corporate loans and 2.1 percent in retail for fall, I think this contrasting with the optimistic microeconomics scenario, this is a serious increase in the losses of the bank. From that perspective I think the assumptions are quite good and difficult.

Now, one thing we can say is that the market reaction was important to the stress test. So, if the criticism regarding the assumptions being too generous was founded, then of course the market would not have reacted in this positive way. There was genuine new information that was coming from the exercise.

Viv: Five of the seven banks that failed the stress test were Spanish cajas or savings banks. Why did they fail and what does this now mean both for those particular banks and for the Spanish banking system?

Prof. Freixas: First, why did they fail? A combination. What comes to mind is the phantoms of Chuck Prince that when the music goes on, you get up and dance. Indeed this was hurting into the same investment and strategy, and this is reinforced, because you see all of your competitors are investing in real estate mortgages. And so the problem was losses in real estate development, so those financing real estate development had to resell to these cajas.

In addition, this comes at a point in time where cajas begin to compete more with one another and try to expand the market outside their region. The cajas are small financial institutions which are quite regional. So, these cajas start lending in regions and in markets which they are not so knowledgeable about, with the so called winner's purse.

That is when you enter a new market, you start basically getting the borrowers that nobody else gets. And the statistical evidence on this tells us that after three years, you have losses that are due to the fact that you are entering a new market. So, this has, combined with the first point--with the cajas investing in real estate development--they have combined this with excessive growth outside their own zone of competence, outside their own natural market.

The third point is that there has been bad corporate governance. There is a very interesting paper by Vicente Cuñat and Luis Garicano from the London School of Economics—they’re both Spanish, from London School of Economics—on performance. And they show that the loan losses of the cajas depend on the board of directors. And when the managers do not have graduate studies, then you have one percent additional loan losses. If they don't have any banking experience then you have one percent additional loan losses. Then finally, if they have been elected to political position, then you have to add one percent additional loan loss.

Now, the new law for the cajas implies that in order be a manager for the cajas—this is quite recent—you cannot have held any political position, which is great. That will help a lot. And finally, the final nail in the cajas' coffin is the fact that you have a negative growth environment. You have negative growth, and this will affect all Spanish banks, of course. Those that are well and will survive, like Santander, BBVA, which have a fraction, a large fraction of their business in Latin America, of course, are less affected by the negative growth in Spain.

So that's, how will this affect the Spanish system? Well, it has affected the Spanish system, because the market has reacted to this by considering all Spanish banks as a uniform type of financial institution. Well, now the stress tests have been very good for Spain, and that’s why the Bank of Spain has chosen very strong assumptions, very rigorous assumptions. Thirty percent drop in real estate prices, for instance. So that the financial markets are able to see the difference between a caja and, say, Banco Santander, which are completely different animals, even if both are in the same jurisdiction.

Viv: During the last week, we've seen international investors rushing back in to fund the activities of Europe's banks, in spite of the criticism over the robustness of the tests. Some commentators have suggested that this is the result not just of the outcome of the stress tests, but also a consequence of the relaxation of the proposed Basel III bank regulations. What do you make of this renewed confidence and buoyancy? Is it justified?

Prof. Freixas: Well, I think this is very positive reaction from the market. I like to think that there is something in the etymology of word, and the turning point, this diakríseis--in the original Greek, it's from the Greek word to separate, to decide or to judge--and the stress test has indeed discriminated among top, well-kept, alive, efficient banks and those who are not. So, what we expect that is, what we expect from the crisis in general, is an efficient banking system. And this we can only have if we have a wave of mergers and acquisitions. Takeovers, whether hostile or not. And so what we need is, what we want to see is definitely some activity on that front. Now, of course, if all banks are limited in their funding, if all banks are facing market liquidity, funding liquidity, then this will never develop.

With the stress tests, the market has more information so that it will be easier for the well-kept, alive banks to access resources and then maybe to buy, say, assets from other banks, or to buy other banks. The example I have in mind is on August 4th, or August 3rd, two days ago. Santander bought 318 branches of the Royal Bank of Scotland. This means that Santander is now confident enough that it has access to liquidity and, in my view, this is directly related to the stress test.

Viv: But, given the extent of bank debt in the Eurozone generally, with its high loan to deposit ratios, how vulnerable do you think the banking system really is in Europe? Do you think it could withstand a severe shock such as, for example, a sovereign default by a Eurozone member?

Prof. Freixas: This is an unlikely event, and this is a question which is difficult to answer. To some extent it depends on how the default is managed. It may be the case that we are thinking of a default, like an Italian default, where you restructure and then the three months become ten years, or something like that. If this is the case then the European Central Bank can manage and could do something about it. If not, things are more complicated but nevertheless the stress tests have shown one interesting point that some of the banks that are more vulnerable to sovereign risks, are those banks that are precisely in Germany or in France. It's good news because the public finances in those countries are much better than those, than the public finances in Spain or Greece of course.

Viv: Generally, do you think the whole exercise of stress testing at this time in Europe has been a successful project? A successful initiative?

Prof. Freixas: Definitely. And while in the US it's easier to coordinate because, of course, there are several regulators but there is a main regulator, which is the Fed. Here, it really shows how the Fed is becoming a serious European banking authority, and able to coordinate a complex exercise. Of course, it has to lead with assumptions presumably with each country regarding what is a reasonable assumption for real estate drop. In Austria, something is an increase of 50 percent, is what is assumed. But still, I think it's very positive and unprecedented. I think it's quite a success in coorporation and quite the success in transparency. So overall I'm very positive in how successful the exercise has been. And of course, it could be improved, definitely. And of course, you could say, rather than G 1, I would have preferred to have core G 1 excluding those actual [inaudible], those types of securities. But, overall, it is a minor point.

Viv: Xavier, thanks very much for speaking to us today.

Prof. Freixas: Thank you, Vivian.
 

Viv Davies interviews Daniel Gros for Vox

July 2010

Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/5255]

Viv Davis: Hello and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davis from the Centre for Economic Policy Research. It's the 29th of June, 2010 and I'm talking to Daniel Gros, director of the Brussels based Centre for Policy Studies about the Vox eBook he has recently edited with Richard Baldwin on "Completing the Eurozone rescue: What more needs to be done?" I began by asking Daniel, "What went wrong with the Eurozone in the first place?"

Daniel Gros: Actually, everything that could have gone wrong did go wrong. The fiscal constitution of the Eurozone was based on the assumption that no country would be bailed out by the others. And that actually, a bailout would never be needed because the Stability and Growth Pact would prevent countries from running large deficits. And we see that, in the case of Greece, the Stability Pact didn't work. Greece accumulated very large deficits, and we have problem number one.

The second thing that went wrong is that, by creating monetary union, we actually wanted to create an interconnected, integrated banking market. But we forgot that, at that point, banking weakness in any part of the Union would spill over into the entire system. But we didn't foresee any systemic, European wide bank rescue operations. And FBC is now something that is missing that had to be invented very quickly.

So these two key elements were missing. They are actually interconnected: weakness on the fiscal side leads to banking weakness and vice versa. That's why we have now one very big, interconnected mess.

Viv: I see. So does this imply, perhaps, that the basic foundation for the Eurozone was essentially flawed? Many commentators might say, for example, that without a coordinated fiscal policy amongst Eurozone members, the whole concept of monetary union was bound to fail.

Daniel: The design of monetary union was certainly incomplete. That is actually what is done very often in Europe. You build the bicycle, get on it, try to pedal a bit. And if it doesn't work, you add while you are hopefully getting along. Now, this time managed to be different because financial crises require extremely rapid reactions by policy makers, and we see that is very difficult under the current circumstances. It's quite clear that talking about more fiscal policy coordination would really have saved us. This tragedy was not about fiscal policy coordination in the sense of saying, "You, Germany, spend a bit more, France a bit less, and Italy does something different again." This talks about keeping, actually, debt levels under control. Not only debt levels of governments, but also the private sector. Therefore, we need something quite different from just the term "fiscal union."

Viv: Eurozone leaders made what some have called a bold move in May this year, and provide 110 billion Euro bailout package for Greece and a special purpose vehicle to fund future bailouts. Isn't that enough to contain the problem? Or was there a coherent conclusion, perhaps, on what more needs to be done from amongst the authors in the ebook?

Daniel: As we have argued in the book, these measures were needed to prevent total shut down of the European banking system. They could perhaps contain the problem for a while, but they are certainly not sufficient. As we see in the ongoing tension on both the banking market, and the government debt market of a number of countries. Now, just throwing money at a fundamental problem doesn't always solve it and that's the case right here. In the case of Greece, we have a 110 billion package, unprecedented for a country of that size. Does it solve the problem? It just buys time, two or three years. But we know that most markets look ahead, they look ahead much more than two or three years, 10 years, 20 years. And what they see at the end of the adjustment period is not very nice. That's why we have continued problems for Greece to refinance itself, and the Greek saga is certainly not over.

The same for the banking system. This special purpose vehicle which has been created these days legally should be able to provide over 500 billion Euros in financing, unheard of in European history. These sums have never been put together by national leaders. But are they enough? Yet, we don't know because we are discovering a key problem in the case of Spain, for example, is not so much government debt, which is actually quite limited, but is banking debt, and banking problems, not only in Spain, but in Germany, France and other areas.

Therefore, this is an untested vehicle. We don't know whether it will be actually working and we have argued, therefore, that more needs to be done.

Viv: What the book is suggesting is a prioritization of reforms across the Eurozone countries in terms of bank restructuring, fiscal transfers, competitiveness, structural reforms. And other reforms, such as independent fiscal authorities. Could you explain a little bit more about your recommendations?

Daniel: Yes. It is quite clear that the key order of the day is to have stress tests. What does it mean "stress tests?" It means that the national regulators have gone to the banks, seen what they have in terms of credits outstanding on forms in their portfolio, and asked themselves, "What happens if a really bad scenario arrives? Can this bank survive? It doesn't have enough capital.” That has to be done across Europe. It has now been more or less decided to do it for more of the largest banks, which should cover, more or less, the European banking system.

That, of course, will be extremely important to establish confidence in the interbank market. In the interbank market, we expect banks to lend each other at very low interest rates so there must be very little risk that's left. Banks must be sure that their counterparts can provide.

So we have a stress test. The next question is, "What do we do with the results?" Of course, we publish them. But what do we do when we find that a certain bank has perhaps not enough capital to withstand the stress, or just enough capital? How can you force this bank to take on more capital very quickly?

That is a key trend for policy makers now in the very short run. They have said that they will face up to it. But we have to see, first of all, how the stress tests are being conducted and whether there is a credible way to recapitalize banks which need capital very quickly. That has to be done. Without that, the problems will continue and would actually increase. This is the conditio sine qua non for any group. Once the stress tests have been done, the banking system should come down, the interbank market should work again. And the next order of business is, "What country needs actually fiscal transfers?"

The European Union has to distinguish between different countries. Greece is patently over indebted. Many people think they can't service a debt so a solution must be found. It's no good that policy makers say, "We have a nice adjustment program for Greece, Greece can make it. If the markets don't agree, you can't finance the country in the normal way and therefore, something must be done that gives the market some reassurance that Greece can actually pay its debt. The best way might be just to reduce the debt level that Greece is taking. Other countries are in a much better situation. And therefore, I am optimistic actually, that if a solution for Greece can be found, then the remaining fiscal barriers in Europe should be manageable.

Viv: And what is the solution for Greece, do you think?

Daniel: The best way to proceed might be just to recognize that the country needs, for a very long period, some breathing space. So, perhaps one should say to bond holders of Greece, "You have to wait for a bit longer. Greece will give you a zero coupon discount bond for, let's say 10, 20 years. You'll get back the nominal value, but you have to wait for the interest a while." And then I would add to that some sort of warrant which says that the additional interest that Greece is paying will depend on, really, people, because many people in the market say, "We don't believe these growth rates that have been projected officially." So I would say let's make that into a special contract. Greece says that if growth is good, it will pay more to bond holders. And the optimistic ones, they can buy, then, these bonds, and the market will find an equilibrium again.

Viv: Most if not all of these measures that you refer to in the book, in the introduction, with Richard Baldwin, have to be executed at a national level, which will require a considerable amount of national discipline and responsibility. Is it realistic to expect that this can be achieved, given that the Eurozone chain, so to speak, has been shown to be only as strong as its weakest link, i.e., in the case of Greece?

Daniel: For the short term, actually, I'm rather optimistic. The pressure from the markets and the situation is so strong that governments are taking unprecedented measures, in Greece but also in other countries, and actually show some sign of cooperation. Also, think about the stress tests. One year ago, at the height of the crisis, Europe refused to publish stress tests. Now it's being done. So our policymakers can learn. Perhaps it takes some time, but they have learned at least something. For the longer run, it's quite clear that national fiscal institutions would be very useful to have, to constrain national fiscal policy. But it is also clear that we cannot rely on that only. You have to have some mechanism, as one of our contributors called it, "To reduce debtors' blackmail." That is something that the European Monetary Fund, which I proposed sometime earlier, together with Thomas Meyer, an institution which would allow the EU to deal with emergencies, to resolve actual crises. And that is actually what is also being discussed at the official level. I hope that something will come out of that.

Viv: Daniel, I was reading yesterday in the FT that, according to recent research conducted by the Economist Intelligence Unit, world business leaders see a growing risk that the Eurozone could break up in the next three years. Half of the 440 chief executives and heads of banks who were questioned say there's greater than a 50 percent chance of one or more countries leaving the Eurozone by 2013 because of deepening problems of debt amongst the members, and more than a third see at least a 25 percent chance of a complete breakup over the same period. Would you agree that this might be a real possibility, and furthermore, that a continued crisis of confidence in monetary union might even lead to Germany pulling out?

Daniel: These are certainly very tough times for the Eurozone, and unfortunately, one can no longer totally exclude a breakup. But I must remind people that in the 1990s, similar surveys said that a monetary union would never come about. So one has to be a bit careful with these predictions. But it is clear that there's a real possibility that perhaps one or two smaller countries will choose to exit the Eurozone. There's a possibility that the panel is good. But, if you had a messy default in Greece, followed by some policy mistakes in Greece and then an exit of Greece from the Eurozone, would that actually weaken the Eurozone or strengthen it? Investors might actually say, "Ah, the Eurozone is actually imposing tough choices on its member countries. That's a currency which will remain strong. That's a currency I like."

So, if smaller, weaker countries leave the Eurozone, that might actually strengthen it. Would Germany have an incentive to leave the Eurozone? I don't think so, because if Germany were to leave the Eurozone, then German banks would have their claims on the other Euro area countries only in the old Euro, which might be weak, compared to the new D mark, which would be strong. German banks would have to satisfy their own customers in the German D mark, in the new D mark, which is strong. So the German banks would immediately be bankrupt, and the German government would have to save the immediately. So that is not a very winning proposition for Germany, also.

Viv: Daniel, some commentators are of the opinion that it's too late now for tinkering around the edges with national or independent fiscal authorities, and that the only thing that can now possibly save the Eurozone is a much closer political and economic union. Would you agree with that?

Daniel: Yes and no. When I talk about tighter economic or political union, many people have some vague ideas which are not at all helpful. And as one of our contributors, Paul De Grauwe, writes, one has to be realistic. People still feel national first and European second. But one can have some institutions that would actually give us the essence of what we need. We don't need a fiscal policy coordination in the sense that every small fiscal decision has to be vetted and controlled by Brussels. But the key thing is that we have an institution which allows us to say no, to reduce debtors' blackmail. So something like the European Monetary Fund, perhaps even something like this special purpose vehicle that's being created. This vehicle could be used not only to save countries; it could also be used to say no to a country and just save the European banking system instead. That might be a much better way to proceed.

So, in a sense, European leaders have already decided that they're willing to put a lot of money on the table. If they're using this money in a smart way, with institutions which do not only bail out countries, but perhaps also allow the rest of the Eurozone to save its own banks if a country doesn't perform... Then, actually, we could create out of this crisis a system which will be much stronger than before.

Viv: So you, and the book in fact, are optimistic about the future of the Eurozone.

Daniel: I am guardedly optimistic, because we have seen that our leaders, if push comes to shove, they're willing to spend a lot of their financial and political capital to save it. They have taken some first steps, which were needed, not sufficient. They are now about to take another important step in the form of a stress test. If that is done well, then I'm hopeful that this crisis could be salutatory in the end. The stress tests, as I said, are really key. But there, the devil is in the details. They will be out in two or three weeks, so no point in speculating about it. The best way might be to come back once they have been published and actually ask ourselves, "Was that a step forward or backwards?"

Viv: Well Daniel, thank you very much indeed. It's been a pleasure talking to you.

Daniel: OK. Bye bye.

Viv: Bye bye.