Balancing risk and reward in the financial system Over ten years on from the financial crisis, debate continues about how the financial industry can be regulated effectively, balancing the goal of ensuring banks can make profits while also maintaining the stability of the financial system. We spoke to Professor Gerhard Illing about his research into the relationship between monetary policy and banking behaviour. Many central banks across the world responded to the financial crisis of 2008 by injecting liquidity into the market to prevent insolvency arising from illiquidity. While this has helped to maintain market stability, it may also be encouraging banks to continue operating in a similar way as before the crisis. “Banks may anticipate that in a systemic crisis, the central bank will be willing to provide lender of last resort activities, aiming to dampen the impact of systemic risk. This gives private banks an incentive to engage in excessive risk-taking,” explains Gerhard Illing, Professor of Economics at the University of Munich. This topic is at the heart of Professor Illing’s project on illiquidity, insolvency and banking regulation, in which researchers are investigating the feedback between monetary policy and risk-taking in the financial industry. “We are looking at how the actions of central banks affect risk taking. Over recent years central banks have supported financial institutions by providing liquidity and lowering interest rates, even below zero,” he outlines.
Illiquidity and insolvency This has encouraged banks to increase their leverage and invest in illiquid projects, which
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may leave them vulnerable should a financial crisis occur. In the years leading up to 2008 many banks increased their financial exposure to assets which they viewed at the time as highly liquid, being traded on the interbank market. “But when the crisis hit, the liquidity of these assets suddenly dried out,
The 2008 crisis exposed the overdependence of financial institutions on shortterm funding, driven to a large extent by the abundant availability of public liquidity. A prime example is British company Northern Rock; although a mortgage provider, it had hardly any deposits in the traditional
In a systemic crisis, the central bank will provide lender of last resort activities, helping to dampen the impact of systemic risk. The problem is that banks will anticipate this reaction, giving them strong incentives to engage in excessive risk-taking. Ex ante liquidity regulation is needed to counter that incentive. and their value dropped dramatically,” says Professor Illing. Regulators have responded by imposing strict liquidity requirements in the Basel III framework, aiming to prevent the accumulation of excessive risk. “Our research provides a theoretical justification for Basel III rules imposing liquidity constraints and regulations, which incentivize banks to invest more in liquid assets,” continues Professor Illing. “The value of these assets is more stable than illiquid assets, so their value does not fall dramatically during a crisis.”
sense at the time the financial crisis hit. “Northern Rock mainly got their liquidity either from other banks, or from money market funds,” explains Professor Illing. This worked for a period, but the onset of the financial crisis revealed inherent problems, eventually leading to a run on the bank. “As distrust among banks grew, the inter-bank lending market essentially dried up and Libor (London Inter-Bank Offered Rate) shot up to
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unprecedented levels,” says Professor Illing. “Northern Rock were cut off from lending, because they relied too much on short-term liquidity in the inter-bank market.” This led to a dramatic deterioration in their position, and after providing tens of billions of pounds in liquidity support, the government eventually had to nationalise the bank. This was an expensive process, but helped to prevent a systemic meltdown, which Professor Illing says would have had serious consequences. “Insolvency, on the aggregate level, is highly costly. So for that reason there is a strong motivation for central banks to provide liquidity support,” he outlines. The challenge for regulators is in both anticipating when a financial crisis may occur, and also taking measures to effectively reduce the impact of a crisis if it does. “If you take measures during a crisis to mitigate the effects, then this effectively encourages bankers to be less careful,” points out Professor Illing. “So you need to try and mitigate the buildup of a crisis ex ante – and then during a crisis, also take measures to dampen its impact.”
Regulatory framework The aim for regulators now is to learn from the mistakes of the past and develop a more effective regulatory framework, that both gives banks the commercial freedom they need to stay profitable, while also discouraging excessive risk-taking. The project will make an important contribution in this respect, with Professor Illing and his colleagues contributing to the design of a new framework for macro-prudential regulation. “It allows us to model the behaviour of banks subject to regulatory constraints, and to model the response of banks to regulatory constraints,” he outlines. The behaviour of banks here is modelled endogenously, as it is subject to change as market circumstances evolve. “We evaluate non-linear dynamics, as banks endogenously change their asset structure and their dividend payment process during a crisis,” says Professor Illing.
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This provides foundations to analyse the likely impact of different regimes, such as changes in capital or liquidity regulations, which holds important implications for financial policy. Changes to the Basel III regulations have recently been proposed, which Professor Illing and his colleagues plan to evaluate during the project, part of the wider goal of improving financial regulation. “We aim to provide more evidencebased insights, for example in stress testing. This is a very challenging topic mathematically,” he continues. “Until now, the focus has been on micro-prudential stress-testing, rather than macro-prudential stress testing. That’s something we are interested in looking into in future.” The nature and extent of the financial regulation regime is a matter of ongoing debate. “During good times, it’s hard for policy-makers to resist the pressure to relax regulation, because everything seems to be running smoothly, with strong pressure to argue that regulation hinders growth,” explains Professor Illing. His research indicates that credit booms triggered by financial liberalization may actually push the economy into persistent stagnation, seducing borrowers into unsustainable consumption spending, driving them into a debt overhang.
Illiquidity, Insolvency, and Bank Regulation Illiquidity, Insolvency, and Bank Regulation Project Objectives
The provision of central bank liquidity as lender of last resort is seen to have contributed to incentives for excessive risktaking in the financial industry. Researchers in the project analyse the feedback between monetary policy and risktaking of financial intermediaries, aiming to contribute to the design of a new framework for macro-prudential regulation. In the project, researchers model the impact of liquidity provision by central banks on incentives of financial intermediaries to engage in activities creating systemic risk.
Project Funding
This project is funded by the German Research Foundation (DFG).
Contact Details
Professor Gerhard Illing Ludwig-Maximilians-Universität München Seminar für Makroökonomie Ludwigstr. 28 / 012 (Rgb.) 80539 München T: +49 (0) 89 / 2180 - 2126 E: illing@econ.lmu.de W: https://www.sfm.econ.uni-muenchen. de/personen/professor/illing/index.html
Priority program The project itself is part of a larger priority program “Financial Market Imperfections and Macroeconomic Performance” funded by the German Research Foundation (DFG), focusing on the link between macroeconomics and financial economics. The program is comprised of over 20 projects, analyzing the effect of financial market imperfections on financial market stability, macroeconomic volatility, and long-run economic growth. “Various international conferences have been held as part of the programme,” says Professor Illing. This has encouraged the exchange of ideas and led to new collaborations, which Professor Illing hopes will stimulate further research in the years ahead.
Professor Gerhard Illing
Gerhard Illing is a Professor of Economics at Ludwig-Maximilian University of Munich. His main research areas are monetary theory, financial stability, systemic risk and lender of last resort policy. He is CESifo Research fellow and member of the German Economic Association, active in the areas of Monetary Economics and Macroeconomics.
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