System effects of bank crisis underestimated

The system effects resulting from banks’ behaviour during the credit crisis are much greater than expected. The financial world has underestimated the risk to the system of these effects, which are also known as second-round effects. Economist Jan Willem van den End came to this conclusion in PhD research which investigated how banks and governments acted during the crisis. Van den End is a senior economist at De Nederlandsche Bank (DNB), the central bank of the Netherlands. ‘Now that we know how banks respond to such financial upheaval, we are better prepared to deal with the consequences.’ Van den End is strongly in favour of strict criteria regarding the financial buffers banks are required to have. He will be awarded a PhD by the University of Groningen on 27 October 2011.

The behaviour of banks and bankers is a hot topic, in the most recent financial crisis too. It’s being discussed all the way from Wall Street and Damrak sidewalks to IMF and ECB boardrooms.

Herd behaviour

Jan Willem van den End investigated at microlevel how bankers dealt with the credit and liquidity risks in 2008. They were prone to herd behaviour: ‘It’s quite clear that this behaviour had destabilizing effects. Although they all acted rationally in considering their own interests, doing so en masse meant that liquidity evaporated. The entire financial world underestimated just how large the negative effect was of the way the banks responded to the beginning of the crisis. This was also the case with the supervisory bodies. This has led to stress tests being used more often, which make us aware of the risks.’ Van den End hopes that his conclusions on banks’ behaviour will be incorporated in financial models more often.

Models

Theories abound on interaction in the financial world, as well as models for many of its subfields, but it is well-nigh impossible to capture all these complex relationships in a single model. This is one of the reasons why the resulting behaviour is so unpredictable. The present wealth of knowledge, however, can help us to understand what is happening, according to Van den End. ‘Take, for instance, the capital ratio, the reserves banks are required to have. You can safely conclude that banks took too many risks with too low capital ratios. A contributing factor was the belief that they would be bailed out by the government and the central bank if things went wrong. The crisis led to such support actually happening. Policymakers are now attempting to make banks cover more of the costs that are incurred by society when banks receive aid.

Buffer

Van den End’s findings have convinced him of the necessity for stringent rules for the capital and liquidity buffers banks are required to maintain, as set out in the Basel III Accord. Requirements for the quality of capital mean that banks can no longer include certain things.  Banks are also required to retain at least 7% of their risk-weighted assets in capital, a much larger proportion than before the bank crisis. Van den End: ‘The fear that this is bad for the economy is exaggerated. Its effect is very small and the benefits are huge. Chances of a crisis occurring diminish, as does the severity of any crisis that does emerge. Reserves should be even larger when things are going well, as a buffer for any economic downturn. Banks would then be better able to shepherd businesses and households through the bad times, which would mean that banks are better able to carry out their basic duties.’

Government intervention

Van den End also studied the effects of government intervention during the bank crisis. He concluded that governments had little choice but to attempt to save the banks. ‘When this was not done in the case of one bank in the United States, the consequences for the stability of the financial system were tremendous. However, I also established that while intervention did lead to an upturn in the short term, this effect can become detrimental in the long term. Such side effects can be limited by bringing support measures into line with market forces and by having a proper exit strategy: you have to retreat in time.’

Curriculum vitae

Jan Willem van den End (IJsselmuiden, 1970) studied at the Faculty of Economic Sciences and Econometrics of VU University Amsterdam. He has written a number of publications on the financial risks of banks. Van den End has been an economist with DNB since 2001 and is now a senior economist there. He conducted his PhD research at the Faculty of Economics and Business of the University of Groningen where he was supervised by Prof. Jakob de Haan. His thesis is entitled ‘Credit and liquidity risk of banks in stress conditions. Analyses from a macro perspective.’

Contact

Jan Willem van den End, tel. 020 524 28 34; e-mail: w.a.van.den.end dnb.nl