Sinn calls for temporary state controlling interest in the banks, drastically higher capital reserve requirements and restrictions for dubious business models.
“The main problem is not the ethical deficiencies of the actors but wrong incentives and far too lax regulation”, according to Sinn.
Professor Hans-Werner Sinn, President of the Munich Ifo Institute, has presented his comprehensive analysis of the current financial crisis – Kasino-Kapitalismus. Wie es zur Finanzkrise kam, und was jetzt zu tun ist (Casino Capitalism. How the Financial Crisis Came About and What Must Now be Done). In his book, Sinn examines the causes of the crisis, points out the flaws in the German rescue package and presents a master plan for the reform of financial markets.
At the heart of the banking crisis, Sinn sees the speculative behaviour of American homeowners and banks as resulting from differing liability limitations. Private households took risky real-estate gambles because they knew that if the investment failed their liability would be restricted to the property and would not extend to their other assets or salaries. Similarly, banks extended loans because low capital requirements allowed them to participate asymmetrically in the profits and losses of the transactions: The profits were privatised, and losses exceeding the equity capital were socialised. Sinn shows how the increasingly lax capital reserve requirements influenced banks’ business practices: Only because the exposure to loss was largely shifted to external investors or to the taxpayer was it possible for the banks to achieve returns of 25 percent and more on their capital.
“The main problem is not the ethical deficiencies of the actors but wrong incentives that arise from the limited liability of the banks in combination with far too lax equity regulation. Because the banks were allowed to do business with minimum capital reserves, they were tempted to play roulette on the world capital markets using their customers’ money”, Sinn explains.
In addition, Sinn points out, there was the failure of the rating agencies. With much too positive assessments they were largely responsible for the worldwide sales of highly complex US securities that turned out to be worthless.
Sinn directs sharp criticism at the German rescue package and the US Geithner plan. These plans are not suitable for strengthening banks’ capital reserves, which could have dire consequences for the real economy. After the losses of the past quarters, many banks today operate in dangerous proximity to the minimum level of the tier-one capital reserve. If a bank falls below this level, it loses its licence to do business. Banks can only avoid this if they acquire fresh equity capital or if they cut back on their loans. Since equity cannot be raised on the market today because of miserable market prices, it makes sense for the state to step in.
The government, however, is concentrating on measures against liquidity problems, disregarding the solvency problem resulting from excessive equity losses.
“Under these circumstances it is no wonder that the banks are reducing their business volume in order to protect their business licences. With balance-sheet capital reserves of 4 percent, a one percent loss can only be compensated by a 25 percent reduction in lending. This huge multiplier could be disastrous for the economies because money for needed investments would not be forthcoming”, Sinn points out.
There is also a major constructional flaw in the currently planned bad banks, according to Sinn. The banks only need to carry the probable losses of the bad banks to the extent that they can finance these losses from future profits from normal banking operations. Their equity capital is not exposed to liability.
“Bad banks are a bad idea. They will result in increasing the assets of the banks’ stockholders with little for the taxpayers”, Sinn sums up.
In his book, Sinn proposes a number of remedies for the crisis. As an emergency measure, the state should force banks to increase their equity with state funds if they are unable to raise capital in the markets. The purpose of this investment is to ensure that at least 4 percent of equity capital underlies the average balance-sheet volume of the past three years, and at least 8 percent for the risk positions. Sinn sees the state’s involvement as only a temporary solution, however. After the crisis the state must sell off its stakes since, although the state has deeper pockets, it is a bad banker.
Sinn argues for a stricter, internationally harmonised regulation of the banking system in the medium and long term. As the most important regulation, states should demand that also in the long run banks hold considerably higher capital reserves. In addition, the Ifo President calls for a worldwide return to more cautious accounting methods following the model of the German Commercial Code (lowest value principle), a ban on extremely speculative short selling, as well as strict regulations of conduits, hedge funds and credit default swaps.
Kasino-Kapitalismus is published by Econ Verlag. The book is 352 pages long and is available for €22.90. ISBN-13: 9783430200844
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