The dilemma surrounding US investment Bank Lehman Brothers has at least shown one thing: the insolvency of such a financial giant has the potential to rock the global economy, prompting policy makers to act.
It was the German poet Goethe who wrote the poem about the Sorcerer's Apprentice who couldn't control the powers he's called forth. That seems to be a good analogy for the policy makers who set uncontrollable powers free when they deregulated financial markets.
Financial institutions have become too mighty. Business done by the world's ten largest banks currently accounts for some 40 percent of global economic activity. The total assets of Germany's Deutsche Bank towards the end of last year equaled 84 percent of the country's gross domestic product (GDP). Only a fifth of the assets in question were the result of conventional credit activities. The lion's share resulted from investment banking which also includes a lot of risky bets on market developments.
That sort of dicey trading takes place on extremely uncertain ground. Whether a lender grants a loan or does business on behalf of a real client or for its own business, it's not their own money they're using - it almost always comes from other banks. For quite a long time, Deutsche Bank's own core capital hovered around 2 percent. That meant that if 2 percent of transaction had gone wrong, the bank would have faced insolvency.
Deutsche Bank a 'highly risky lender?'
The consequences for the German and global economies would be unforeseeable. That's why Deutsche Bank was classified as belonging to the highest risk category in a joint study by Citigroup and JP Morgan Chase of the US and HSBC of Britain. They said such banks should boost their core capital quota to 9.5 percent by 2019, that's two percentage points more than envisaged under the Basel III international banking reform package.
But Clemens Fuest of Oxford University told Deutsche Welle that wouldn't be enough. "In my opinion, one should go beyond what's laid down within the Basel III framework", Fuest said. "Switzerland is already doing that."
The two big Swiss banks UBS and Credit Suisse are indeed obliged to increase their core capital to 19 percent by 2019. They are not expected to suffer any competitive disadvantages as it will be easier for them to refinance their commitments, given their future status as reliable debtors.
But so far a bank has also counted as a reliable debtor just because it's extremely big - "too big to fail." That philosophy had led governments around the world to spend 10 trillion euros ($13 trillion) to save the banking sector, and thus the world economy, from total collapse. That makes 1,500 euros for every man, woman and child on the planet.
Risk-free for banks
But that ignores an important principle of the market, by which every company is liable for its own risks. German author and economic expert Max Otte calls that "Socialism for banks and the super-rich," under which profits are private while losses have to be covered by the public. The director of the Institute for Economic Policy at Cologne University, Johann Eekhoff, proposes a different approach: "We should establish smaller units, and even split the banks up, so that they won't be able to blackmail governments."
The European Commission too has suggested restructuring the banking sector to this end. A group of experts found risk-taking operations should be separated from the normal credit business. But that doesn't go far enough, says Fuest: "If savings banks lend big sums to investment banks, and those investment banks run into trouble, they could drag down the savings banks with them." He says it's more important to actually let the banks declare insolvency.
And that's what the German regulatory authority, BaFin, plans to do. It wants the Deutsche Bank to submit a plan by the end of the year, in which it would say how emergencies could be dealt with. Other financial institutions have until the end of 2013. That would make it easier to see what the real risks were, and would lower the cost to the taxpayer if something went wrong.
Politics and finance intertwined
Even though the financial sector is currently facing strong headwinds, Otte does not believe that politicians can turn the banking world upside down. "That's because policy makers are fully in the hands of financial market actors and their lobby groups," he says. There's a revolving door between government and banks: in 2005 for instance, Caio Koch-Weser left his post as undersecretary in the German Finance Ministry only to be appointed to the Deutsche Bank executive board three months later. Otte wants politicians to have to wait at least five years before they can cross the line.