Besides the necessity of financial stability, a well-functioning credit market is required for the economy to prosper. Therefore, the Cologne Institute for Economic Research recommends the European Commission a balanced approach to bank regulation. This approach should not treat all bank business models equally, but according to their risk and it should abate the preferential treatment of sovereign debt.
Seven years ago, Lehman Brothers' insolvency triggered a financial and economic crisis which impacts the European economy up until today. The European Commission has strengthened bank capital requirements regulation as a crisis response. Recently, the Commission launched a public consultation, which runs until October 2015, on this capital requirements regulation. The Cologne Institute for Economic Research (IW) takes part in the consultation providing in-depth analyses and policy recommendations.
In their study, the Cologne Institute's experts highlight that different bank business models mirror different risk types: banks which are specialized on financing small and medium-sized companies and banks which are specialized in long-term finance are characterized by lower risks compared to banks which are predominantly engaged in trading assets. The Cologne Institute concludes that different risk types should be treated with different capital requirements, with higher capital requirements for higher risks.
Moreover, one has also to consider that it is easier for banks which engage in more risky and higher return activities to issue equity capital, while it is more challenging for safety-oriented banks to attract equity investors. "Those banks with a less risky business model have no alternative but to shrink their balance sheet in order to reach higher capital ratios – with the result that these banks restrict their lending activities", says the Institute's financial market expert Heide Haas.
The Institute's second recommendation is to abate the preferential treatment of sovereign debt in bank regulation. In the European Union sovereign debt is treated as riskless, so banks are allowed to purchase sovereign debt instruments without issuing equity capital. "We have to change this rule. A lesson from the sovereign debt crisis is that these financial instruments are far from riskless", says the Institute's financial market expert Markus Demary.
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