Why Germany Is Going to Prevail

Hans-Werner Sinn has spent much of his career studying risk-taking and national competitiveness, and his prescient calls have made him one of Germany’s most-respected economists. He warned about the build up of risk in the banking system in 2003 and called for tighter regulations to contain it. Sinn, who is president of the Munich-based Ifo Institute for Economic Research, has also been a vocal advocate of supply-side economic reforms to improve Germany’s economic performance.
Interview, institutionalinvestor.com, 30.09.2010

In a recent interview with Institutional Investor writer Franziska Scheven, Sinn explained why he welcomed the recent Basel III accord on higher bank capital requirements, and why the German economy stands to benefit from changes in the flow of international capital in the years ahead.

Institutional Investor: In 2003, you touched off an academic debate on banking regulation in which you favored stronger rules to limit excess risk. Do you feel a satisfaction now that you know your warnings were accurate?

Sinn: Unfortunately the crisis has confirmed my fears. I was not surprised when I saw what happened. I am glad that Basel III considers stricter banking regulations now.

What influence will the new regulations have on the future of the global financial system?

Banks are doing business with a high leverage factor and little equity. This strategy results in high returns but also in irresponsibility. There is excess risk-taking because those who have little equity are not fully liable for the risks they are taking. If worst comes to worst, they shift the burden onto their creditors or rely on the taxpayer.

Raising the equity requirements will lead to more responsibility by the banks. Banks will then implement incentive systems that force their managers to engage in less risky deals. And this is good.

What are the most important steps that need to be taken to prevent another crisis?

You have to raise the tier-one ratio and you have to introduce a maximum leverage ratio. Both are considered within Basel III. In addition, we have to adjust the risk weights when calculating the sum of risk-weighted assets, i.e. the denominator of the tier-one ratio. Investments in financial assets should be weighted higher, while investments in the real economy should receive less weight in risk distribution.

Then, you have to reduce or even eliminate the system of nonrecourse loans. This is true for loans to homeowners as well as for nonrecourse forms of securitization. All in all, there has to be more liability, because liability brings responsibility. Additionally, offshore companies have to appear on the balance sheets from now on in order to back their business up with equity.

What is Germany’s role in global finance going forward?

Germany was the second-largest capital exporter in the world, after China, for the last few years. Germany helped to finance the boom in southwest Europe, from Greece to Portugal to Ireland. It also co-financed the American boom. Now, with the crisis, banks are starting to have a new awareness of risk. They give less money to foreign countries, but offer their savings to domestic investors instead. This will warm up Germany’s internal economic activity. Germany was a loser for the last 15 years. It had the lowest net investment rate of all OECD countries and the second-lowest growth rate in Europe. Now there will be a phase where Germany is going to prevail.

Should the euro zone have a single representative on the IMF board to facilitate governance reform of the fund?

No, all countries on the IMF board are represented according to their capital share. And this is how it should be.