Nout Wellink: Rebuilding the financial sector
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel
Committee on Banking Supervision, at the Colloquium of the Centre for Financial Studies,
Frankfurt am Main, 8 December 2010.
* * *
Introduction
1. Ladies and gentlemen, the financial crisis that has raged since July 2007 is a
manyheaded monster. At its core is a lack of market confidence in financial institutions and in
some countries. I will speak about the background to the global financial crisis, its impact,
and about the current situation in some European countries. I will elaborate on some
challenges we face for the future. In particular, I will focus on strengthening the resilience of
the banking sector, including the approach towards too-big-to-fail banks. I will conclude with
the initiatives to enhance macro-prudential supervision.
Causes of the global crisis
Global fire fuelled by interdependencies, ...
2. After the first signs of difficulties with subprime mortgages in the United States
emerged in the summer of 2007, they were long thought to be a specific US problem that
would only indirectly affect other parts of the world. That proved an illusion: the mortgage
problem in the US was the spark that set the system on fire worldwide. The flame was
kindled by the negligent contracting of mortgage loans, via risky constructions and poor
documentation. The popularity of financial innovations generated an opaque pyramid of
financial risks that became steadily more unstable.
... and insufficient buffers
3. The innovations enlarged the net leverage in the system, because they enabled
banks to operate with an ever slimmer capital position; the ratio between assets and capital
at large banks before the crisis averaged out at more than 30. The supervision of liquidity
risks at banks was inadequate and fragmented, also in Europe. In addition, the innovations
deepened the interdependencies between financial institutions, and hence the pace and
scope of contagion channels. In other words: the fuel to start a great fire was omnipresent.
The crisis eventually erupted with great force after the collapse of the US investment bank
Lehman Brothers in September 2008. The losses caused by that collapse and the major
uncertainty about who exactly was hit, led to a disappearance of market confidence and a
full-blown systemic crisis.
Global imbalances contributed to indiscipline
4. Although the relative importance of the various causes is subject to debate, there is
now a rather broad consensus about the developments that led to the crisis. The
globalisation and integration of some parts of the global economy, like China and Eastern
Europe, that had thus far been isolated was coupled with the build-up of global imbalances.
Excessive debt build-up in Western, notably Anglo-Saxon, countries went in tandem with
huge surpluses in oil-exporting countries and Asian countries. Asian countries stuck to a
stable currency, causing the imbalances to continue and their currency reserves to
accumulate. The investment of these reserves in the US kept US interest rates low, the
socalled global savings glut, contributing to financial indiscipline in that country.
Loose monetary policy another cause
5. The accommodating monetary policy, particularly in the US, sowed the seeds for the
imbalances. In the years before the crisis, money supply growth well outpaced potential GDP
growth. This was not reflected in mounting inflation, because the supply of relatively cheap
products from Asia kept price rises moderate. Nonetheless, the monetary expansion resulted
in an acceleration of asset prices and credit aggregates. Before the crisis, lending in
industrial countries grew by around 10% annually. The low interest rates and the abundant
availability of credit encouraged a search for yield. Risks were underpriced and bubbles
could easily arise, especially in real estate. This was the case in the US but also in some
European countries. With hindsight, the interest rates were too low to tame the monetary
expansion and other, more macro-prudential, instruments should have been deployed to
contain the credit expansion.
What has been the impact of the crisis?
Serious damage in financial sector, partly at governments' expense
6. Writedowns on securitisation products and on ordinary loans led to huge losses in
the banking sector. Banks worldwide have written down around USD 1,400 billion. This blew
big holes in their capital base, and in order to uphold confidence in the sector, governments
rigged up extensive support programmes. Some USD 500 billion was pumped into the
banks, while bank debts and asset risks were guaranteed and deposit guarantees were
extended. Large amounts were required to stabilise institutions, relative to GDP especially in
Ireland, Belgium and the UK.
Real economy hit hard
7. The current economic downturn is deeper, more prolonged and more widespread
than those occurring after 15 previous crisis periods in history, according to a multi-country
study by Reinhart and Reinhart (2010). This reflects the radical deleveraging in the financial
system. The study shows that deleveraging after a financial crisis is often initially postponed
and is a lengthy process of on average seven years. The revival following a financial crisis
hence tends to be very slow. A rapid recovery in the global economy set in over a year ago.
As of the end of last year, that recovery has gradually flattened out somewhat, but the
likelihood of a double dip in the US seems slight.
The European debt crisis: imbalances underpin negative momentum
8.
Let me mention some words on the debt crisis that is currently plaguing Europe, on
the causes and on the policy response. It was clear when establishing EMU that the currency
union did not satisfy the ideal conditions. A currency union should preferably be coupled with
a political union, and the latter - notwithstanding the continuing European integration - is still
not in place. Large balance-of-payments imbalances had been built up, with Germany and
the Netherlands running surpluses of around 5% of GDP and the so called peripheral
countries reporting deficits of 5% of GDP or more. The current account deficits were a signal
of major structural imbalances, such as in public finances. When investors became reluctant
to finance the deficits, the debt crisis unfolded. This threatened financial stability Europe-wide
because the countries in the euro area are highly interdependent financially.
Decisive action by governments required
9. In the market turbulence last May, Greece was the epicentre. With drastic
intervention, government leaders and the ECB temporarily managed to turn the tide and
market turmoil abated. However, owing to concerns surrounding Ireland, the market
turbulence flared up again recent weeks, with market participants fearing potential contagion
to other peripheral countries. To maintain market and public confidence, it is essential that
countries make every effort to introduce a credible consolidation programme and reforms to
bring public finances onto a sustainable path. The primary responsibility for improving public
finances lies with the authorities. Moreover, Europe and the IMF have set up an ultimate
safety net that could also be resorted to if need be, while the Eurosystem provides enhanced
credit support with the aim of safeguarding monetary transmission and preventing tight credit
rationing in the private sector. In November, Ireland concluded a program with the European
Commission and the IMF, in liaison with the ECB. This program will deliver an important
contribution to restoring financial stability in the country.
Lessons learned and challenges
10. The worldwide crisis has exposed some fundamentally weak spots in the
international economy and the global financial system. In many cases the efforts to address
them have only just got under way, while there is still much uncertainty about the effects of
the measures. I will focus on two main challenges, first strengthening the banking sector and
second enhancing macro-prudential oversight.
Strengthening the resilience of banks
11. Banks were at the epicentre of the crisis. After the wave of bank collapses,
nationalisations, conversions, break-ups, sales, bailouts - all of which impacted on the real
economy - the financial and banking system seems to have stabilised and to be on its way to
recovery. However, reforms are essential to make the financial and the banking system truly
resilient during periods of stress. The Basel Committee on Banking Supervision has
announced a comprehensive package of measures to strengthening the banking sector. The
contents of what we now call Basel III were endorsed by the G20 World leaders, in Seoul
bankspecific
beginning of November. Basel III contains reforms, the goal of which is to make
banks more resilient to shocks. It also addresses system wide risks, as a bank-specific
approach will not be enough.
Bank specific reforms
12. The core of the bank-specific reforms is stronger capital and liquidity regulation.
Raising the quality of the capital base has been one of the primary objectives of Basel III. In
core
the future, the emphasis will be on capital, that is common equity and retained earnings,
and banks will have less incentive to attract lower quality capital. In line with these qualitative
improvements is the increase in the minimum quantity of regulatory capital. For the first time,
a hard minimum requirement has been set for core capital, namely 4.5% of a bank's total
risk-weighted assets. In addition, the Committee has improved risk coverage of the
regulatory framework and more improvements are on the way. The goal is to ensure that all
material risks are captured. During the crisis, many risks were not reflected in the risk-based
regime. Capital requirements for trading book exposures as well as for complex
securitisations and exposures to off-balance-sheet vehicles will be increased substantially,
about three to four times the old capital requirements.
13. An additional element to the capital framework is a leverage ratio, which will serve
as a backstop to the risk-based capital requirement. In the lead-up to the crisis, many banks
reported very strong risk-based capital ratios while, at the same time, managed to build up
high levels of on- and off-balance sheet leverage. The use of a supplementary leverage ratio
will help contain the build-up of excessive leverage. It will also serve as an additional
safeguard against attempts to "game" the risk-based requirements and it will help address
model risk. A minimum leverage ratio of 3% will be tested during an observation period.
14. The proposed liquidity framework will also have a profound effect since a global
liquidity standard does not currently exist. During the crisis, funding remained in short supply
for an extended period. In response, the Committee has proposed global minimum liquidity
standards to make banks more resilient to potential short-term disruptions in access to
funding and to address longer-term structural liquidity mismatches in their balance sheets.
The Liquidity Coverage Ratio will require banks to have sufficient high-quality liquid assets to
withstand a 30-day stressed funding scenario. This is complemented by the Net Stable
Funding Ratio, which is a longer-term structural ratio designed to address liquidity
mismatches.
Addressing system-wide risks
15. However, this firm-specific approach by itself will not be sufficient. Broader
macroprudential measures to strengthen the entire banking system are equally important. An
essential element in addressing system wide risk is the build up of buffers in good times that
can be drawn down in periods of stress. The Committee has introduced two capital buffers.
First a capital conservation buffer, which will increase the minimum capital requirements with
2.5%. As bank's capital levels move closer to minimum requirements, the conservation buffer
will impose a constraint on its discretionary distributions, like dividend payments, share
buybacks and bonuses. Secondly, the countercyclical buffer, which would be imposed when
excess credit growth is associated with an excessive build-up of system-wide risk. This buffer
can vary between 0 and 2.5%.
16. In order to give banks time to adjust to the new requirements and to support the
ongoing economic recovery, Basel III will be implemented gradually. From 2013 onwards, the
increase of the minimum requirement for core capital will be phased in three years' time. And
only thereafter the capital conservation buffer will be introduced step-by-step in four years'
time. The new liquidity standards will be implemented after an observation period to ensure
their effectiveness.
Too important to fail
17. But an effective system wide focuses also addresses problems related to
interconnectedness and the perception that some banks are too important to fail. Some
institutions have grown so vital for financial stability that they have become systemically
important and their failure is not a socially acceptable option. During the financial crisis,
government authorities had no other choice then to save these institutions. At the same time
losses of external capital providers were kept to a minimum. Let me explain the concept of
systemically important financial institutions, the so called SIFIs, and discuss the international
policy response to address the problems related to "too important to fail".
18. There are roughly three characteristics that make an institution systemically
important: its size, interconnectedness and limited substitutability. Size measures the volume
of financial services provided by a financial institution. Interconnectedness increases the
extent to which problems at an institution may affect the financial system. This may happen
via an institution's direct links with other institutions as well as indirectly, via its role in the
financial infrastructure or financial markets. The third factor, limited substitutability, indicates
that if crucial functions or services cannot be quickly and easily taken over by another party,
the system can become seriously disrupted.
19. Aside from these structural characteristics of institutions, two other factors may
accelerate the spillover to the entire financial system. First of all, the complexity of the
organisation structure. Complex and internationally active banks cannot be easily wound up
nor can their crucial functions be easily transferred to another party. Secondly, in a crisis
situation, confidence effects and herding behaviour of market participants play a reinforcing
role.
FSB Framework for SIFIs
These contagion channels made bailouts of systemic institutions during the crisis inevitable.
Such intervention, however, carries a number of problems, like a burden on fiscal position,
creating moral hazard by making government guarantees explicit, and undermining the level
playing-field between institutions. Therefore, steps have been taken to tackle the
tooimportant-to-fail
problem. The Financial Stability Board has developed a policy framework to
deal with systemically important financial institutions, which the G20 World leaders ratified
last month. This framework is designed to reduce the probability and impact of a failure of a
SIFI. It rests on more intensive supervision, higher buffers for SIFIs compared to Basel III
and an increased resolution capacity of national authorities.
The case for macro-prudential oversight
20. On top of these new standards and regulations, enhancing supervision is also vital.
Macro-prudential oversight is, to put it simply, the missing link between the different
approaches of a central bank and a financial supervisor. A central bank significantly
promotes financial stability by aiming at low inflation, sound payment systems and
sustainable credit growth. Supervisors exercise their responsibility for the stability of
individual financial institutions by ensuring that they have adequate buffers to withstand
shocks. The problem is that both responsibilities, although closely interrelated, have been
poorly attuned. Let me explain.
21. In the run-up to the crisis, most central banks warned against the risks to the
financial system. But these warnings did not prove meaningful, as they were not effectively
translated into mitigating action by supervisors. Likewise, most supervisors believed that if
individual institutions were sound, the financial system as a whole would be too. However,
the financial crisis has shown that supervision of individual institutions is important, but not
sufficient to preserve financial stability.
22. The message is clear: the supervision of the financial system as a whole should be
strengthened to lower the chance and impact of future crises, and this requires central banks
and supervisors to join forces. One important added value of macro-prudential oversight is
that it looks at the interactions between financial institutions and their environment. A single
bank, say, can exercise only a limited influence on housing prices. But, if many banks eased
their credit standards for mortgage loans, housing prices could soar, possibly causing the
housing market to overheat. A housing market crash can entail huge losses for the banking
sector and the real economy. Thus, by monitoring the interactions within the financial system,
including the dynamics behind a build-up of imbalances, macro-prudential oversight can
identify threats to financial stability. In light of these lessons, the EU political authorities have
decided to establish a new European Systemic Risk Board per 1 January 2011 to strengthen
macro-prudential oversight in the EU.
Conclusion
23. Ladies and gentlemen, let me come to an end. I have talked about one of the most
sweeping crises the financial world has been confronted with since a long time.
Governments, supervisors and the financial sector worldwide have replied to this with
ambitious measures and reforms. I am sure that many people, maybe even some among
you, will question whether all these measures and initiatives will in the end improve the
world? It is a simple and fair question, with no easy answer! And though I am no fortune
teller, I firmly believe that these reforms will make the financial sector healthier, stabilise
economies and so improve the world.
24. And the need for these reforms is evident. A recent IMF study, for instance,
estimates the costs of a financial crisis at around 15 percent of GDP, while research that
factors in the long-term impact of a crisis might easily arrive at a multiple of this figure. With
the measures we discussed, future crises will become less probable. At the same time we
should realise that this objective is not presented to us on a silver platter. All the parties
involved will have to work hard to meet all the requirements now that implementation is the
next challenge. So let us not wait too long, and start making plans instead.
Thank you for your attention.