Christian Noyer: Financial stability in Europe and in the world - a French
perspective
Speech by Mr Christian Noyer, Governor of the Bank of France and Chairman of the Board
of Directors of the Bank for International Settlements, at the Open podium debate on "The
euro in the financial crisis - lessons and perspectives", Copenhagen, 22 March 2010.
* * *
It is a great pleasure to be here in Copenhagen at the gate of the euro area. This makes it all
the more stimulating to discuss here with you issues related to the single currency, the
financial crisis and the emerging new financial order. It allows for sharing experience and
perspectives, which in and of itself is valuable for policy-makers.
I would like to focus my remarks more on the emerging new financial order. More specifically,
in the few minutes I have, I would like to share with you some thoughts, in a candid way, on
three important policy questions.
How can we make our financial systems more resilient?
How can we reduce the procyclicality of financial systems?
How can we best address systemic risk?
Resilience
Central banks have a strong stake in the resilience of financial systems. An environment of
financial stability reduces the risk that monetary policy instruments become less efficient due
to frictions and volatility in financial markets.
Strong prudential standards are a certainly a prerequisite. It is now apparent that the level
and quality of pre crisis capital in the banking system has not been adequate for the types of
losses that have been experienced and that are expected to materialize from the broader
economic downturn. Larger capital and liquidity buffers are necessary especially for trading
activities.
In the Basel framework we have recently taken decisions which will lead to a much more
robust and resilient banking system in the future, with both a stronger capital and liquidity
base. The challenge, now, is to calibrate and phase in the new framework in a way that does
not impede the recovery and does not contradict our macroeconomic objectives. In the long
run, we want stronger balance sheets in the banking system. In the immediate future,
disorderly deleveraging is one of the main downside risks to the recovery process. Striking
the right balance, in our actions and in our communication, is important, but difficult. The
top-down assessment underway in the context of the Basel committee and the FSB is trying
to reach that balance. The broader point here is that the proposed reforms can have
significant macroeconomic consequences and these should be factored in when designing
and implementing them. While the crisis has clearly had global ramifications, its impact on
financial systems was not uniform across the world. Differences in financial structures do
matter. Banks remain central in our financial systems: this is especially true for continental
Europe where they are responsible for more than 80% of financial intermediation. These
differences suggest that we should be careful in crafting the regulatory answer to the crisis.
Our experience in France is that our banks' universal model has weathered the storm
relatively well. It would be a major paradox to put in place rules which would challenge such
universal models. There needs to be scope for different countries to tailor solutions to their
circumstances, while at the same time doing so within a globally agreed framework.
Many banks have improved significantly their capital position through raising high quality
capital. Yet, banks may not feel comfortable if their new capital position is barely above the
new minimum. Indeed, a critical issue going forward relates to the behavior of banks with
respect to capital buffers they retain on top of the existing minimum. If banks target buffers
above the regulatory minimum, which is an endogenous market outcome, they may need to
raise even larger amount of equity than what can be expected just looking at the current
package. On the one hand we know from empirical studies that weaker capitalized banks
typically exhibit weak loan growth compared to other better-capitalized banks. On the other,
banks may find it less costly to adjust loan volumes and loan pricing than capital, as frictions
in the market for bank capital make the latter option more expensive.
Finally, any regulatory framework needs to manage avoidance and regulatory arbitrage, and
keep up with innovation and other forms of structural change. For this, a necessary, but not
sufficient condition is that standards are comprehensive in coverage and consistent across
jurisdictions. I am not sure, for instance, that the leverage ratio, if it was to be implemented
as a compulsory instrument, would meet this double test. At the current level of accounting
divergences, consistency will be very difficult to achieve. Furthermore, there is a risk that it
would encourage migration of credit activities towards other - less regulated - parts of the
financial system.
It is therefore important that consistency apply across standards and countries. Convergence
between accounting standards is a precondition for a consistent implementation of some of
the prudential reforms discussed by the Basel Committee. It is also essential that new
prudential standards for banks become truly universal.
Procyclicality
Strictly speaking, procyclicality is a tendency of financial systems to fluctuate around a trend
with the economic cycle.
By extension, procyclicality can encompass all "amplification mechanisms" through which an
initial shock results in wider movements in asset prices, credit flows, market liquidity, and,
possibly, the real economy.
Our accounting and prudential regimes have increased procyclicality in recent years. In a
mark to market environment, asset prices movements quickly translate into changes in the
capital base of financial institutions. This, in turn, triggers additional demand for assets and a
further increase in their prices. This kind of "inverted demand curve"; where demand
increases with prices, may create the conditions for deep and lasting financial instability.
Addressing procyclicality caused by the regulation itself is therefore a priority.
The first line of defense against procyclicality should be the accounting framework. I strongly
support the current focus on changing the accounting rules. More precisely, moving from an
incurred loss model to a forward looking model is essential. We need a robust, auditable and
straightforward provisioning system at the accounting level based on a forward looking model
that would allow provisioning efforts commensurate with credit risks through time. This
framework should also be simple, bearing in mind the ultimate objective of creating synergies
between prudential and accounting standards.
The Basel Committee is working on a very comprehensive approach, which is casted in its
"Principles for revision of IAS 39". Accounting standard setters have also been working hard.
I firmly believe that two steps are required going forward. One is that the IASB should follow
the principles by the Basel Committee. Another is that the IASB and the FASB should adopt
a common methodology regarding provisioning based on expected credit losses. This is a
precondition to ensure that the G20 countries have convergent accounting systems.
Some of the procyclicality can also be trimmed through prudential regulation. Efforts to make
solvency ratios potentially less procyclical are welcome and should be pursued. In particular
those efforts aimed at imposing a measure of risks "through the cycle" or "downturn" are
useful. Other options to take some of the procyclicality off through prudential standards
include a fixed buffer, which would act as a capital conservation device. I see some
limitations to such an option. It is hard to see how this fixed buffer, supposed to be on top of
the minimum requirement, would not be perceived as a new regulatory minimum. Also, it is
very hard to see how this mechanism may not have adverse impact on banks' share
ownership. Another avenue to address procyclicality through prudential rules is by putting in
place a countercyclical capital buffer. The logic is simple and, in principle, appealing: the
mechanism, indexed on a macroeconomic variable, would force banks to build capital
reserves when they can do so and allow them to consume such reserves in a downturn. This
would be expected to ensure that banks accumulate and use self-insurance in
synchronization with the financial cycle. In practice, we still need to clarify the conditions and
the set up for triggering the release of surplus capital accumulated through the mechanism.
Such a mechanism may not necessarily be cumulative with others and we may have to
choose.
Systemic risk and moral hazard
As techniques for managing and allocating risk became more sophisticated, the network of
counterparties expanded in scale and in complexity. This was, truly, a systemic change that
was properly understood but not fully captured by regulators at the time. Credit and market
risk was supposedly more broadly spread. But counterparty risk increased. Overall, the
overall impact on financial stability may well have been negative.
There might be a temptation to assess systemic risk through a crude "size" criterion. "Too big
to fail" certainly warrants special treatment. But, the position and role of even smaller or
medium size actors may also put them in a situation to have a strong influence on the
system's dynamics. There is a need to account for other dimensions of systemic importance
such as interconnection, complexity, substitutability. Furthermore, the "systemic" character
strongly depends on circumstances, the environment and the specific features of the
financial system. Drawing up an a priori list of systemically important institutions would give a
false sense of certainty. It may also fuel the moral hazard associated with such firms being
perceived by markets as - exactly that - systemic.
Various initiatives are currently discussed, including stronger cooperation between
supervisors and, more controversially, additional capital charges. They certainly require
further thorough analysis It is essential to avoid threshold effects and never forget that risks
are continuous in nature, time-varying and state-contingent.
The debate about systemic firms echoes also concerns about the activities and business
models of some institutions. It is especially so in countries where public intervention to
rescue the financial system was on a massive scale. The presumption is that smaller and
leaner financial institutions would pose less risk to financial and macroeconomic stability than
larger and more diversified ones. Yet, facts suggest this cannot hold as a general lesson
from the crisis. Indeed, those banks which suffered most from the crisis were precisely those
which were more specialized, such as the investment banks. By contrast, large universal
banks, reliant on a large deposit base, could withstand the shocks comparatively better.
To deal with systemic risks, there is a lot of merit in investigating more what I would call
"market options". Financial innovation can bring an essential contribution to growth and
prosperity. It can also create significant instability. To reap the benefits of innovation and
reduce its risks, we need robust and resilient financial systems and infrastructures.
In this respect, concentrating systemic risks in central clearing counterparties for the most
important markets (interbank, derivatives) may bring us a long way in reducing them. Even in
CCPs, counterparty risk never disappears. Clearing houses concentrate the risks and remain
vulnerable to a default by a major participant. They should operate under appropriate
oversight in order to ensure that they are properly capitalized; maintain robust risk
management practices; and meet high standards of governance. They must also not be
dependent on liquidity provision by other financial intermediaries, which means they should
have access, at any time, to Central Bank liquidity.
Credit Default Swaps (CDS) are a case in point. The market is very opaque and increasingly
concentrated between a small numbers of institutions. Worldwide, five banks - one of which
is based in Europe - account for half of the CDS market. Besides, leading CDS players trade
primarily among themselves and the actual transfer of risk through CDS has become more
limited. Concentration and interconnectedness have increased with financial crisis. They are
sources of vulnerability, a risk for the liquidity of the market and a threat to efficient pricing.
The transparency of the CDS market should also be enhanced. Data warehouses, because
they hold the register of all positions, are key players in that respect: whatever their location,
they should provide supervisors and regulators with access to all the data they need to
conduct effective macro- and micro-surveillance. With both a stronger market infrastructure
and greater transparency, we will be in a good position to ensure that CDS provide a safer
contribution to the financing of the economy.
Most of these remarks have been focused on the major and vital impetus to enhance
financial regulation. I cannot conclude without mentioning that changes in financial regulation
are not a panacea for strengthening financial systems and ensuring that the new financial
order will be less prone to instability. What is also absolutely critical is that macroeconomic
policies do not derail financial stability. As I mentioned in my introduction, there is no free
lunch in being a member of a monetary union. The credibility of policies for financial stability
is contingent upon the conduct of other policies. Disciplined fiscal policy is a precondition to
achieve macroeconomic and financial stability.
Looking into the future, a macro-prudential policy framework could provide further rooms for
maneuver. In a nutshell, macroprudential policy could alleviate some of the constraints
associated with the conduct of monetary policy when faced with asset price instability. It
might also alleviate the burden on fiscal policy by limiting systemic risks and thus lowering
the need for state financial rescue packages. That said, in practice, developing a
well-articulated macroprudential policy framework raises some challenges. I trust the benefits
of addressing them are worth the impressive hard work currently underway.
Thank you for you for your attention.