ESIGELEC - Rouen
25 May 2023
Digital transformations and financial system turbulence:
What lessons for regulators and supervisors?
Speech by Denis Beau, First Deputy Governor
Introduction
[Go to slide 2]
Dear Professors, dear students. I am very pleased to have the opportunity of sharing with you
some of the lessons that we at the Banque de France and the ACPR, under our financial stability
mandate, have learned from the recent turbulence that has affected the international financial
system.
This turbulence, which has impacted both traditional financial players in the wake of the SVB
bankruptcy and players in the "new digital finance" ecosystem in the wake of the FTX
bankruptcy, results from the realisation of risks, whose impact has been amplified or whose
spread throughout the financial system has been sped up, by digital innovations that are
transforming at high speed, or even shaking up, the way in which finance works.
While the effect of this turbulence on the financial system as a whole and the real economy
seems to be contained for the time being, the impact of digital innovations raises questions as
to the regulation and supervision practices of both traditional finance and the emerging digital
finance. I propose presenting these questions to you one after the other, together with the
answers that I believe to be appropriate.
1. Traditional finance put to the test by the digital world: what lessons can be learned from
recent bank failures?
[Go to slide 3]
Silicon Valley Bank (SVB), which was virtually unknown to the general public before its collapse
last March, was a - if not THE - tech bank and as such had a specific business model, based
on two pillars:
- its sources of funding were heavily dependent on uninsured deposits, stemming from a highly
concentrated customer base of entrepreneurs and venture capitalists in the tech and digital
world.
- a very high share of these deposits was invested in long-term government bonds, issued by
the US federal government or federal agencies, at fixed rates, since these securities are
intended to be held for the long term.
In 2022, the change in the US economic and financial environment transformed SVB's
business model into a source of vulnerability to liquidity and interest rate risk. This vulnerability,
combined with major failures in the bank's management and governance system, proved fatal.
Indeed, in this new environment marked by rising interest rates and slowing growth, the cash
flow needs of tech companies led them to withdraw a portion of their deposits, causing a liquidity
problem for SVB, which forced it to sell part of its government bond portfolios. These forced
sales, which were not anticipated by the bank, resulted in the crystallisation of unrealised
losses, real losses in other words, as the securities sold shed value with the increase in key
interest rates decided by the US central bank (the FED). The subsequent downgrading of SVB's
rating by Moody's and the aborted capital increase by the bank fueled a negative spiral between
liquidity and solvency, which led to its bankruptcy on 10 March 2023. Tech players, fearing the
loss of their deposits, which greatly exceeded the minimum guaranteed by the US guarantee
fund, withdrew them all the more massively and in record time - in one click - as they represent
a financially and digitally "educated"
clientele.
Does this "one-click" bank run, which neither banking regulation nor supervision by the
authorities responsible for enforcing it were able to prevent, means that the digitalisation of
our economies and of finance is making this regulation and supervision fundamentally
inadequate?
1.1. The current framework has not been invalidated by the current crisis...
I will give a negative but cautious answer to this question. In other words, I will answer with
a "no, but". The "no" seems justified to me for the following three reasons:
- Since 2019, SVB has benefited from a very light regulation compared to the rules laid down
by the Basel Committee to limit the liquidity and interest rate risks inherent to the transformation
activity carried out by banks. As regards the first risk, these rules require that banks comply
with short and long-term liquidity ratios, and as regards the second risk, that the sensitivity of
banks' balance sheet to various interest rate shocks be monitored. In the United States, these
rules were not applicable to SVB, as certain exemptions, introduced in 2019 under the
proportionality principle, apply to banks that are considered to be less important, this concept
being understood in a broad sense since it includes banks with a balance sheet total of up to
USD 250 billion.
- The post mortem analyses carried out and published by the FED suggest that, had SVB been
subject to these rules, it would not have complied with the short-term liquidity ratio as defined
by the Basel Committee. Moreover, SVB's heavy reliance on tech companies' deposits should
have alerted its supervisor if the additional monitoring tools required by international standards
had been put in place. The same FED analyses estimate that SVB's interest rate risk sensitivity
was around 35% before the crisis, well above the 15% alert threshold set out in the international
rules and supposed to trigger supervisory action.
- Monitoring compliance with regulations calls for strict, intrusive and reactive supervision,
which, according to the FED, was not the case.
Let me reassure you on one point: the European situation is radically different. The Basel
Committee's rules are applied in Europe in their entirety and to all banks. By the way, I would
like to add that Europe is in the process of finalising the transposition into European law of the
latest reinforcements of the Basel III agreements, ahead of the other major jurisdictions. As
regards supervision, the euro area has a single supervisor, the European Central Bank, which
has intrusive supervisory powers and regularly mobilises sophisticated tools such as stress
tests and on-site inspections.
...
1.2. but it must be deployed and applied in a consistent manner
Go to slide 4]
While the case of SVB illustrates the consequences of poor implementation rather than an
ineffective regulatory and supervisory framework, this does not mean that it would not be
appropriate to amend this framework in the light of experience. Hence the "but" after my "no"
to the question I asked about the relevance of regulation and supervision.
There are indeed several issues that deserve to be addressed, and will undoubtedly be the
subject of intense discussions among supervisors in the months to come. I would simply like
to mention three of them here.
should the current framework
The first issue concerns the supervision of interest rate risk:
for supervising interest rate risk evolve towards a more systematic and mechanical application
of rules? At the ACPR we believe not. The heterogeneous nature of interest rate risk requires
fine-tuned supervision. This is what the current "enhanced supervision" approach is about: it
imposes standardised risk measurement tools, while recognising the specificities of the
financing models of the different jurisdictions, such as the granting of long-term fixed-rate loans,
or regulated savings, in France.
The second issue concerns the treatment of unrealised losses on debt securities carried
at amortised cost - I am referring to the unrealised losses that materialised when SVB had to
sell part of its government bonds portfolio: should these unrealised losses be recognised in the
current prudential framework, beyond their simple disclosure in the financial statements? More
precisely, should these unrealised losses be fully reflected in the banks' equity capital? On this
subject, we believe that we must take the time to identify precisely all the advantages and
disadvantages of such a solution, which may appear simple but has multiple side effects. On
the one hand, the impact of these unrealised losses is already taken into account in the short-
term liquidity ratio, the LCR. On the other hand, systematically accounting for debt securities at
their market value would lead to a rise in the volatility of equity capital, with the risk of generating
pro-cyclical sales phenomena. In particular, this would have a downward impact on equity
capital during periods of rising interest rates - as we are currently experiencing - with the harmful
consequences that you can imagine for the financing of the economy and for the public debt
market: a fall in the supply of long-term fixed-rate loans and disorderly sales of debt securities.
The third issue concerns supervisory practices. Sound regulation implemented at the global
level is a good thing. But it cannot be at its best without strict, intrusive and reactive supervision.
The tools provided by the Basel Committee for the supervision of liquidity risk, in particular
those used for monitoring the concentration of financing or the maturity gaps between assets
and liabilities, already enable supervisors to have a detailed view of the risks specific to each
bank and to react appropriately. Could they be strengthened by introducing, for example, new
alert thresholds? Could we also consider introducing such thresholds on the level of unrealised
losses, which would trigger supervisory action?
Will these adjustments to regulation and supervision be sufficient to prevent failures in
While Basel Committee members undertook, when
this new age of one-click bank runs?
finalising the Basel III agreements in 2017, to only consider new changes to the rules once they
had been implemented at a global level (a commitment known as the "hard stop"), should the
recent emergence of digital transformations in the financial sector and their rapid evolution not
prompt us to be more vigilant and to anticipate the next move? I believe so. It is essential that
the role played by new technologies and social networks in speeding up liquidity stresses be
properly taken into account by regulations. At the same time, in the digital age, with easier
access to information, and rumours, and the ability to conduct banking operations
instantaneously, we will have to examine the regulatory assumptions, in particular with regard
to the flight of some deposits.
2. Digital finance: a regulatory challenge
[Go toslide 5]
I will now turn to digital finance and its regulatory and supervisory challenges.
2.1. Rapidly growing markets but increased risks
This digital finance relies on new players, new assets and new infrastructures. Among these
new players are big techs, which should not be reduced to the GAFAMs alone. These have
made targeted and fragmented inroads into financial services. These incursions include the
provision of cloud services to financial institutions, which are progressively migrating their IT
systems and infrastructures to these new solutions in order to reduce costs, increase the
flexibility and security of their infrastructures, and improve customer experience. Furthermore,
big techs are setting up their own financial activities, in a fragmented and unregulated manner,
in the form of technical services (e.g. Apple Pay digital wallet, Google Pay, etc.), or in the form
of financial products and services (savings products, loans, issuance or trading of crypto-
assets, etc.) which are developed in-house or in collaboration with traditional players. For
example, Apple offers a savings account in partnership with Goldman Sachs, while also offering
its own fractional payment service.
What are the risks associated with these inroads into financial services? The provision of cloud
services carries a systemic risk of operational resilience and some providers are already "Too
a few of the big techs' systems
Big To Fail": the interruption or failure of could indeed impact
financial stability and the economy in general, given the very high level of concentration of
providers1 and the dependence of financial institutions using their services. Moreover, some of
their financial activities, which are closely linked to those of traditional financial players but are
carried out outside the regulated framework - and therefore without any constraints! - carry a
strong risk of moral hazard which could again prove detrimental to financial stability. One
example among others: if they were to provide both brokerage services and credit scoring
services, these companies could be inclined to generate more business in order to collect
commissions, while reducing the attention paid to credit quality, in the absence of risk
participation.
But alongside the big techs, other players, at the crossroads of IT and finance - maybe you will
soon join one of them, once you have graduated from your engineering school - are profoundly
transforming the latter. They offer a wide range of services, particularly focused on crypto-
assets. I would like to remind you in passing that the term "crypto-currency" is misleading and
often used incorrectly, as no crypto-asset currently fulfils the three functions of money, i.e. a
medium of exchange, a unit of account and a store of value. This crypto-asset market has
grown exponentially since the Covid-19 pandemic. However, in 2022, the succession of
spectacular crises including the collapse of the ill-named (algorithmic) stablecoin Terra USD
and the collapse of the FTX platform, brought to light the vulnerabilities of this emerging
ecosystem and the nascent bridges between crypto-assets and traditional finance. The collapse
of FTX led to the bankruptcy of two banks - Signature and Silvergate - while, conversely, the
failure of the Silicon Valley Bank threatened the deposits of Circle (the USD Coin issuer) which
were placed there. Some of these vulnerabilities are specific to the crypto sector, such as the
high volatility associated with the lack of economic fundamentals underlying some crypto-
assets; others are shared with the traditional financial system, such as operational risk and in
particular cyber risk. All of them may jeopardise the stability of the financial system as a whole.
How then should these new players be regulated?
2.2 The existing framework - Europe is leading the way thanks to DORA and MICA
big techs'
The European regulatory authorities reacted swiftly to regulate the new risks that
inroads into the financial sector carry, with the Digital Operational Resilience Act (DORA) on
operational resilience, and the Digital Markets Act (DMA) on fair and non-discriminatory access
to platforms. DORA in particular represents a major and innovative step forward, with the
establishment of an oversight framework for monitoring third-party service providers that are
identified as critical for European financial institutions. These providers shall be required, under
possible on-call duty, to collaborate with client institutions to enable them to comply with their
own obligations in terms of IT security and business continuity.
As regards crypto-assets, although the size of the ecosystem remains relatively small to date,
which limits the contagion effects on traditional finance, the instability of the sector shows that
establishing a reliable regulatory framework is necessary to ensure its long-term growth. France
has been a forerunner in this respect since 2019 with the enactment of the PACTE law and the
introduction of the status of Digital Asset Service Provider (DASP). Europe is also leading the
way in this field with the Markets in Crypto-Assets (MiCA) regulation, which has just been
adopted in its final version.
Elsewhere, approaches are still being developed: some countries are hesitating between
regulation and an outright ban, while others, such as the United States, are taking a fragmented
approach to regulation, which is not always respected by the players. In any case, given the
global dimension of this market, it is important that international regulation be implemented as
rapidly as possible. In this respect, it is essential that it results from the high-level
recommendations drawn up by the Financial Stability Board on crypto-assets and stablecoins.
The recent Basel standard, published at the end of 2022, which regulates banks' exposure to
crypto-assets is also a very encouraging first step in shielding the banking sector from contagion
risks.
2.3 Pursuing regulatory efforts and harmonising supervisory practices
[Go to slide 6]
Regulatory efforts must therefore be pursued and new initiatives have already been identified:
regulations on Artificial Intelligence, open finance data sharing, and electronic identification. It
is clear that we are walking a tightrope: we must not restrict financial innovation in order to
benefit from the contributions of digital finance and big techs, while anticipating the possible
bypasses that these players will no doubt exploit, to the detriment of financial stability. To this
end, the community of regulators has a clear guideline: "same activity, same risk, same rules".
With this objective and this guideline in mind, what regulatory changes concerning big techs
can we hope to see to ensure financial stability and fair competition with other players? First,
the strengthening or introduction of a prudential framework and requirements harmonised at
the European level regarding payment services and non-bank loans, which are the areas where
big techs are developing more specifically. Second, the introduction of a new framework for the
non-financial conglomerates that are developing in the financial sector (also known as mixed
activity groups). More specifically, this could involve requiring that financial and related activities
be grouped and segregated under a specific structure and, in the event of a systemic footprint,
applying the banking framework to these "financial sub-groups" as long as the activities are
similar in nature to those of banks.
As regards crypto-assets, while MiCA is a regulatory milestone, it needs to be rapidly
complemented with additional requirements to extend its scope, in particular to address two
issues that are heightening the existing risks posed by crypto-assets. First, it will be necessary
to address the challenge raised by the concentration of crypto-asset service activities within so-
called crypto-conglomerates. The challenge is to guarantee investor protection, for example by
imposing segregation of client funds, rules of good conduct and risk management for
intermediaries, and even the unbundling of activities. Next, we need to devise rules to regulate
the decentralised finance ecosystem (DeFi). Last April, the ACPR published a discussion paper
for consultation that presents the challenges posed by this regulatory development, which could
take a hybrid form between traditional financial regulation and regulation inspired by other
economic sectors. I'll say no more about it and leave you to discover it, hoping to have aroused
your curiosity.
Conclusion
To quote your director,2 "to specify, design and implement (and I would like to add, to master)
the intelligent and connected systems that will transform our society on a daily basis", as future
trained engineers, I know that the few elements I have just outlined will resonate with you.
These intelligent and connected systems - some would say complex - are already present in
the banking and financial sector. Digital transformation is both an opportunity for the financial
sector and a risk. It is an opportunity if and only if it is framed by fair regulation and strong
supervision, for the benefit of all. Central banks and supervisors have a major role to play, and
new talents, and here I am thinking of you, will be welcome to contribute to meeting these
expectations, both among the players of the digital transformation, and among central banks
and supervisors such as the Banque de France and the ACPR.