Carlos da Silva Costa: Regulatory and supervisory institutional
frameworks in Europe
Opening remarks by Mr Carlos da Silva Costa, Governor of the Bank of Portugal, at the Seventh
Bank of Portugal Conference on Financial Intermediation, Lisbon, 7 July 2017.
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It is my great pleasure to welcome you to the 7th Banco de Portugal Conference on Financial
Intermediation.
This conference series has taken place every other year since 2005 (when it was called the
"Conference on Financial Fragility and Bank Regulation"). It aims to bring together senior and
young researchers from academia and central banks to discuss the most recent developments
in financial intermediation, markets and regulation.
Back in 2005, awareness of the challenges ahead in terms of financial stability was already
increasing. Some key topics were becoming important in the theoretical and policy debate:
rapid financial innovation in a context of international integration;
liquidity management practice and the associated systemic risk;
the role of central banks as lenders of last resort; and
the set of problems related to "too big to fail" financial conglomerates.
When the international financial crisis began, followed by the European sovereign debt crisis and
the vicious circle linking sovereigns and banks in several countries, these issues became a focal
point. Many new topics also joined the research agenda, such as:
the misuse of the so-called originate-to-distribute model, in particular resorting to complex
derivatives and other opaque products;
the pro-cyclical nature of the existing capital regulation framework;
the adequacy of financial regulation and supervision frameworks.
Banks were forced to adapt their business models and management strategies. In particular, the
very low interest rate environment and the unconventional monetary policies conducted by the
main central banks dramatically changed the operating environment and the incentives for banks
and markets.
At present, there are
four key issues that in my opinion deserve the attention of
policymakers and researchers:
1. The regulatory and supervisory framework
An economy's regulatory framework reflects society's preferences in terms of risk protection.
These preferences evolve over time and in tandem with them the supervisory regulatory
framework.
In the aftermath of the recent crisis, the public asked for stricter financial and supervisory
regulations. This led to a significant change in financial regulation, guided by two main concerns:
improving financial institutions' governance models; reducing their degree of risk and creating
capital buffers to absorb risk, should it materialise.
But more recently the idea that we have reached a point of overregulation has started to emerge
in the public debate and consequently proposals for deregulation and arguments for greater
supervision discretion have been put forward.
This discretion poses serious problems of transparency and of equal treatment, due to the
temptation to shape the financial system by handing regulatory powers over to supervisory
authorities. A clear distinction should be made between regulatory and supervisory functions.
This segregation is key to ensuring a greater balance of powers and responsibilities, allowing
proper accountability.
2. Regulatory arbitrage
The financial crisis also showed the limitations of decentralised supervision in a world of
increasingly integrated financial markets and institutions. We are now in a process of moving
from a situation in which the regulatory and supervisory frameworks were of national
competence to a situation where there are common rules and in the euro area also a common
supervisor.
A need for greater cross-border integration of financial regulation and supervision emerged from
the policy debate and motivated the still on-going reform of Basel rules and the creation of the
Banking Union in Europe.
However, the degree of implementation of the post-crisis global regulatory reform agenda across
countries varies significantly, giving rise to regulatory arbitrage. This is reflected in the search for
gaps in national legislation that justify avoiding compliance with previous international
agreements, as well as in the behaviour of the authorities that accommodate specific
requirements, conditions and interests of the major international financial conglomerates.
It is very important to identify and assess what the risks and cost of regulatory arbitrage are.
3. Regulatory flaws in the European regulation
The current Banking Union framework suffers from a critical weakness: its micro approach to
managing banking crises disregards the financial stability risks resulting from interventions in
ailing banks. The current resolution framework does not envisage a credible public backstop and
lacks government stabilisation tools.
In fact, the framework governing intervention in problematic banks does not take into account the
fact that the need to preserve financial stability must always prevail over the specific rules of
intervention in banks. As recent cases illustrate, the European bail-in framework does not
exclude bail-out events when financial stability issues (or the public perspective of it) are at stake.
In addition, there is also the question of whether the lender of last resort is prepared and willing to
lend all the liquidity that is needed when a bank is in distress but is still solvent. Otherwise, the
trigger for a banking failure is not insolvency but illiquidity.
Another limitation stems from the rules on MREL (minimum requirement for own funds and
eligible liabilities) and TLAC (total loss-absorbing capacity), which are good ideas for banks that
are mainly financed in the market, but do not work as expected for banks essentially dependent
on deposits. The latter are obliged to go to the markets and to issue debt with high costs that, in
all likelihood, will be taken up by other banks, thus creating negative externalities for the stability
and resilience of the financial system as a whole.
This is particularly worrying because it can undermine the construction and sustainability of the
Banking Union.
4. Financeable risk and risk that is acceptable to society
Banks take risks as part of their normal activity. However, when such risks are excessive they
can lead to huge losses - not only for banks and their investors, but for the whole economy.
Regulation plays a key role in reducing vulnerability and sources of risk and in containing the
costs of financial instability when it arises. Nevertheless, it should be taken into account that the
higher the capital required for the banking system, the higher the intermediation cost, decreasing
the credit multiplier. A banking system with minimum risk means a banking system with
maximum cost and, hence, smaller capacity to finance investment. If it is accepted that the
financial system has to take some risk, regulations must lay down how society should react
when risk becomes systemic, for instance, setting out the role of the different stakeholders in
these cases.
Regulations should seek to make the financial system safer, but flexible enough to fulfil its
function as a driver of economic development while being adaptable to new paradigms, namely
to those resulting from technological innovation. Society's preferences in terms of financial
security are not always consistent with the economy's financing needs or risks arising from
innovation.
I will stop here, resisting the temptation to keep talking about these important and fascinating
issues related to the regulatory and supervisory institutional frameworks in Europe. Let me just
wish you a rich and fruitful debate and a very pleasant stay in Sintra.
Thank you for your attention.