Andreas Dombret: Regulatory reform - unresolved issues and the need
for international cooperation
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, at the Harvard Law School Symposium on "Building the Financial System of
the 21st Century - An Agenda for Europe and the United States", Armonk, New York,
28 March 2014.
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1 Introduction
Ladies and gentlemen
Thank you for the opportunity to speak today at the Harvard Law School Symposium on
Building the Financial System of the 21st Century - An Agenda for Europe and the United
States. It is a great pleasure to be here.
In November 2008, just a few weeks after Lehman Brothers failed, the leaders of the G20
met in Washington D.C. In their meeting they took far-reaching decisions - not only to
combat the current crisis but also to prevent future crises. A central passage of their
declaration was as follows: "We pledge to strengthen our regulatory regimes, prudential
oversight, and risk management, and ensure that all financial markets, products and
participants are regulated or subject to oversight, as appropriate to their circumstances."
Today, more than five years later, we have made good progress. Nevertheless, we must be
aware of what Mark Roe from Harvard University calls the "regulatory confidence cycle". He
writes: "Regulators react to an explosion by creating new rules. The economy recovers; the
regulators conclude that they did their job well, and the regulated then resist further
tightening. [...] As the recovery continues and the memory of the financial crisis grows faint,
the appetite for regulatory change dissipates. Why fix something that is no longer broken?".
On a superficial level it appears that the financial system has been mended. However, we
have to ensure that it will not break again - and this is an objective we have not yet
achieved. There are still issues we need to address in order to create a stable financial
system. In my speech today, I would like to highlight three of these issues: the too-big-to-fail
problem which has already been discussed this morning, the shadow banking system, and
the market for OTC derivatives. Let us begin with the too-big-to-fail problem.
2 Taming the beast - the too-big-to-fail problem
Leaving aside all the nitty gritty, there is one thing we have to do to resolve the too-big-to-fail
problem: we need to introduce more "market" to the financial markets - that is, we have to
restore the fundamental principles of a market economy.
The most important of these principles is the principle of liability. Everywhere it is common
sense that people should be held responsible for their actions. Everywhere but in the world of
banking, it would appear. During the crisis, governments around the world spent billions of
dollars out of taxpayers' pockets to save the banks. This indicates that the too-big-to-fail
banks, at least, play by a different set of rules. They are woven so deeply into the fabric of
the financial system that their failure might tear everything apart.
The consequence is this: whenever a too-big-to-fail bank runs into trouble, the government
might be compelled to bail it out in order to prevent a full-blown financial crisis. This means
that these banks are implicitly insured. Whatever happens, the government is likely to stand
ready to help.
And this has consequences for the nature of the game. First, according to a recent study by
the Federal Reserve Bank of New York, "too-big-to-fail" banks have a funding advantage
over smaller banks. Second, the implicit insurance provides incentives to engage in risky
business that promises high returns. If things turn out well, the bank wins. If things go wrong,
the taxpayers lose.
The principle of liability has obviously been violated. The crucial question at this juncture is
the following: what do we need to do to restore it? Well, the decisive point is that banks must
be able to fail without dragging the entire financial system down with them. What we need
are effective resolution mechanisms for banks. This is common sense at the conceptual
level. However, when it comes to implementation, things turn out to be a little more complex.
Putting practicable resolution procedures in place is a difficult endeavour, especially in the
international context. Systemically important banks have large numbers of entities in many
countries, each of which has its own procedures and supervisory traditions. In the absence of
a sound legal basis and close cooperation, resolution measures executed in one country
might not always be recognised by other countries.
Thus a well-coordinated approach between authorities is needed. The purpose is to maintain
systemically important activities while resolution procedures are applied. Coordination and
advanced planning of resolution measures enable authorities to consider financial stability
from an international point of view, not merely from a national perspective. To this end, a new
international standard on the recovery and resolution of systemically important institutions
has been developed by the Financial Stability Board. Having this new standard is a big step
forward.
At the European level, a central pillar of the envisaged banking union is the Single Resolution
Mechanism. This instrument will allow authorities to restructure or resolve banks without
putting taxpayers' money at stake. In the future, whenever a bank fails, resolution costs must
be borne first by shareholders and creditors. After that, a bank-financed resolution fund is to
come into play, and only as a last resort are public funds to be used and the taxpayers made
to pay.
3 Bringing light to the shadows - the shadow banking system
We have made good progress at the global and the European level in addressing the
toobig-to-fail problem. However, discussions have mainly centred around the banking system.
Yet there are other parts of the financial system that might become a source of systemic risk.
One of them is the shadow banking system.
According to the Financial Stability Board, the shadow banking system comprises "credit
intermediation involving entities and activities outside the regular banking system". What I
think is relevant from a financial stability perspective is that such entities create bank-like risk
without being subject to bank regulation.
The overall effects of the shadow banking system on financial stability are ambiguous.
Theoretically, non-banking financial institutions that perform bank-like activities are
associated with diversification and specialisation benefits. Therefore, it could be assumed
that they contribute to making the financial system more efficient and more resilient.
However, developments in the run-up to the financial crisis revealed something else:
activities and entities in the shadow banking system can pose a threat to financial stability.
These potential threats are mostly the result of maturity and liquidity transformation, the
build-up of leverage and credit risk transfer conducted outside the perimeters of bank
regulation.
All these activities are not evil per se, but the ensuing systemic risk needs to be contained.
All activities must be made transparent, in particular vis-à-vis supervisory authorities, and
they need to be adequately regulated. In that regard, I welcome the global regulatory
initiative on shadow banking - again under the leadership of the Financial Stability Board.
And here too, international cooperation is essential for establishing effective regulation. A
central feature of the shadow banking system is regulatory arbitrage: activities are shifted
from the banking system to the shadow banking system in order to evade regulation. A
geographically fragmented approach to regulation would not curb regulatory arbitrage but
just take it to another level. Against this backdrop, it is to be welcomed that the G20 have
placed the shadow banking system high up on their agenda.
4 Structuring the market - OTC derivatives and CCPs
The third issue I would like to raise relates to the structure of the market - the derivatives
market, to be precise. Trading in derivatives certainly has the potential to cause massive
losses, to disrupt markets and to threaten financial stability.
But it is not just during trading that financial stability can be put at risk; it can also be
jeopardised at the back office level when transactions are cleared and settled. And this might
pose a problem for all market participants, be they part of the banking system or the shadow
banking system.
The G20's decision to require OTC derivatives to be cleared centrally was an important
cornerstone in regulating OTC derivatives markets.
Central counterparties, or CCPs in short, are able to mitigate systemic risk and act as risk
buffers in global financial markets. This appears particularly striking when we consider two
sources of potentially huge losses: first, extremely one-sided derivatives positions and,
second, the high degree of opacity surrounding the interconnectedness of global financial
players. In this regard, CCPs will help to better solve another problem I already mentioned:
the too-big-to-fail issue.
However, CCPs themselves are becoming more systemically important. This harbours
potential side effects which need to be monitored. Furthermore, effective recovery and
resolution regimes need to be in place for CCPs. To shield taxpayers' money, potential
losses have to be distributed among clearing participants, which are often globally active
banks. This gives rise to potential contagion risks and domino effects. Therefore, a careful
calibration of recovery and resolution regimes is crucial.
Against this backdrop, international coordination is again essential. The regulation of OTC
derivatives markets should be the same across all jurisdictions - in spirit, in wording, and in
terms of its outcome. This would allow the corresponding national regulators to defer to each
other's rules when cross-border transactions occur. Otherwise, regulatory arbitrage, market
fragmentation and liquidity disruptions might be the consequences.
Some progress has been made over the past year towards resolving these cross-border
issues. One example is the 'Path Forward', a joint statement which was agreed upon by the
European Commission and the CFTC in July 2013. This statement is a necessary foundation
for further cooperation. However, some cross-border matters are still unresolved and
urgently need to be addressed.
Major differences between the US and EU regulations can be found, for instance, in the
methods used to compute the initial margin coverage of CCPs. And they can also be found in
the scope of reporting requirements to trade repositories. Let us take a brief look at these two
examples.
First, the rules used for calculating the minimum initial margins of CCPs differ between the
US and the EU. Generally speaking, CCPs ask for initial margins in order to hedge the
market risk of a derivatives position during the liquidation period in case a clearing member
defaults. Under the existing EU and US regulation, risk managers at CCPs have to take into
account different minimum liquidation periods and confidence intervals when calculating
adequate initial margins. As a result, the initial margins requested by CCPs may vary
considerably, depending on the location of a CCP. This might eventually drive business
towards those CCPs with less strict initial margin calculation requirements. To prevent such
regulatory arbitrage from happening, it might make sense to agree on consistent and strict
international standards in detail and thus reduce national leeway.
Second, the mandatory reporting rules differ significantly in terms of timing and scope. In the
US, only CFTC-registered "Swap Dealers" and "Major Swap Participants" are required to
report their transactions to trade repositories in real time. In the EU, meanwhile, transactions
have to be reported by the end of the next business day by both contracting parties.
Furthermore, exchange traded derivatives, market prices and collateral levels have to be
reported in the EU, but not in the US. It remains to be seen whether these differing reporting
rules can be recognised as being equivalent. And - more importantly - it also remains to be
seen how a meaningful and accurate global aggregation of trade repository data can be
brought about.
5 Laying the groundwork - cooperation and harmonisation
Ladies and gentlemen, I have briefly discussed the too-big-to-fail problem, the shadow
banking system and the market for OTC derivatives. Each of these issues highlights the
need for international cooperation. If we do not coordinate our approaches towards
regulation we will create a fragmented financial system. A financial system with vast
opportunities for regulatory arbitrage and ample sources of systemic risk.
Against this backdrop, recent regulatory initiatives in the US worry me. They seem to
contradict the need for international cooperation. A "Balkanisation" of the regulatory space
represents a genuine risk, and any regulatory decision should be taken with that
consideration in mind - in Europe as well as in the United States.
And this not only applies to regulation itself but also to the foundation on which it rests.
Regulating and supervising financial institutions requires information. And to satisfy the need
for international cooperation, this information has to be internationally comparable.
Unfortunately, this is not always the case.
It is not an entirely new insight that differences in accounting standards across countries
hamper the international comparability of balance sheet data. This in turn can potentially
impede financial regulation. A prominent example is the treatment of derivatives and how this
affects balance sheet ratios which are subject to regulation.
Derivatives netting rules under US GAAP allow US financial institutions to net their
derivatives positions to a large extent. In Europe, the IFRS accounting rules are far more
restrictive in this regard. That is why derivatives volumes appear to be much larger at
European banks than at their US counterparts.
Going one step further, regulatory balance sheet ratios which relate to total assets differ
between US and European banks. The leverage ratios of US banks, for instance, generally
appear much lower than those of European banks. Hence, in this particular case, distortions
arising from different accounting rules may make it easier for banks in the US to comply with
a given regulatory leverage ratio than for their European peers.
So far, standard setters have only agreed to harmonise the information disclosed in the notes
of financial statements. Nevertheless, global harmonisation of accounting standards is
needed in order to create a regulatory level playing field and avoid regulatory arbitrage. In my
view, this is certainly something that has to be moved higher up the agenda of global
regulation.
6 Conclusion
Ladies and gentlemen, we have made good progress in adjusting financial regulation.
Nevertheless, we have not reached our destination; regulatory reform has to continue. I have
discussed some of the outstanding issues in my speech: too-big-to-fail banks, shadow
banking, OTC derivatives and accounting standards. I also highlighted the need for
international cooperation.
At the beginning of my speech I cited a passage from the G20's Washington declaration. Let
me close my speech by quoting another passage: "Our financial markets are global in scope,
therefore, intensified international cooperation among regulators and strengthening of
international standards, where necessary, and their consistent implementation is necessary
to protect against adverse cross-border, regional and global developments affecting
international financial stability."
That is the spirit, ladies and gentlemen. To reach our destination - a stable financial system
- we will have to walk together.
Thank you very much.