Gertrude Tumpel-Gugerell: The interplay of banking, financial
intermediation and regulation
Speech by Ms Gertrude Tumpel-Gugerell, Member of the Executive Board of the European
Central Bank, at the 13th Conference of the European Central Bank-Center for Financial
Studies (ECB-CFS) Research Network on "Macro-prudential Regulation as an Approach to
Contain Systemic Risk: Economic Foundations, Diagnostic Tools and Policy Instruments",
Frankfurt am Main, 27 September 2010.
* * *
Ladies and Gentlemen,
It is a real pleasure for me to speak today at the 13th Conference of the ECB-CFS Research
Network on "Macro-prudential Regulation as an Approach to Contain Systemic Risk".
The Roman senator and historian Tacitus tells us that in 33 A.D. the Roman Empire suffered
a major financial crisis. The trigger was a re-establishment of laws that Julius Caesar had
introduced as a war measure in 49 B.C. to prevent the flight of capital abroad and the fall of
land values. After having been disregarded for a long time the re-introduction of the laws,
which forced lenders to invest a large share of their capital in domestic real estate, triggered
a scramble for money as many loans were called in. The disastrous effect was a
postponement of investment and a fall in real estate values, compounded by investors
withholding funding in view of the prospect of finding better bargains in a falling market. The
crisis was eventually ended when Emperor Tiberius arranged for three-year interest free
loans to investors.
Although the global crisis of the last few years had little to do with drastic measures of war
financing of the Roman kind, the involvement of real estate, elements of the transmission
and aspects of the resolution still sound familiar. These analogies are not isolated examples.
The long list of financial crises in human history and their parallels over time have been
extensively documented.1 One of the key issues - today and in history - has been that there
were limited means to contain the systemic dimension of crises. Hence, the recent focus on
macro-prudential supervision and the topic chosen for this conference. The regulation of
systemic risk is very topical.
In my remarks today, I would like to look a bit more at the issue how financial regulation
should react to instances of widespread or systemic instability. I shall do that from two
angles: First, I want to look back at regulatory reactions in the past, namely the
GlassSteagall Act in the United States and the establishment of the Basel Committee and its
standards at the international level, and, second, I want to consider the particular challenges
we are facing for the current regulatory reforms.
How has regulatory policy reacted to the occurrence of financial instabilities in the
past?
One prominent example is the regulatory reaction to the stock market crash in 1929, which
resulted in the establishment of the Glass-Steagall Act of 1933. The Act was to a large extent
motivated by concerns about the role of banks in the run up to the Great Depression and in
particular about conflicts of interest between the lending, underwriting and proprietary trading
functions. Therefore, the Glass Steagall Act banned commercial banks from underwriting,
holding or dealing in corporate securities, hence essentially separating investment from
commercial banks.
The Act not only had a major impact on the evolution of banking in the US, but also
worldwide. For instance, the emergence of large US investment banks, also with
dependencies in Europe, is a direct consequence from the implementation of this Act. The
Act also affected the supervision of banks worldwide. Owing to their funding structure based
on deposits by many small and relatively uninformed agents, hence the possibility of a bank
run and their involvement in the payment system, commercial banks were regulated
relatively heavily. In contrast, investment banks were regarded to need less close public
monitoring and regulation, as they were seen to be less important from an overall financial
stability perspective and mostly the domain of sophisticated investors. However, the crisis
has shown that all actors in the financial system contributed to the build up of systemic risk.
Research on the pre-Glass-Steagall-era in the United States provides evidence that
securities underwritten by commercial banks' subsidiaries did not have a higher probability of
default than those underwritten by investment banks.2 However, whether the Glass Steagall
Act has contributed or not to financial stability is an open question. Nonetheless, in 1999, the
Gramm-Leach-Bliley Act repealed the Glass Steagall Act on the grounds that this would
allow banks to become more competitive, attain favorable economies of scope and diversify
their sources of income. However, the recent regulatory reform in the US under the
Frank-Dodd Bill has re-introduced some restrictions on proprietary trading by deposit taking
institutions.
A regulatory response with a worldwide impact on regulatory standards and banks' business
was the creation of the Basel Committee. The failure of the German Herstatt bank led to
serious spill-overs to the US banking sector. In late 1974, central bankers from Canada,
Japan, the US and 9 European countries founded a new body at the Bank for International
Settlements in Basel, which became later known as the Basel Committee on Banking
Supervision.
This new organization was founded on the understanding that the increasing cross-border
activities of banks and the associated risk that financial instability would be transmitted
across borders required improvements in the quality of supervision and regulation globally as
well as greater international cooperation in this field. Over the years it has increasingly
developed into a standard-setting body and although its standards - such as Basel I and
Basel II - are not legally enforceable they have in fact become the worldwide benchmark.
The list of factors that contributed to the financial crisis is long. However, irrespective of the
multiplicity of factors, we had to realize that the provisions put in place by Basel I and Basel II
were not sufficient to ensure the necessary resilience of the banking sector needed to
withstand a situation like the one we are currently facing.
In my view, the major lessons from the current crisis for any future regulatory policy are the
following:
First, Basel II rested on the principle that the purpose of regulation is to ensure the safety
and soundness of individual financial institutions against the risk of loss on their assets.
However ensuring the soundness of each individual institution does not necessarily ensure
the soundness of the financial system as a whole.
Second, the crisis has highlighted that the main types of risk, notably credit, market and
liquidity risk are ultimately linked, and that funding liquidity of banks is an essential element
of determining their resilience. Awareness about the importance of regulating liquidity risk
was limited until the crisis brought it to the fore.
And third, part of banks' risk taking activities were left to other, non-bank entities of the
financial system and, thus, these activities were able to escape the regulatory web that had
been built for banks.
Already from these three points we see how the lessons learnt lead us to the systemic
dimension of supervision and regulation.
The current regulatory challenge
So let me turn to the challenges of the current regulatory reform to discuss what is needed to
prevent or contain financial instabilities and systemic crises in the future. These challenges
concern three major fields: (i) classic bank regulation, (ii) market and infrastructure
regulation, and (iii) systemic risk regulation.
Regulating banks
Concerning the bank regulation, major progress has been made. The Basel Committee has
just published the regulatory reform package known as Basel III. It addresses the
weaknesses brought to the fore by the crisis. The aim of the Basel III reform is to enhance
capital regulation and to introduce liquidity regulation. In particular the Basel Committee
proposes: first, to improve the quality and quantity of capital, especially Tier-1 capital to
improve loss-absorption on a going concern basis; second, to introduce a non-risk-based
leverage ratio as a supplementary measure to the Basel II risk control framework; third, to
introduce capital buffers and forward-looking provisioning to ensure that the financial system
absorbs the shocks and thus lowers the volatility of the financial and real economic cycles;
finally, to elevate resilience of financial institutions to liquidity stresses by introducing a
liquidity risk framework, improving liquidity risk management and harmonising liquidity risk
supervision.
The significance of internationally coordinated oversight and the cross-border web of
dependencies in the financial system are exemplified by systemically important financial
institutions (SIFIs) that often operate internationally. These played a major role in both the
impact and the transmission of the crisis. In order to increase long term financial stability
there is the need to reduce the moral hazard they exhibit. To address this, policy
recommendations are being developed that include: (i) a framework for measuring an
institution's systemic importance, (ii) resolution tools and frameworks for the effective
resolution of financial failures without taxpayers ultimately bearing the burden, as well as
(iii) prudential and structural policy tools to reduce the probability and impact of SIFI's failure.
Looking further ahead, important challenges remain to improve banking sector stability:
In my view, banks'
First, banks' business models need to become more sustainable.
business strategy should not be directed towards increasing short-term profits by way of
taking on extensive risks to the detriment of the long term viability of their business. In fact,
the level of announced profit targets and their impact on peer banks has also to be seen from
the perspective that higher profits mean higher risk taking and, hence, do not necessarily
originate from efficiency gains alone.
Second, I believe that it is crucial for banks to undergo a serious reform of their
corporate governance and compensation schemes. In particular, the incentives of
traders, CEOs and creditors of the bank should adequately reflect the risks involved so as to
internalize the costs of their risk taking and potential failure. This can be achieved through
appropriate compensation schemes, more transparency vis-à-vis creditors and shareholders
and generally improved oversight of banks' business. Overall, the managing board of a bank
has to shift the focus away from short-term objectives towards a longer term corporate
strategy. This also includes being more accountable for the risk taking of the overall business
of the bank, which brings me to the next challenge. Third, risk management practises
need to be improved. Most risk management techniques - not just used by banks but also
by rating agencies - neglected the correlations of risks across securities and did not
sufficiently internalize the growing systemic (credit, market and liquidity) risks.3 Moreover,
banks underestimated tail risk. The existing risk management techniques worked well at
predicting small day-to-day losses under normal circumstances but failed to predict severe
losses that are very infrequent. However, it is exactly those severe losses that matter the
most. Therefore, banks need to devote greater attention to their risk management. This
means in particular that the risk management function needs to receive a more prominent
role in the organizational structure, specifically with respect to authority and independence.
Regulating markets and infrastructures
Concerning the regulation of financial markets, the crisis has clearly shown that turbulences
in one segment of financial markets can create spill-overs and contagion to other segments.
Moreover, we have seen that both banks and other types of financial intermediaries had
been seriously affected by the financial crisis. Therefore, I welcome the recent agreement to
establish three pan-European micro-prudential supervisory authorities - the European
Banking Authority (EBA), the European Securities Markets Authority (ESMA) and the
European Insurance and Occupational Pensions Authority (EIOPA). They are expected to
become operational at the beginning of next year.
With regard to the regulation of market infrastructures, let me first say that I see it as a great
achievement that market infrastructures have fared very well. They were able to withstand
the shock-waves of the current crisis and continued to ensure the clearing and settlement of
financial transactions. Thus, they contributed critically to containing the spreading of financial
instability.
This resilience, however, was not a "dues ex machine". It was the outcome of well designed
international standards for market infrastructures. Still, we need to closely analyse the
lessons from the crisis also in this area - e.g. in terms of market infrastructure risk
management and transparency and the arrangements for cross-border cooperation among
authorities. These lessons will be incorporated in the global CPSS-IOSCO recommendations
for financial market infrastructures to be issued early next year.
Despite the good performance of market infrastructures, there is a need to further develop
highly resilient market infrastructures, particularly in the field of OTC derivatives. The crisis
showed that legislation, supervision and oversight of global derivatives market arrangements
need to be improved - and that this needs to be done in a consistent way globally. Following
agreement by the G20 on high-level objectives, new legislation has recently been introduced
in the US and is in an advanced stage in the European Union. Such legislation stipulates,
inter alia, that all OTC derivatives trades will need to be reported to trade repositories and to
the extent possible be subject to central clearing via a central counterparty (CCP).
Overall, also with regard to regulating markets and infrastructures, important challenges
remain:
The activities in the shadow
First, striving for more transparency in financial markets.
banking sector and the over-the-counter business have contributed tremendously to the
creation of uncertainties and opaque transmission channels for risks. Therefore, a central
goal for any future regulatory action should the improvement of market transparency.
Clearing of OTC derivatives via CCPs, the reporting of derivative trade data to trade
repositories and the recent proposal by the European Commission to increase transparency
for shortselling activities are important steps in the right direction.
Second, dealing with financial innovation. Independently of the doubtless benefits of
financial innovation, it poses a constant challenge to regulators, supervisors and overseers of
financial markets and infrastructures. The banking business is in a constant state of flux with
new financial instruments constantly being developed and traded. New techniques and
instruments have been developed, particularly to diversify and trade credit risk, making
markets more complex and sometimes less transparent. For example, the risks involved in
the so-called "Originate to Distribute" model - an intermediation approach in which banks
originate, repackage and then sell their loans (or other assets such as bonds or credit risk
exposures) on to the financial market - was insufficiently recognized by market participants
and supervisory authorities. Therefore, financial innovation and growing complexity mean
that market participants and authorities need to constantly build up in-depth knowledge of
financial innovations and broaden their analysis across the whole spectrum of financial
market actions.
Third, minimization of risk transmission between institutions and markets. Given the
resilience of market infrastructures in the current crisis, we need to further strengthen and
encourage their use. Moreover, the crisis has shown that the exclusive focus on banks has
proven insufficient as contagion has also occurred across different types of financial
intermediaries, such as insurance companies and money market funds. Therefore, looking
forward it will be crucial that the cross border cooperation between authorities be further
strengthened. In this respect the work of the newly created European Supervisory Authorities
will be key. Looking more into the interrelation between markets from a systemic perspective
will be another key task, which brings me to the third major field of regulatory challenge,
namely regulating systemic risk.
Regulating systemic risk
As
indicated, traditional banking regulation was designed to limit each individual institution's
risk seen in isolation. It did not sufficiently focus on systemic risk, put simply, the risk of a
simultaneous collapse of institutions.
Institutionally, significant progress has been made in the strengthening of macro- and
microprudential supervision. In Europe, the European Systemic Risk Board (ESRB) and - as
mentioned - three pan-European micro Supervisors will be established.
The ESRB will provide a thorough analysis of systemic risks to the financial system in the
European Union and will issue warnings if significant risks are identified. It will also provide
policy recommendations to address these risks and prevent a renewed build-up of excessive
risk in the financial system as a whole. With its involvement in the ESRB, the ECB will
continue to play an active role in safeguarding financial stability in Europe. The ECB Vice
President will go into greater detail at tonight's conference dinner on how we are preparing
for that task.
The main challenges that I see ahead in the area of regulating systemic risk are as follows:
First, determining the perimeter of regulation. It is important that the regulatory web is
cast wide enough to ensure that all systemically important institutions, markets and products
are captured. Caution is also necessary to avoid that tighter regulation simply shifts activities
to unregulated market segments or entities. Therefore, the steps taken towards more
harmonised banking supervision as well as the progress made in Europe towards a Directive
on alternative investment fund managers, which affect financial markets through their tight
web of interlinkages with the financial sector, are appreciated.
Second, ensuring the availability of information and data. The detection and the early
warning on systemic risk crucially depends on the quality and the availability of relevant data
as well as on the adequate assessment of the risk bearing capacity of the system. Therefore
it is important that information is made available that can feed into future assessments of
systemic risk, especially in view of this being a key input into the working of the newly
founded ESRB. In this regard, it will be equally important that the use of qualitative data and
market information is strengthened and that this information will be fed into the regular
analysis of systemic risk in a more systematic way.
And third, measuring systemic risk. A basic difficulty in regulating system risk relate to the
difficulty in measuring the contribution of individual institutions to systemic risk. The
importance of an institution for systemic risk is a function of its size, interconnectedness and
substitutability. One way for regulators and private markets to be able to monitor financial
institutions and to assess their systemic reach, is to assess the risk of multiple defaults.
Measuring such risk is difficult, as measures may be too backward looking or face data
limitations.
I am happy that after the break we will have the chance to hear about the latest advances on
how to measure systemic risk in the keynote speech by Professor Robert Engle from
New York University. He has developed a measure of systemic risk capturing the systemic
impact of an individual institution's shortfall and which is published in the so-called NYU
Stern Systemic Risk Ranking.
The keynote speech will be followed by two outstanding papers on measuring systemic risk.
Kim and Giesecke will present a paper estimating systemic risk on the basis of actual
defaults and the timing of their occurrence. The paper by Yang and Zhou goes beyond the
usual focus on the existence of contagion and will present an analysis of the pattern of
propagation across financial institutions.
For an illustration showing how big the challenge to identify systemic risk is, one does not
need to go back very far in history. In 2003, a young analyst in New York stated the
following:
"You just have to watch for the level at which a nearly unlimited or unprecedented credit
growth can no longer drive housing markets higher. I am extremely bearish and feel the
consequence could be a 50% drop in residential real estate in the US. A large portion of the
current [housing] demand at current prices would disappear if only people were convinced
that prices were not rising. The collateral damage is likely to be of orders of magnitude worse
than anyone now considers".4
It took another 4 years that these risks and, particularly, the systemic impact and costs
materialized. Analyzing systemic risk means, therefore, mainly going beyond mainstream
thinking and challenging widespread beliefs. We are in need of the type of analyst I just
quoted. I am very much looking forward to hearing this conference's analysis on the
containment of such systemic risk, the future challenges and the possible policy options we
have going forward.