Erkki Liikanen: How to improve financial stability and resilience of
systemically important financial institutions after the crisis?
Speech by Mr Erkki Liikanen, Governor of the Bank of Finland and Chairman of the Highlevel
Expert Group on reforming the structure of the EU banking sector, at the EBA Policy
Research Workshop "How to regulate and resolve systemically important banks", London,
14 November 2013.
* * *
Accompanying slides can be found on the Bank of Finland's website: Slides.
[Slide 2 - Outline]
[Slide 3 - Heeding the lessons of the crisis]
Heeding the lessons of the crisis
[Slide 4 - Substantial crisis impact on the real economy]
The vast scale of the Global Financial Crisis and its ramifications have been the main
motivator of the regulatory reform agenda; endorsed by the G-20.
When the crisis began, the resulting economic downturn for a while resembled the pace of
developments in the Great Depression.1 Only the liquidity support operations by central
banks at different stages, and the explicit state guarantees to banks that were announced in
different countries, changed the course of developments, compared to the 1930's.
Paradoxically, the success in averting the worst that could have happened, may be making
some of us forget the lessons from the crisis too soon, or having us downplay the need
for true reforms.
However, it is crucial not to forget the crisis, and to properly implement the reform agenda.
Have we done enough to solve the too-big-to-fail problem?
In response to the crisis, a number of international and EU wide regulatory reforms have
been launched.
The capital requirement framework has been strengthened, new liquidity requirements
have been proposed and the recovery and resolution directive will enable orderly "failure"
of banks.
Now we need to assess whether we have done enough? I will argue that the regulatory
reforms have taken us a long way, but not far enough. Banks will still be too complex to
manage, supervise and resolve.
Below I will argue that structural reforms are an essential complement to the new resolution
regime, because structural reforms are meant to reduce banks' complexity and
interconnectedness. We need these reforms to make orderly resolution of systemically
important financial institutions a credible option, even in the midst of a systemic
crisis. Credibility of the resolution regime will be key to truly end the too-big-to-fail problem
and get market discipline back to work.
Before exploring these arguments further, let me start by reviewing the main lessons of the
crisis a bit further.
Excessive financial expansion in the run-up to the crisis
[Slide 5 - Rapid growth in the EU banking sector]
One important lesson from the crisis has been that we should better understand the point
when and why the expansion of the financial sector turns excessive. Some recent
research suggests that an excessively large financial sector may even turn from being a
driver of additional economic growth to being an impediment to growth.2
Surely, large-scale financial crises are very bad for the long-run accumulation of economic
output, even if some crises might have a silver lining in the sense of promoting necessary
"creative destruction".3 It is essential that banks with unsustainable strategies are allowed
to fail in an orderly fashion so that viable banks may compete and prosper on a level playing
field.
Especially when the into large proportions, the risk of a
financial sector grows rapidly
serious crisis is heightened.4
[Slide 6 - Shifts in focus of operations as illustrated by shifts in assets structures]
Focus on trading-related activities, the rise of new complicated financial products, and
increasing reliance on short-term market funding by financial institutions are symptoms of
growing risks, as we saw in the years before the crisis.
This time, the ultimate risk stemmed largely from the US housing market, but it had been
transferred also onto European banks' balance sheets.5 This took place with the help of
securitizations and the related new financial intermediaries, generally dubbed as the
shadow banking sector.
As a result, the number of counterparty relationships and the ensuing counterparty risks
increased. The global financial network became highly interconnected and complex.
It is evident that many of these developments prior to the crisis did not benefit the real
economy in a sustainable manner. Economic recovery from the crisis has been slow.6
The benefits of risk-taking were private whereas the enormous costs of the crisis
became the responsibility of the society as a whole.
Regulatory and macroprudential failures and problems with management
[Slide 7 - Increased leverage as illustrated by shifts in funding structures]
Why did the financial sector and its risks grow so much? And why were they funded by
increasing short-term leverage which added to the vulnerability?
There were global behind the crisis developments, but also
macroeconomic reasons
failures of regulatory and macroprudential policies.
Global imbalances provided a fertile ground for the development of financial excesses.
Moreover, the monetary policy stance was accommodative in much of the early 2000.
There may also have been a
false sense of security resulting from the successful track
record of monetary and macroeconomic policies.7 As a result, the markets placed their
trust in central banks' ability to take care of liquidity if markets were to be hit by serious
shocks.
These expectations may also have contributed to imprudent risk-taking which, once the crisis
started unfolding, led to real losses.
These experiences underline all the more the need to develop macroprudential
supervision and policy. Macroprudential tools have to be applied when necessary to
complement other policy areas in curbing excesses in the financial sector.
Banks' capital requirements and liquidity buffers did not keep pace with the growing risks.
Serious short-comings in risk measurement within the Basel framework became apparent
once the crisis hit. This was symptomatic in the slower growth of risk-weighted assets
relative to total assets in the years preceding the crisis.
There was also a lack of sufficient systemic view of financial risks. Macroprudential tools
and mandates to deal with such risks were largely missing.8
Another important reason concerns market expectations of public support if a large-scale
crisis hits. Leading European banks are very large in an international comparison, especially
in relation to the size of their home countries.
[Slide 8 - Implicit subsidies remain high]
As a result, many large and complex financial institutions appear to have benefited from
cheap funding, thanks to such too-big-to-fail expectations.9
Cheap funding which is insensitive to balance sheet risks may easily spur risk-taking,
especially when banking competition gets tougher. Sheer ignorance by bank managements
of the true risks may also have played a role.10
[Slide 9 - Market discipline vs. structure of banks - a "chicken-and-egg" problem to be
solved]
The too-big-to-fail assumption weakened market discipline, as did the opacity of large,
complex financial institutions. As a result the banking sector has not been renewed or
restructured in a way that might have happened in a world with efficient market discipline.
Inefficient business models have not been outdated in the same way as they have been
done in the corporate sector, where the conglomeration trend of the 1980s reversed already
some time ago. The market indications of a appear to be too
diversification discount
weak.11
The challenge at hand is thus to implement regulatory reforms and policies which help steer
the financial sector and banks towards a size and structure, which in a better way support
economic growth while maintaining financial stability. No one really knows what the right size
of the financial sector or banks is. But at least what we can do is to
remove any perverse
incentives which could lead to an excessive growth of the sector and its risks.
Eliminating the too-big-to-fail assumption by making resolution of systemically
important financial institutions a credible option lies at the core of the solution.
Finally, there was also problems in the management culture of banks. The culture of the
customer focused retail and commercial banking is inherently different from the one of the
transaction based trading oriented banking.12 The transaction-oriented management and
compensation culture of trading spread to more traditional banking. This provided incentives
to risk-taking.
The former Citigroup architect, Mr. John Reed, has recently described how this "cultural
mixing" had an impact on risk-taking. In traditional banking risk officers might easily say "no"
if they judged a proposed new loan not good enough. However, if the loan officer's pay is
linked to making new loans, as increasingly happened, then saying "no" becomes much
more difficult in practice.
Last days events and currency exchange manipulation incidents have once more brought the
issue of corporate culture of banks to the surface.
[Slide 10 - Policy reforms]
Regulatory and macroprudential policy reforms
[Slide 11 - Financial market liberalisation and governance must be complements]
Before the crisis the benefits of deeper financial integration were pursued via market
liberalization. Improving the governance of financial markets was lagging behind,
leaving the system vulnerable to crises.
We now understand that liberalization and governance are complements. We need them
both to reap the benefits of financial integration in a sustainable manner.
[Slide 12 - Focus of current regulatory reforms]
Much has already been done to improve financial stability and resilience of financial
institutions after the crisis, particularly of those seen as too systemically important to fail.
In an ideal world the externality imposed on the society by large systemically important banks
might be dealt with by a single optimally designed regulatory instrument. However, in the real
world subject to substantial uncertainties concerning the nature of risks and their
measurement, it is better to rely on several regulatory instruments.13
First, Basel III agreement which is implemented here in Europe through the
capital
requirement regulation and directive will strengthen banks' capital and liquidity positions.
This is a major step to improve banks' resilience, but will also reduce incentives to take
excessive risks across different banking operations. Basel III also tackles the too-big-to-fail
problem by imposing an extra capital requirement on international, systemically important
financial institutions.
which previously did not exist bring additional important resilience
Liquidity requirements
as liquidity typically dries up when a systemic crisis starts.
Note that capital requirements also help maintain liquidity in the markets: when banks have
higher capital buffers to absorb losses, there will be less need for fire sales of assets. Fire
sales seriously undermined market liquidity during the crisis.
Second, new recovery and resolution tools have been constructed. The key instrument is
to make it possible to bail-in bank debt in a crisis, in order to avoid bail-outs with taxpayer
money. Moreover, the resolution authority is given great powers to restructure a bank when
the point of likely to fail has been reached.
This will be a key in restoring private market discipline on banks, and thus to reduce the
too-big-to-fail problem. The importance of implementing the Bank Recovery and Resolution
Directive, upon which political agreement was achieved in the summer, cannot be
overstated.
In Europe bank resolution (Single Resolution Mechanism, SRM) is part of the larger aim of
forming a true banking union. The establishment of the SRM will facilitate the resolution of
cross-border banks. The other element of the banking union is the Single Supervisory
Mechanism in connection with the ECB.
The banking union project also includes a third element; the prospect of creating a common
deposit insurance system. However, the first priority ought to be to harmonize the national
systems, which currently vary greatly.
There are also a number of regulatory initiatives that intend to increase transparency in the
financial markets. For example, accounting standards and disclosure practices are reviewed,
and banks are urged to improve risk management and corporate governance practices.
Supervision and regulation of derivatives markets and the shadow banking system are
revised, including moves to central counterparties which will help address the contagion risks
embedded in long counterparty chains in the OTC markets.
[Slide 13 - Authorities should foster the stability of the entire financial system]
Macroprudential analysis and tools are being developed mainly on the national basis, but
also in accordance with Basel III (and its application in Europe; the capital requirement
directive) for the purpose of setting counter-cyclical capital buffers. Moreover, the European
Systemic Risk Board has published guidelines on the implementation of macroprudential
tools across the EU member states.
This is a highly important but challenging area of work where we will see a lot more research
to be done.
The challenge is to find indicators which are able to warn early enough of looming
vulnerabilities. Potential candidates are at least market prices, credit-to-GDP ratios, and
changes in banking sector liabilities as emphasized by professor Shin of Princeton
University.14
Finally, structural reforms of banks are already taking shape in some jurisdictions, such as
the USA, the UK.
These were the elements of the regulatory reform which were on the table as we in the
Highlevel expert group set out to evaluate the need for structural reform in the EU banking sector.
The question we were encountered with was whether these regulatory reforms will take us
far enough.
[Slide 14 - HLEG proposal for structural banking reform in Europe]
The work of the High-level expert group
In our deliberations we considered two avenues as possible ways forward. In the two
avenues we put different emphasis on the most promising measures to end the
too-bigto-fail problem; capital requirements, resolution regimes, and structural reform.
[Slide 15 - Two avenues as possible ways forward were considered]
In the first avenue, additional, non-risk-weighted capital requirements on trading activities
and credible recovery and resolution plans for banks would have been the main instruments.
We acknowledged that the measurement of risks inherent in trading assets is prone to a
significant "model risk". Robust capital requirements which do not rely on complicated
models are one way to tackle this issue (as are limits on risk concentrations and counterparty
exposures). Avenue 1 was based on this approach.
The possibility of structural measures did enter Avenue 1, but only as a conditional
instrument. The idea was that if a bank was not able to prove that the required recovery and
resolution plans were credible, separation of trading activities was to be imposed by
authorities.
In the second avenue, by contrast, any significant trading activities would be required to be
separated from retail deposit banking. The separation proposal outlined in Avenue 2 was
based on the notion that capital requirements are not by themselves sufficient to limit
excessive risk-taking incentives induced by deposit insurance if risks are difficult to measure
and risk profiles can be changed rapidly, as in trading activities.
Avenue 2 also acknowledges the risk of heterogeneous application of tailor-made separation
based on the credibility of the recovery and resolution plans of individual banks. Thus
avenue 2 includes uniform separation ex ante in order to facilitate resolution of large and
complex banks without public funds and hence reduce the too-big-to-fail problem.
Structural reform proposal for Europe
[Slide 16 - Rationale for mandatory separation]
Our Group came to the conclusion that although the regulatory reforms already
implemented or in progress take us a major step forward, not enough has been done to
eliminate the too-big-to-fail problem. Structural measures aimed at the largest banks and
banks with significant trading activity are thus needed to complement them.15
I will also argue that structural reforms support the creation of the banking union.
More precisely, we found that the benefits of separation are the following.
Our Group's proposal focuses much on limiting the spillover of benefits from safety nets
such as the deposit insurance to outside the core banking activities thus reducing the
incentives for banks to become too-big-to-fail in the first place. Separation will restrict
risktaking opportunities of a deposit bank. The blending of the commercial and investment
banking management cultures will also be reduced, which reduces the risk-taking
in traditional banking, evident in the years preceding the crisis.
incentives
Moreover, limiting the spillover of benefits from safety nets to outside the core banking
activities will reduce risk-taking incentives and incentives for excessive growth in the
trading entity. This is because the funding of the trading entity will be subject to more
effective market discipline in the absence of insured deposits.
Reducing complexity by means of separation
facilitates monitoring by outside
stakeholders such as shareholders, bank creditors and other market participants, thus
further reinforcing market discipline.
Reduced complexity by means of separation also has benefits for stakeholders closer to the
bank. In the Group we argued that it would facilitate the task of the management and the
board as steering effort to the right direction by means of incentive schemes, for example, is
easier in a less complex organisation, where the organisational units are more
homogeneous.
A more primitive benefit of separation is that reduced complexity makes it easier to
understand the bank. This is a line of thought that the head of ECB's financial stability
division, Ignazio Angeloni, aired recently by stating that "... very often [the CEO's] don't know
what's going on, and they don't understand because it is very, very complicated".16
The supervisors face similar challenges. I think it is safe to say that the simplification of the
structure of the largest, most complex European banks would facilitate the task, not only of
the national supervisors, but also of the Single Supervisory Mechanism.
Finally and perhaps most importantly, I would once more like to emphasize that structural
reforms are essential to make resolution of systemically important financial institution
If there is even a slightest doubt
ex ante credible, even in the midst of a systemic crisis.
that the resolution tools will not be applied, the adverse implications of the too-big-to-fail
assumption on market discipline, funding costs and risk-taking incentives will prevail.
A forthcoming Journal of Finance paper by Gandhi and Lustig show that a "tail-risk subsidy"
can explain differences in equity returns of large and small banks.17 Interestingly this
"tailrisk subsidy" grew dramatically as the Glass-Steagall was dismantled.
As previously noted, we have often seen that market discipline ultimately enforces
structural changes which promote efficiency in non-financial industries. Unfortunately,
the evidence suggests that the financial industry may be trapped in a "bad equilibrium" of
weak market discipline and inefficient structures.
Hence a push from structural regulatory reforms is needed to move the financial
industry to a "good equilibrium" with strong market discipline and efficient structures.
[Slide 17 - HLEG proposal]
Thus we in the Group proposed the separation of core commercial banking which is
allowed to take insured deposits from which are not
trading and market making activities
allowed to take deposits.
Financial linkages between the separated entities need to be limited in order to make the
separation effective.
Trading and the bulk of market making should be moved together to the separate entity. This
is because it is very difficult to make the distinction between the two and any rules would be
prone to circumvention.
Separation does not touch the universal banking model because the deposit bank and
the trading entity are still allowed to be part of the same group. Moreover, mandatory
separation would only apply to the largest institutions, consistent with the aim of
tackling the too-big-to-fail problem.
[Slide 18 - Stylised classification of structural proposals: activities and strength]
On capital requirements
Another important issue which has been much discussed also recently is that regulations
need to be robust enough. Robustness of capital requirements is needed because there
will always be errors in risk measurement, and managerial incentives to manipulate
riskweights downwards will always be there.18
One answer is to add capital requirements which are not based on risk-weights, to
complement the risk-based ones. An important example is the leverage ratio requirement of
Basel III.
Our Group also considered, although did not directly propose, additional robust capital
requirements on trading activities. If these were calibrated so that the robust requirements
formed the bottom and the risk-based requirements came on top of that, then banks'
incentives to keep on improving their risk measurement technologies might be better
maintained.
The Basel Committee on Banking Supervision is still considering the merits of
introducing the standardised approach as a floor or surcharge to the models-based
approach.19 Of the proposals for how the market risk framework could be altered recently
presented by the Basel Committee, I particularly welcome two key features. First, the
suggestion of revising the standardised approach to be sufficiently risk-sensitive thus
creating a credible alternative to the internal models. And second, the requirement of
mandatory calculation and publication of the standardised approach by all banks, which
would improve transparency and comparability.
Note that separation of trading-based risks from deposit banking can also be seen as a
form of robust regulation. If potential errors in the measurement of trading risks may prove
fatal to core banking services, it may be better to move the risks elsewhere altogether. This
is what separation does: it compartmentalizes risks within the banking group, a bit like
firewalls help restrict the spreading of fire.
A combination of structural reforms with capital and liquidity buffers may be a cost-effective
way of regulation in the long-run.
Taking into account both public and private costs, bank equity capital is not as costly as
one might deduce from banks' preference to use very high levels of debt financing.
This point has been carefully scrutinized by Admati and Hellwig (2013).20
However, it is challenging to measure precisely
how much bank equity would be socially
optimal, although the crisis itself strongly suggests the levels of capital were far less than
optimal before the crisis.
Hence, a combination of higher capital and liquidity requirements together with
restrictions on deposit banks' riskiest activities might be a balanced choice of
regulation.
This is
Structural reforms may also contribute to successful macroprudential policies.
because structural measures add simplicity and transparency of financial institutions, and
reduce their interconnectedness. As a result, the identification of good macroprudential risk
indicators becomes easier, and they can be measured with higher precision. The
effectiveness of the respective macroprudential tools improves accordingly.
As a counter-argument to separation, some have argued that by separation we lose risk
diversification benefits. However, the crisis itself suggests that we may have overestimated
these benefits while underestimating the effects of risk contagion which separation helps to
reduce.
Regarding banks' recovery and resolution, our group also made a proposal of additional
designated bail-in instruments. These could be triggered in a relatively early phase of a
bank's financial distress to provide for recovery. Their holding would be restricted to investors
outside the banking sector in order to avoid contagion. Similar ideas have recently been
aired also by others.21
In comparison with other structural proposals, our group's proposal settles in the middle
in terms of narrowing down the activities of the deposit bank and in terms of the strength of
separation.
Conclusions
[Slide 19 - To conclude: On the role of banking]
Banks serve central functions in a well-functioning economy. Their role in providing finance
to the real sector is particularly important in Europe.
The regulatory reform agenda to prevent future banking crises is very ambitious, and it is
essential to take it into completion. There are short-term adjustment costs to the banking
sector, but as societies we must keep our focus on the long-run benefits.
As regards the potential structural reforms in Europe, good implementation will be the key to
achieve the intended goals.
International coordination of the structural measures as called for by BIS and IMF would be
highly welcome.