Hermann Remsperger: Fundamental issues of stabilising the financial
system
Keynote speech by Professor Dr Hermann Remsperger, Member of the Executive Board of
the Deutsche Bundesbank, at the conference on "Determinants and implications of the
financial crisis" of the Frankfurt School of Finance & Management - Bankakademie, HfB,
Frankfurt am Main, 17 September 2008.
* * *
Ladies and gentlemen
What I was afraid of has occurred. There is hardly anything more difficult than speaking after
Michael Heise. Actually, he has already said all there is to say. But since I cannot simply stay
silent, I would like to discuss with you some fundamental issues of stabilising the financial
system. And I hope that my thoughts will perhaps have some small value added, even
though I quite deliberately do not wish to go into the very recent events. My topic will
therefore not be crisis management but the long-term prevention of crises. I would certainly
be missing the point of the topic I am dealing with if I were now to list the whole wealth of
existing proposals on stabilising the financial system. There isn't enough time for that
anyway. Therefore, instead of going into details, I shall try to highlight the fundamental issues
that underlie many of the recommendations for action.
I have chosen to take this approach not least because I am also constantly concerned with
fundamental issues precisely as a result of my work and involvement in the Financial Stability
Forum. For example, one of the questions that arises for me this morning is how the
institutional structure for maintaining the stability of the financial system should be configured
in the long term, especially in the United States. Or, even more basically: how much freedom
should the market participants have in the financial system and in what areas are the
degrees of freedom to be limited?
These questions are the reason why, for my talk, I finally chose a matrix with keyword
headings which feature all those recommendations for action that we encounter almost every
day in the media. These headings include "enhancing transparency", "refining Basel II",
"reforming deposit guarantee schemes", "regulating rating agencies", and "modifying
monetary policymakers' operational framework". Under these headings, such
recommendations relate to three sets of fundamental and interconnected stability issues,
namely
1 key issues in the area of regulation
2 questions about the institutional structure for financial stability, and
3 fundamental issues with regard to procyclicality.
To put it quite plainly, in setting the individual topics against the fundamental issues, it has
again become very clear to me that a lasting stabilisation of the financial system calls for a
holistic, system-oriented policy approach, which is based on institution-oriented banking
supervision but which also goes beyond it.
Let me start with the fundamental issues in the area of regulation.
I Fundamental issues in the area of regulation
Put in a nutshell, fundamental issues in the area of regulation relate to the tension between
the poles of self-regulation and sovereign regulation. In other words, where are market
solutions possible and where is sovereign regulation necessary? Another question is about
the political level at which this fundamental decision is to be taken. Is it the national, the
European or the international level? This adds a further, complex dimension to the underlying
tensions and strains between self-regulation and sovereign regulation. I shall return to this
point in a moment.
But allow me first to emphasise that, in a market-based system, approaches involving
selfregulation are the obvious course to take. Put in simple terms, the state in this case relies
mainly on the fact that the market participants, first, set the standards themselves; second,
that they will commit themselves to complying with these standards and, third, that they will
organise an effective means of monitoring this compliance. Now, given the backdrop of
current events, I probably do not need to over-emphasise the fact that, with regard to the
necessary stability of the financial system, we cannot trust self-regulation alone. Sovereign
regulation that "orders" the financial system is also part of the market economy.
I take the view that sovereign regulation is particularly appropriate where the market players
are unable or unwilling to set effective rules or where there are overriding reasons why the
regulatory power of government has to be brought to bear. Banking supervision is a prime
example of this: not only do banks have a key position in the financial system and, therefore,
in the economy as a whole. They also have access, albeit a conditional one, to central bank
money. As a result, there is unanimous agreement that self-regulation is not an option.
A fundamental decision in favour of sovereign regulation in banking supervisions by no
means settles the question of whether such regulation necessarily has to set detailed and
prescriptive rules. Indeed, regulation can also be organised in a principle-oriented way. In
this case, the state demands that the market players follow certain principles in their
transactions and monitors compliance with these principles. This approach should therefore
not be confused with simple laissez faire. Rather, it places high demands on all those
involved. Above all, principle-based regulation is predicated on the supervisors and the
supervised having a shared understanding of the prudential aims.
If, with these principles, I now look closely at Basel II - the regulatory framework which has
applied to our banks since January - I find both: rules, on the one hand, and principle-based
provisions with room for manoeuvre, on the other. For example, Pillar 1 of Basel II contains
clear provisions on how much capital has to be maintained for what credit risks. And, from
the Bundesbank's perspective, I would add that these regulations should be partially refined
given the experience of the financial market turbulence. Among other things, we are in favour
of higher capital cover for re-securitisations. This includes CDOs on asset-backed securities,
for example. In addition, we advocate higher capital requirements for credit risks in the
trading book and some adjustments in the area of qualified liquidity facilities in the
standardised approach for securitisation.
Pillar 2 of Basel II contains qualitative requirements for risk management in financial
institutions, which are specified for Germany in the principle-based Minimum Requirements
for Risk Management. The disclosure obligations in Pillar 3 also fall into the category of
principle-oriented regulation. They leave the credit institutions scope in determining the type
and scale of the information they provide.
In my view, all of this shows that, although the question of "rules or principles?" is a
fundamental decision of sovereign regulation, it is not necessarily an "either-or" decision.
Perhaps that also explains why, in reality, we regularly encounter a combination of principles
offering fixed rules and flexibility. I believe that, on the whole, this is likely to be the best way
to serve the requirements of a stable financial system as we now understand it.
Nevertheless, I can see an approaching debate in which the flexibility of the second pillar of
Basel II is at least partially called into question by supplementary provisions. I would warn
against this.
As you are aware, however, fundamental issues of regulation for stabilising the financial
system arise not only in banking supervision but also, say, in securitisation business, the
hedge funds and, as an especially pressing issue, in the case of the rating agencies.
In the United States, rating agencies have to be registered with the SEC. Furthermore, it
should be borne in mind that Basel II relies on ratings for classifying bank loans. In Europe
there is therefore a procedure with which agencies are authorised for the use of their ratings
in determining a bank's minimum capital.
Following the experience with ratings in the recent financial crisis, the current practice of
having only a non-binding IOSCO code of conduct is generally perceived to be in need of
reform. The rating agencies themselves are in the process of reviewing their internal
procedures and rating methods.
In addition, in May the Committee of European Securities Regulators (CESR) proposed the
establishment of an international Standard Setting and Monitoring Body (SSMB) at IOSCO,
in which the agencies are to set up standards together with the regulators. Compliance with
these standards should then be monitored by the SSMB, albeit without the involvement of
the agencies. This approach is claimed to be virtually a midway solution between
selfregulation and sovereign regulation.
As you are aware, the European Commission has now put forward a proposal for
consultation which envisages an authorisation procedure and the supervision of rating
agencies - in other words, sovereign regulation. I would like to make three fundamental
comments on this.
First of all, every effort should be undertaken to ensure that solutions at the European level
are consistent with a level playing field internationally. The crucial point on which everything
hinges should be the IOSCO code of conduct since anything else might result in competitive
disadvantages in Europe.
Second, emphasis should be placed on the investors' own responsibility when using ratings.
EU registration must not lead to "rubber-stamped in Brussels" being interpreted as a seal of
quality for individual ratings.
Third, an EU registration procedure would have to be decentralised in structure; in particular,
no new authority should be created. The Basel II authorisation procedure is a good reference
point in this respect.
In making this comment, I have now basically arrived at the fundamental question of the
suitable sovereign level for regulation. National and international regulations are in
competition, with a third way existing in Europe in the form of regulation at the EU level. The
more decentralised regulation is, the better it can be adapted to the characteristics of the
financial system in question. The more centralised regulation is, the more the same
regulatory conditions prevail.
Deposit guarantee schemes are a good example of how the tensions between national and
cross-border regulation can be resolved. In Europe we have a minimum level of
harmonisation in the form of the Deposit Guarantee Schemes Directive. In Germany, besides
this statutory deposit protection at the minimum European level, there exist additional, private
protection schemes operated by the various categories of banks.
Not least in the wake of the bank run on Northern Rock last summer, the European
Commission is considering a revision of the Deposit Protection Directive. It is aiming for a
greater degree of harmonisation. In particular, this concerns a higher level of minimum
protection and the abolition of the co-insurance. As the discussion in the EU now stands, this
would mean that the principle of subsidiarity would be basically retained. We at the
Bundesbank attach great importance to this. Deposit protection has to be consistent with the
specific features of the national banking systems.
II Fundamental institutional questions
With the distribution of powers among the sovereign regulatory levels, I am now very close to
the second set of fundamental issues. I would now like to talk about a number of
fundamental institutional questions about the stabilisation of the financial system. I am doing
this because, during the financial crisis, it has become clearer to me than ever before how
much institutions matter. I am therefore concerned with the institutional framework for the
monetary, supervisory and regulatory infrastructure.
In the USA, the shortcomings of governance in the financial system have been revealed for
all to see in the crisis, at the same time posing two major challenges. The first challenge
arises from the fragmented structure of financial supervision. In some cases, however, quite
new institutional arrangements - that is, institutions - have to be put in place.
With its "Blueprint", the US Ministry of Finance has now presented an ambitious but cogent
overall strategy for a longer-term reform of financial supervision. It envisages a radically
overhauled institutional structure with a complete change of design in its tasks. I see one
particularly important aspect of this blueprint in that fact that the Fed in the role of a "market
stability regulator" would, for the first time, institutionalise a primarily macro-oriented
perspective on the financial system. I await with keen interest how this debate will proceed.
With regard to the second institutional challenge in the USA, namely the review of the
monetary policy instruments, a lot has already happened. To begin with, the Fed was not so
well equipped with instruments for the liquidity policy action necessitated by the subprime
crisis. The Fed was very quick to create efficiently functioning instruments in the crisis,
however.
When I now look at the institutional structure for financial stability in Germany and in the
Eurosystem, I would like to highlight the synergy effects between operational money market
management and banking supervision. The financial market turbulence has shown us quite
clearly that these synergy effects can indeed be very large. As the Bundesbank is closely
integrated into banking supervision, we can also fully exploit such synergy effects. Our
deliberations on the time profile of liquidity provision and, hence, our stance in the
Eurosystem benefit from general information from banking supervision. Conversely, the
insights gained in contact with the banking industry in the practical conduct of refinancing
operations and in payments are helpful to the banking supervisors.
These synergy effects quite certainly played a part in the Eurosystem being able to take
early, resolute and successful countermeasures when the distribution of liquidity among the
banks was no longer functioning as normal. In terms of the distribution of powers among the
institutions, it is therefore sensible to have the national central banks closely integrated into
banking supervision.
And I am, of course, also glad to say that the success of central bank operations since
August 2007 has certainly not been due just to the efficient division of labour among various
institutions. Rather, the Eurosystem's monetary policy framework has played a crucial part in
this.
As I can report from my own experience, but without giving too many secrets away, the
Eurosystem has earned a great deal of respect in the international institutions and bodies
which are dealing in depth with the financial crisis and the lessons and implications to be
drawn from it. A key role in this institutional structure of bodies is being played by the
Financial Stability Forum, which our former Bundesbank President, Hans Tietmeyer, had the
foresight to initiate within the G7 in 1999. The FSF demonstrated its great value in the crisis
as an agency of informal cooperation between national bodies, international organisations
and standard-setters. The list of recommendations reached by consensus and adopted by
the FSF is now at the heart of the international response to the turbulence. The
recommendations are being worked through in stages. A progress report on this will appear
in just over three weeks.
Even so, it is undoubtedly no surprise that the international governance of the financial
system - as after every global crisis - is now being subjected to critical scrutiny again. If we
are thinking about changes, I believe we should strengthen those institutional structures that
did their job well during the financial market turbulence. For me, this means that, first and
foremost, the FSF should continue to a play key role in terms of responsibility for financial
stability. Its widely drawn membership from central banks, ministries of finance, supervisors,
regulators and international institutions means that the holistic assessment of the financial
system is one of the key strengths of the FSF.
The International Monetary Fund should engage all its forces in the FSF, above all, with an
in-depth analysis of the way the financial system interacts with the real economy. For the
analysis of these interactions, the IMF can draw on decades of experience in Article IV
consultations and a decade of assessments of the financial sector [FSAP]. The IMF therefore
has almost ideal conditions for this in place. Despite the financial crisis, however, I do not
see any compelling reasons for additional financing facilities at the IMF, which would bring it
quite close to performing the tasks of a central bank.
III Fundamental issues of procyclicality
After outlining some fundamental issues in the area of regulation and the institutional
structure for safeguarding stability in the financial system, let me now turn to my third key
issue, which, internationally, is right at the top of the agenda and, in my view, will also be
under discussion for some time to come. Mario Draghi, the governor of Banca d'Italia, made
this very clear yesterday evening at our Bundesbank Lecture in Berlin. Basically, the
question is whether the regulatory framework for the financial system, as well as the
provisions for accounting, act procyclically - and, if so, what can be done to counter that.
To reduce the complexity, I shall interpret the term "procyclicality" quite narrowly for once,
namely as a reinforcement of the natural cycle of the financial system. Procyclical policy and
procyclical elements of regulation would amplify the natural upswings and downswings of the
financial system. If this leads to boom-bust cycles, the functional viability of the financial
system is jeopardised.
Naturally, considerable caution is called for when dealing with the topic of procyclicality as
we still don't know enough about the cyclical effects of regulatory provisions. Added to this is
the fact that the potential means against any procyclicality have not yet been researched and
tested in detail, such as components that dampen procyclicality or even automatic stabilisers
in the regulatory framework which are anticyclical in effect. My concern today is therefore
quite a modest one. I merely wish to raise even further your awareness of all the issues
associated with the proposition that the regulatory framework is procyclical.
To avoid any misunderstanding, I do now wish to stress once more that the regulatory
framework with the risk-sensitive minimum capital requirements under Basel II and the use of
fair value accounting under IRFS (or US GAAP) does contain cyclical elements. It is unclear,
however, how far these built-in elements can also develop procyclical potential. Other
experts argue, in turn, that the cyclicality of these two frameworks is a side effect of their
desired characteristics. It is claimed that the potential procylicality has been deliberately
condoned in order to make the capital requirements risk-sensitive and make capital
requirements consistent with market conditions. And, just like you, I, too, have become
familiar from this debate with the proposition that the traditional micro view of regulation has
gained the upper hand over the macro or systemic perspective.
What is generally agreed in all of this is that the risk-sensitive minimum capital requirements
under Basel II are based on probabilities of default, which fluctuate over the economic cycle.
In a downturn, probabilities of default increase - along with the minimum capital
requirements. Buffers, which are designed to dampen the procyclical potential, have now
been built into Basel II. For example, long-term averages are to be used for the probabilities
of default and the assigned loss given defaults are also to take due account of scenarios with
a potential economic downturn.
So far, it is unclear - and how could it possibly be otherwise so soon after the introduction of
Basel II? - whether the cyclical fluctuations of the minimum capital requirements actually
impact on the propensity to lend - in other words, whether they really have a procyclical
effect. The extent to which this happens hinges on a large number of factors - for example,
on how far the capital buffers exceed the regulatory minimum, on the willingness of the
banks to let these buffers "breathe", and, naturally enough, on the use of alternatives, such
as raising additional capital. Moreover, not all the fluctuations in actual lending are on the
supply side; demand, too, can fluctuate considerably over an economic cycle.
Furthermore, my cautious attitude to the question of procyclicality also has to do with the fact
that empirical studies on the impact of risk-sensitive minimum capital requirements need
longer time series. Less than one year after the introduction of Basel II in Germany, the
database is still very narrow. It is not yet possible to make a detailed assessment of whether
the minimum capital requirements are becoming binding and therefore acting in a procyclical
manner. Knee-jerk responses, such as the general introduction of additional general capital
buffers by means of Pillar 2 are therefore, as we see it, not appropriate.
What is, in fact, called for is a close monitoring of developments and a careful analysis of the
incoming data. It is important, first of all, to gain a deeper understanding of the complex
mechanisms of banks' capital management and of Basel II's impact over an adequate period
of time. The banking supervisors are working very hard on this. Their findings, as well as
others, can then be used to assess any systemic effects of the prudential requirements. If
procyclical effects exist on a significant scale, they should then be taken into account in a
system-oriented supervisory approach.
Now, I have already indicated that the fundamental issues concerning procyclicality also
have to do with accounting. Fair value accounting leads to valuations fluctuating along with
market prices. This evidently heightened the financial market turbulence. With a
mark-tomarket valuation of the paper, losses result in falling asset values, making the reduction of
risk positions seem advisable, thus triggering a further wave of selling. Computer-controlled
procedures for automatically limiting losses can give further impetus to this procyclicality.
Conversely, rising asset values in an upswing make additional investment possible, which
can drive market prices up even further.
Nevertheless, by means of "prudential filters" the banking supervisors have ensured that
these fluctuations in the balance sheet items do not impact fully on the regulatory capital.
This means that the nexus of falling market prices for assets, declining own funds and
restricted ability to lend in a downswing is dampened. In an upswing the reverse applies.
This prudential correction mechanism therefore limits only part of the effects of
fair-valuebased accounting, namely its impact on the potential supply of credit.
IV Conclusion
Ladies and gentlemen
In conclusion, let me return once more to the beginning. After well over a year of financial
market turbulence and following the experience of the past few days, I firmly believe that
stabilising the financial system cannot consist solely in working through "to do" lists with their
recommendations for action, however positive and correct they may be. Rather, a lasting
stabilisation of the financial system calls for a holistic policy approach which links the
microprudential base - in other words, the perspective on the individual institutions - with the
macroprudential perspective and which simultaneously integrates the macroeconomic
background and developments in the financial markets.
Realising such as a holistic approach is certainly not an easy task. But I regard it as the right
course for arriving at a lasting stabilisation of the financial system.
Thank you for your attention.