Andreas Dombret: Rules and tools for capturing systemic risk
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, at the SVP Global's European Symposium on "Perspectives on the European
Distressed and Credit Markets", London, 4 October 2011.
* * *
1. Introduction
Ladies and gentlemen
This symposium could hardly be more topical. Following on from this morning's contributions
on the subject "Perspectives of the European Distressed and Credit Markets", I'm very
pleased to have the opportunity to look beyond the credit markets and add a new dimension
to the debate, namely that of regulation.
The financial and economic crisis rocked the very foundations of the global financial system
and ruthlessly exposed the weaknesses in international financial supervision. In areas where
there are a large number of road accidents, the authorities put up additional safety barriers,
bring in speed limits or divert the traffic. On top of that, each car has to have a regular MOT.
After the major crash that was the financial crisis, many people fear that regulatory reform
will lead to an unfettered spiral of regulation. I disagree.
As a central banker, I would assess the impact of this reform package by whether we
succeed in strengthening the resilience of the financial system. Ideally, the result of this
process should be enduring and should not trigger any negative side-effects, eg on
competition. But there is a long and arduous road ahead. And it will entail costs for the
banking industry.
2. The international reform agenda: what have we already achieved?
As an example of what we've already achieved, take the key points of the reform framework
already adopted at international level: "Basel III", a far-reaching new global regulatory
standard for bank capital adequacy and liquidity that was endorsed by the G20 at the end of
2010. Its objective, in brief, is to better equip banks for weathering future stress situations.
The European Commission recently published a legislative proposal to translate the Basel III
rules into EU law, which will affect over 8,000 banks. The Commission cited the IMF's loss
estimates in its justification for this move. According to these estimates, crisis-related losses
between 2007 and 2010 incurred by European banks alone were close to €1 trillion, or 8% of
EU GDP.1 Given this situation, we must not postpone the global implementation of Basel III;
that would send out the wrong message. The Bundesbank welcomes the fact that Europe is
playing a pioneering role in this area. The other G20 countries would be wise to avoid delays
to or departures from the agreed Basel III implementation plan. In the interests of stability
and competitiveness, ensuring that the Basel III rules come into force at the same time in all
countries is just as vital as ensuring that they are implemented consistently at a global level.
In Europe, Basel III will apply to all credit institutions. Going back to the traffic analogy, all
road users have to follow the highway code. The fact that another cornerstone of the reform
agenda affects the large, systemically important financial institutions, or SIFIs, is therefore
very important. They are the heavy goods vehicles - or even the super trucks - of the
banking world; their size means that any accident they are involved in can cause gridlock on
the roads. These SIFIs will have to obey stricter rules in future; one of the most important is
that SIFIs will have to meet higher capital requirements than all other market participants.
Some say that the regulatory reforms are forcing small banks to pay for the mistakes of the
big banks. I disagree.
Many countries felt impelled to rescue some of these institutions with huge sums of
taxpayers' money in order to avoid a systemic collapse. The problem of banks that are "too
big to fail" and the moral hazard that this entails are to be remedied by establishing a specific
supervisory framework for SIFIs. We should not forget that, just as cars primarily serve to
transport people, the financial sector also has to serve the real economy.
In July 2011 both the Basel Committee on Banking Supervision and the Financial Stability
Board, or FSB, published a consultative document2 which is an important step forward. The
member states have agreed on a methodology for assessing the systemic importance of
banks. In addition, special capital surcharges above the minimum capital requirements will
be imposed on SIFIs. The more systemically important a bank is, the higher its SIFI capital
surcharge will be. After evaluating the more than 40 commentaries to the consultative
document it is clear now that the Basel Committee has done a very good job. Aside from a
few adjustments and updates to the underlying data, which are already underway, the
document is ready to be submitted to the G20 for approval at their summit this November.
The agenda for financial reform also regards a consistent implementation and surveillance of
international standards as crucial to its success.3 FSB peer reviews are one means of
achieving this. FSB members are to ensure that standards are implemented as strictly and
consistently as possible following the principle "leading by example", ideally triggering a "race
to the top".
One example of this kind of peer review are the remuneration standards. No one, not even
the managers themselves, would dispute that misaligned remuneration systems for bank
managers at least played a role in worsening the financial crisis.4 The G20 countries
therefore adopted the FSB Principles for Sound Compensation Practices as early as
September 2009 and, on this basis, specific implementation standards.5 The Basel
Committee has since incorporated the disclosure requirements specified in these standards
into Pillar 3.6 Germany was one of the first countries to implement the standards. The
Regulation Governing Remuneration at Institutions, or Instituts-Vergütungsverordnung, came
into force in Germany on 13 October 2010. This regulation takes account of both the
international regulations and the subsequent EU provisions.
3. What progress have we made on ...
3.1 ... restructuring and resolution regimes for SIFIs?
However, the international supervisory community still has much to do in the field of
restructuring and resolution procedures for SIFIs. In a free market economy, we cannot and
should not ever fully rule out the possibility of a specific financial institution collapsing. The
insolvency procedures in individual countries have during the crisis proved to be insufficient
- particularly for cross-border institutions. We must make it possible for SIFIs to undergo an
orderly exit from the market without the use of taxpayers' money. Only credible resolution
mechanisms can eliminate the market's rescue expectations - which means that having
systemic importance must not be tantamount to being "too big to fail".
The more than 60 sometimes opposing commentaries in the FSB's public consultation7 on
this issue have been carefully reviewed. The resulting "Key Attributes of Effective Resolution
Regimes for Financial Institutions" will very likely be ready for endorsement by the G20
leaders in Cannes. Yet, the G20 countries must take account of the fact that the European
Commission is currently working on a legislative proposal8 on the same issue. In my view, we
need to strive for international consistency between the G20- and the European framework.
Germany was quick off the mark in creating possibilities for winding up SIFIs. The
Restructuring Act, or Restrukturierungsgesetz, which recently came into force in Germany,
provides for all banks - regardless of their size - to be either restructured or wound up in an
orderly procedure. In addition, the whole of the banking sector has to pay a bank levy which
feeds into a Restructuring Fund so that the sector shares in the costs of overcoming future
financial crises. It is estimated that the bank levy will channel around €1 billion per year into
the Restructuring Fund, and the levy rate to be paid by each institution depends on its
systemic importance - an aspect which I expressly welcome.
However, it is vital that we do not overburden financial institutions. I am therefore
unenthusiastic about the plans to introduce a financial transaction tax. Much as I get the
moral arguments for such a tax, setting the wrong incentives often means that the harm
caused in practice outweighs the intended benefits - particularly when measures are not
introduced internationally, which encourages business to migrate. We need to have a level
playing field across the globe, especially within the EU.
3.2 ... the shadow banking system?
Ladies and gentlemen, how would a traffic authority react if there was a sudden spate of
accidents involving vehicles that weren't - and still aren't - obliged to have an MOT purely
because they aren't technically defined as cars? This is more or less what happened with the
shadow banking system in the financial sector. First, I would like to stress that bank-like
transactions outside of the banking sector should not be regarded as a bad thing per se.
There can be advantages to certain activities being carried out by specialist enterprises
rather than banks. The shadow banking system should not be considered the "villain of the
piece", and I would not wish to support this standpoint.
The crux of the matter is to ensure that financial supervisors have sufficient information to
promptly identify risks to financial stability originating from the shadow banking system.
Containing risks emanating from the shadow banking system might well require regulatory
changes. In particular, we need to avoid regulatory arbitrage at all costs, since we can expect
activities and risks to be shifted away from the banking system in response to stricter bank
regulation. I would therefore like to stress my support for greater transparency. Of course, I'm
aware that reporting obligations engender costs. But, as every economist knows, there's no
such thing as a free lunch. And I believe that the objective of financial stability justifies the
costs that such obligations entail. The relevant authorities should therefore be entitled to
impose reporting obligations on market participants - and this means all players that could
be a source of systemic risk.
So which participants are we talking about here? The FSB defines the shadow banking
system as "credit intermediation involving entities and activities outside the regular banking
system". These can be non-bank entities, such as special purpose vehicles or money market
funds. Hedge funds can also constitute links in a chain of intermediation outside the banking
sector - after all, they collect funds and invest them in bonds and other credit instruments,
including derivatives. But the FSB's definition of the shadow banking system isn't confined to
participants; it also includes activities, such as securitisation.
Work towards addressing the issue of shadow banking is progressing well; this autumn, the
FSB will submit recommendations to the G20 in a report focusing primarily on closing gaps
and loopholes in transparency and regulation; these recommendations will have to be
fleshed out next year. Again, I would like to stress that the oversight and possible
subsequent regulation of the shadow banking system is primarily about the systemic risk that
can arise in the shadow banking system.
4. What still needs to be done?
There is another lesson to be learned from the financial crisis: The pre-crisis supervisory
approach of focusing mainly on individual institutions proved insufficient. It has to go hand in
hand with macroprudential oversight, which aims to identify systemic risk and regulatory
loopholes at an early stage so that countermeasures can be taken swiftly. To achieve this,
we need, in particular, to improve the underlying information and data - as the situation in
the shadow banking system illustrates.
In keeping with the international standards that are currently being elaborated, Germany's
governing coalition proposed expanding the macroprudential oversight of the German
financial system at its central bank. I understand that work is underway to draw up legislation
based on this proposal - a development which I very much support.
Central banks are especially suited to the macroprudential aspects of financial supervision
because they already have a duty to maintain a constant overview of market developments.
As I've already mentioned, central banks are also aware of the side effects of regulatory
initiatives. For example, central bank experts analysed the macroeconomic impact of the
transition to Basel III in detail before it was adopted.9 An extended study on the implications
of the planned SIFI capital surcharges provisionally concluded that they can be expected to
have only a relatively small negative impact on economic growth beyond the planned
implementation period.
In my view, it is generally important to look beyond the traditional confines of supervision
when addressing these issues. This applies, for example, to the question of how recent
international regulatory initiatives are affecting the refinancing conditions of domestic banks.
It is not only the credit rating agencies' assessments which suggest that factors specific to
individual institutions - such as their capital, balance sheet structure and business models -
are the primary influence on banks' individual financing costs. Such factors tend to outweigh
the effects not only of the macroeconomic setting, for example, but also of the costs caused
by regulation. All in all, the large number of regulatory proposals, as well as their complexity
and the rather unfinished nature of some initiatives, make it difficult to assess the overall
picture. Ultimately, however, the competitive situation and bank-specific factors are likely to
be the decisive factors affecting banks' refinancing conditions.
5. Closing remarks
Ladies and gentlemen
Central banks and financial supervisory authorities face a difficult balancing act. On the one
hand, in view of the objective of safeguarding stability, the institutional and regulatory
framework has to be tightened and harmonised internationally. On the other, the new rules
must not overburden market participants, and the effects of regulation, including its impact on
competition, must be evaluated from a macro perspective.
However, the supervisory rules can only set the framework in which financial transactions
take place. Market participants themselves must do their part to strengthen the financial
system - by improving risk management, for example.
I would propose that we central bankers and financial supervisors work through our agenda
item by item and you, as representatives of large institutional investors, work through the
tasks that you have to address. Since we drive on the same roads, so to speak, I look
forward to continuing this dialogue with you. A good dialogue is the best way of avoiding any
more collisions in future.