Nout Wellink: Supervisory arrangements - lessons from the crisis
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel
Committee on Banking Supervision, at the 44th SEACEN Governors' Conference 2008
"Preserving monetary and financial stability in the new global environment", Kuala Lumpur,
6 February 2009.
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When former US President Bush welcomed G20 world leaders in Washington last November
to discuss the financial crisis, neither French President Sarkozy nor German chancellor
Merkel had the honour of sitting next to him at the formal dinner. In fact, none of the Western
leaders had. As a clear display of the shifting balance of economic power, President Hu
Jintao of China and President Lula da Silva of Brazil sat either side of Bush. Evidently the
world economic order is changing. Emerging economies are catching up with the developed
world at great speed. As a result, preserving monetary and financial stability - the theme of
this conference - is an ever more global challenge that requires global cooperation.
The financial turmoil has underlined the importance of better coordination among public
authorities at the international level. From the start of the crisis in August 2007, central banks
across the world have engaged in large-scale coordinated actions to support liquidity
conditions in the global money markets. More recently, national governments have acted to
shore up the capital base of individual financial institutions. Regrettably, but understandably,
they did so in a largely uncoordinated way. Given the many cross-border externalities that
are involved, increased coordination of national measures is clearly desirable, be they capital
injections or state guarantees. In spite of authorities' efforts, uncertainty in the financial
markets remains unusually high, and stabilizing financial systems is still our top priority.
Nonetheless, it is not too soon to think about how we can prevent and mitigate future
financial crises.
Indeed, in light of weaknesses revealed by the financial crisis, the Basel Committee has
developed a series of proposed enhancements to strengthen the Basel II framework. These
enhancements will help ensure that banks' risks, whether on- or off-balance sheet, are better
reflected in minimum capital requirements, risk management practices and disclosures to the
public. Another issue the Committee is currently addressing is procyclicality, or the possibility
that regulatory requirements amplify an economic cycle. This is a difficult issue as there are a
variety of factors at play - such as loan loss provisioning - that influence procyclicality. And,
we should not forget that banking tends to be a cyclical business irrespective of regulatory
requirements. Nonetheless, the Basel Committee has begun a comprehensive review of the
potential procyclicality of the Basel II framework. The objective is to promote adequate
capital buffers over the credit cycle and to mitigate the risk that the minimum capital
requirement magnifies the procyclicality of the financial system. Under discussion are ways
to promote a high quality Tier 1 capital buffer that banks would increase in good times and be
allowed to use in difficult times. Supervisors are also reviewing the need to supplement the
current risk-based approaches with simple, transparent gross measures of risk. This would
constrain the amount of leverage banks could have in good times and therefore also contain
the degree of deleveraging in bad times.
Let me now turn to lessons that can be drawn from the financial crisis with regards to
supervisory arrangements. Over the past one and a half years supervisory arrangements
around the world have been put to the test. These real stress tests have provided us with
important insights into the pros and cons of different supervisory arrangements. And, though
there is no single optimal supervisory arrangement, three lessons can be drawn. First, as
macroprudential supervision and microprudential supervision strongly overlap, central
bankers and prudential supervisors should cooperate closely and continuously. Second,
financial supervisors need to step up international cooperation, simply because the financial
industry is particularly internationalized. Third, while prudential and conduct of business
supervision are distinctly different, they are complementary and should both receive due
attention. Separating prudential and conduct of business supervision institutionally helps to
keep both supervisory goals in clear sight.
As financial sectors today are more concentrated, more integrated and more exposed to the
financial markets than ever before, problems at individual institutions are increasingly likely to
have systemic consequences. Indeed, during the financial crisis we saw several examples,
most notably the collapse of Lehman Brothers in September 2008 which had a truly systemic
impact. These events have demonstrated that the distinction between macro- and
microprudential stability is hypothetical in practice. Therefore, there is an urgent need for
close and continuous cooperation between macro- and microprudential supervisors, of
course with due observance of the relevant legal provisions. Such cooperation can be
achieved in different institutional settings. Also when the central bank plays no role in
microprudential supervision, extensive micro-macro cooperation can be and in fact should be
organized.
The need for effective interplay between central banks and supervisors is particularly
pressing in times of crisis. In the Netherlands, increasing cooperation was relatively
straightforward, because DNB has both central banking and supervisory functions under one
roof. To the best of my knowledge, the same holds for most SEACEN central banks. In
response to the crisis, several working groups have been established within DNB, bringing
together supervisory and central banking expertise to work on multifaceted problems. One
particular multidisciplinary challenge concerned the recent capital injections by the Dutch
State. To determine the amount of capital that needed to be injected in well-known financial
institutions like Aegon and ING, we were able to draw on the extensive expertise available in
our organization. Another example of information-related synergies concerns liquidity. During
the crisis, supervisory information on the liquidity arrangements, sources of funding and
financial position of Dutch banks proved essential in obtaining a clear picture of their liquidity
pressures. Note that the information synergies have also worked the other way round. Insight
into financial market developments and information from payment systems and monetary
policy operations have been extremely valuable for the performance of supervisory tasks.
Contacts with major, market-leading intermediaries have also been useful for producing
timely and meaningful information on major trends and sentiments in the financial system.
While cooperation between central bankers and prudential supervisors naturally intensifies in
periods of financial stress, more cooperation is also desirable in boom times, when the seeds
for later bursts are sown. When confidence levels are high and perceived risk levels are low,
authorities should act to mitigate the build-up of systemic financial vulnerabilities. In the past
we have been pretty good in analysing risks to financial stability. We have failed however in
effectively translating our analyses into concrete risk-mitigating actions. Indeed, we have
been aware of large global imbalances for some time. But little was done about it. While
global macroeconomic conditions are not at the origin of the crisis, they have contributed to
it.
Related to this, I believe that the macroprudential orientation of regulatory regimes, notably
that of the Basel II framework, needs to be enhanced. Tight supervision of individual financial
institutions will certainly remain crucial, but supervisors will also need to devote resources to
understanding interactions among financial institutions and linkages within the financial
system at large. This includes understanding how banks' major business lines are linked into
the broader credit intermediation process and where pockets of risk concentrations may be
emerging in the financial system. A more comprehensive approach to supervision and
regulation will enable supervisors to focus their limited resources on those activities that
contribute most towards counteracting the build up of risk in the banking system. In setting
our goals however, we must be realistic. It is not realistic to believe that we can prevent
financial crises completely, as crises are a fact of life. What we can do is create a more
resilient financial system, thereby decreasing the frequency and severity of financial crises.
Since financial institutions and systems are part of an integrated global financial system, we
need to go beyond more micro-macro cooperation at the national level. In this respect, it is
encouraging that the FSF and IMF will intensify their cooperation at the global level, each
complementing the other's role. The IMF will report on its monitoring of financial stability risks
to FSF meetings, and in turn will seek to incorporate relevant FSF conclusions into its own
bilateral and multilateral surveillance work. A similar initiative is envisaged at the European
level, where the European System of Central Banks Banking Supervision Committee and the
Committee of European Banking Supervisors (CEBS) will intensify cooperation.
Supervisors will also need to step up their cooperation. In line with the recommendations by
the Financial Stability Forum, so-called colleges of supervisors have been established for
several major cross-border financial groups. These colleges include all relevant supervisors
and promote cooperation on ongoing supervisory issues. DNB is currently chairing global
supervisory colleges for Aegon and ING. In fact, only two weeks ago, we hosted the ING
college in Amsterdam. Colleges of supervisors are also promoted on the European level. In
response to the growing integration of Europe's banking industry and to the specific nature of
trans-national banking groups, ECOFIN Finance Ministers have called for the set-up of
colleges of supervisors. Furthermore, the European Commission has set up a "high level"
group headed by former Bank of France Governor Jacques de Larosière, to bring forward
ideas on strengthening EU financial supervision. There are two possible outcomes. Either
cooperation will intensify gradually - building forth on existing institutions such as CEBS -, or
cooperation will intensify abruptly - creating a European Financial Supervisory Authority.
More will be known shortly, as the De Larosière group is set to give its first advice next
March.
Let me now turn to a third lesson from the crisis, which is related to the difference between
prudential and conduct of business supervision. While prudential supervisors' main concern
is the safety and soundness of financial institutions, conduct of business supervisors first and
foremost strive for a fair and transparent market. Undeniably both types of supervision are
important and in fact they are generally reinforcing. Let me give an example to illustrate this.
In the United States, home loans were extended to very risky borrowers, with little or no
income and few, if any, assets. From a conduct of business perspective, these US
consumers were not treated fairly. Had this practice been stopped in time by the relevant
conduct of business supervisor, we would have fewer problems now. Unfortunately practice
did not stop, but rather worsened. And now these US mortgages are awfully problematic
from a prudential point of view.
That being said, prudential and conduct of business supervision can also be conflicting.
Prudential supervisors work most effectively behind the scenes. This contrasts with conduct
of business supervision, which benefits from being in the public eye. Publicity helps to warn
off consumers, investors and the industry from misconduct and wrongful practices. If both
types of financial supervision are exercised by the same organization, there is the risk that an
inappropriate balance is struck. Therefore, in integrated supervisory authorities,
arrangements can and should be made to ensure the necessary amount of resources is
allocated to both types of supervision. Establishing such arrangements, however, can be
rather challenging in practice. Indeed, a key finding of the UK FSA's internal audit review in
light of Northern Rock was that too many resources had been allocated to conduct of
business supervision, and too few to prudential risks.
In the Netherlands, and also in Australia, the danger that either prudential or conduct of
business supervision will be overlooked has been addressed institutionally. In our
objectivebased supervisory arrangement, prudential and conduct of business supervision are
performed by two separate institutions. The former type of supervision is the responsibility of
DNB; the latter is the remit of the Dutch conduct of business supervisor, the Authority for the
Financial Markets. Consequently, our institutional set-up leads to a transparent consideration
of prudential interests on the one hand and conduct of business interests on the other. Let
me give a clear example to illustrate this point. Some years ago a Dutch subsidiary of a
foreign bank had neglected its duty of care. From a conduct of business perspective, the
bank had to be penalized for this. It was clear, however, that this would entail the end of the
bank. Therefore, DNB had extensive talks with the Authority for the Financial Markets on this
issue, as interests clearly conflicted. These talks ultimately led to the consideration that the
bank had to be penalized for not being compliant with conduct of business regulations, as
long as this would not endanger the stability of the financial system. An objective-based
setup thus promotes a transparent consideration of interests.
In addition, linking the regulatory objectives to the supervisory structure also improves
supervisory efficiency. In particular, a major advantage of objectives-based supervision is
that responsibilities are consolidated in areas where natural synergies take place. While
prudential supervisors focus on risks and the management of risks, conduct of business
supervisors concentrate their efforts on disclosure issues and sales and marketing practices.
Confidence in objective-based supervision has been supported by the US Treasury Blueprint
for a modernized financial regulatory structure, which states "an objective-based regulatory
approach would represent the optimal regulatory structure for the future".
Let me conclude. I began my speech with the changing world economic order. Indeed, the
balance of power is shifting. Emerging economies will produce and consume an increasing
share of world economic output. With more economic and political power comes more
responsibility. In this respect, the increasingly active role of emerging countries in addressing
global problems is encouraging. One important challenge we all face now concerns global
financial stability. To promote financial stability now and in the future, cooperation between
macroprudential supervisors and microprudential supervisors should be strengthened.
Especially when the good times return - and they will - this will prove challenging. The
international cooperation between financial supervisors should also intensify, as the current
financial crisis has clearly shown. Regarding the different objectives of financial supervision,
recent experiences have reinforced the arguments in favour of objective-based supervision.