José Manuel González-Páramo: The management of the banking sector
and the economy - what have we learned about financial markets and
regulations?
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the XXVII Reunión Círculo de Economía, Sitges, 3 June 2011.
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Ladies and Gentleman,
It is a pleasure to have the opportunity to speak at this prestigious forum today. The first
round of the meetings of "Círculo de Economía" took place exactly 50 years ago (in 1961),
constituting a very unique event in Spain at that time. Since then, these meetings have
provided an excellent forum to exchange views and ideas on issues of European and global
relevance. Today we meet at a time of multiple challenges for our world, so I am sure that
inspiring discussions will take place.
For more than three years we have been focused on the challenges that the financial crisis
has posed to our economies and our societies. Still, recent developments in European
sovereign debt markets as well as ongoing economic difficulties in some euro area countries
remind us that the crisis is not over yet. While the ECB continues to confront, in a decisive
manner, the tensions in financial markets, it is also involved in the reform of the global
financial system that is currently in progress.
I would like to lay out today what I believe are the core areas of the regulatory reform,
detailing what has been achieved and what remains to be done.
Introduction
Let me start by saying that under the leadership of the G20, a remarkable amount of work
has been done by the Financial Stability Board (FSB) and the Basel Committee regarding
financial reform. In Europe, the European Commission has also adopted several new pieces
of legislation and many more are underway in order to strengthen the regulatory and
supervisory framework.
I believe that we can identify the following key areas of the financial reform: First,
strengthening the resilience of financial institutions. This includes the introduction of the
Basel III framework for banks, eliminating the too-big-to fail problem as well as ensuring
adequate oversight of the shadow banking system. Second, increasing transparency and
mitigating the pro-cyclicality in financial markets and finally, third, introducing
macroprudential supervision, which can be considered as the missing link in the pre-crisis era.
The crisis has shown the need for a systemic perspective of the financial system that takes
into account the interactions within the system as well as with the real economy.
1. Strengthening the resilience of financial institutions
Let me first start with Basel III, which constitutes the cornerstone of regulatory reform for the
banking sector. While Basel II was very much focused on a single ratio (capital to
riskweighted assets), Basel III takes a more comprehensive approach, addressing deficiencies
of Basel II and further strengthening the armoury of prudential requirements. Let me highlight
the main elements of the new Basel III framework:
Basel III provides for higher minimum capital requirements, a stricter definition of eligible
capital and more transparency. The crisis highlighted the urgency of establishing a common
definition of capital. The fact that the definition of what constituted Tier 1 capital was neither
transparent nor harmonized across countries, contributed to a generalised loss of confidence
in the quality of regulatory capital. In addition, it proved necessary to increase the overall
level and loss-absorbing capacity of the capital held by banks.
Moreover, Basel III introduces also entirely new concepts, such as non-risk-based leverage
ratios and mandatory liquidity requirements. The leverage ratio will offer a transparent
measure to the market that will complement the risk-based capital calculations and introduce
additional safeguards against model risk and measurement error. The new liquidity buffers
will ensure, in the short term, that banks hold sufficient high quality liquid assets to withstand
an acute stress. In the longer term, the buffers will increase banks' incentives to use more
stable sources of funding on a structural basis.
Lastly, beyond the micro-prudential dimension of regulation - typically represented by
institution-specific solvency requirements - Basel III also introduces macro-prudential
elements, most prominently the capital buffer regime. This constitutes an important
safeguard to protect the banking sector from periods of excessive aggregate credit growth.
Let me say that, while generally supporting the underlying objectives of the regulatory reform,
the industry has been critical towards the new capital requirements. The industry is of the
view that Basel III will increase costs for banks, reduce profitability, lead to credit supply
restrictions and, ultimately, hurt the economy.1 Theory and historic experience however
demonstrate that those claims are partly based on misconceptions that are important to
dispel. Although I will not elaborate in detail, let me highlight the following:
In the long run, benefits brought by the enhanced capital and liquidity regulation can be
substantial. They include a reduction in the frequency of crises and hence on the expected
output losses associated with systemic events. The new framework should also improve the
level playing field for the international banking sector. This is expected to help financial
institutions to save costs and to encourage cross-border activities. In turn, this should result
in a more efficient financial sector and also bring benefits to non-financial corporations and
households through higher competition and increasing availability of financial services.
In the short term, given that financial markets are characterized by information asymmetries
and frictions, the new regulatory requirements will most likely imply some transitional costs
on the economy through tighter credit conditions. Adverse effects are however expected to
be moderate, notably if they are spread over a long implementation period. Estimates by the
BCBS as well as by the ECB concluded that a 1 percentage point increase in the capital ratio
implemented over eight years would result in a moderate cumulated reduction of GDP of
around 0.15 percentage points. Indeed, the new measures will therefore only become fully
effective on 1 January 2019. This long phasing-in period should provide the banking sector
ample time to adjust to the new regulatory requirements and prevent disruptions in credit
flows.
Looking forward, it is of the essence that Basel III is properly implemented at the global level.
In addition, it is important that the proposals on the leverage ratio and liquidity risk framework
are rigorously calibrated, so that any unintended consequences for individual banks, the
banking sector, and financial markets can be timely addressed.
Second, it is important that work is kept apace on systemically important financial
institutions, or so-called SIFIs. The financial crisis has evidenced that large, complex and
cross-border banks pose exceptionally high risks on the financial system and society at
large. By virtue of their "too big to fail" status, these financial institutions assume a systemic
dimension which, in the event of a crisis, results in large wealth transfers from taxpayers to
the banking system.
Against this background, the G20 has endorsed an ambitious program that aims at reducing
the probability of default of a SIFI. As a key priority, it has been agreed that SIFIs should
have higher loss absorbency capital beyond Basel III standards. The purpose of these
requirements is threefold: first, to increase SIFIs resilience to adverse shocks; second, to
internalise the costs of distress they impose on the financial system; and third, to restore
proper incentives with respect to their risk-taking.
Let me also highlight that a key element of the SIFI policy framework is to develop
strengthened resolution frameworks to ensure that all financial institutions can be resolved
safely and quickly, without destabilising the financial system and exposing the taxpayer to
the risk of loss.
The FSB is focusing on the identification of the key elements of effective resolution regimes,
which will identify the essential features that national resolution regimes for financial
institutions, including non-bank financial institutions, should have. Let me mention that the
EU is actively participating in the ongoing work and is also taking these global initiatives into
account in the design of the European framework.
Third, another important area where work needs to progress relates to the so-called
"shadow banking system". The financial crisis evidenced that systemically important
pockets developed in the financial system without any regulatory oversight. A better
understanding of the interconnections between regulated and unregulated entities is needed.
Moreover, it is important to bear in mind that the introduction of more stringent capital
requirements for credit institutions may provide further incentives to shift activities outside the
regulatory perimeter.
For this reason, the regulatory reform should not only focus on regulated banks. It should
instead be based on a comprehensive system that extends in a proportional way to all
actors, intermediaries, markets and activities that embed potential systemic risk.2 In this area
the identification of data gaps and putting in place an effective monitoring framework as well
as reinforce the accounting rules on consolidation internationally are key.
2. Increasing transparency and mitigating the pro-cyclicality in financial markets
I would now like to touch upon the measures taken with regard to the regulation of financial
markets. Here, reform must ensure greater transparency for the various market segments
and products, sufficient competition in all markets, and attenuate as much as possible the
pro-cyclicality that derives from information asymmetries, structural features such as ratings,
market phenomena such as herding and short selling practices. In this speech I will focus in
particular on improvements in the regulation of OTC markets.
Private financial markets cannot function properly unless there is enough information and
reporting both to market participants and to relevant regulators and supervisors. The financial
crisis evidenced the increasing opaqueness of the financial sector and the resulting
counterparty risk externality. Regulatory initiatives that are underway to remedy these issues
are therefore of utmost importance.
Let me begin by highlighting the importance of establishing an appropriate regulatory
framework for OTC derivatives. OTC derivatives markets have grown exponentially in size
over the past decade and they are closely related to the underlying cash, bond and equity
markets. However, the development of risk management practices for these products has not
kept pace with their growing use and systemic importance as the financial crisis
demonstrated in a number of instances, such as the Lehman default and the near-defaults of
AIG and Bear Stearns.
Against this background, regulators are currently working to address three issues in
particular. First, to foster market transparency through reporting of all transactions to trade
repositories, which in turn will disseminate the related data to regulators and the public in line
with their information needs. Second, to mitigate counterparty risks through use of central
counterparties for sufficiently standardised and liquid products. Third, to ensure the safety
and soundness of OTC derivatives central counterparties and trade repositories, given the
concentration of risks in these new infrastructures.
• In the EU, the forthcoming EU Regulation for OTC derivatives, central
counterparties and trade repositories is the key initiative to implement these
objectives. However, given the global nature of OTC derivatives markets, the EU
framework will only be effective if it is consistent with legislative initiatives in other
jurisdictions and cross-border cooperation among authorities in ensured. To this
end, the new EU rules should be fully in line with the global supervisory and
oversight standards for financial market infrastructures that are currently being
reviewed by the Committee on Payment and Settlement Systems (CPSS) and the
Technical Committee of the International Organization of Securities Commission
(IOSCO). The CPSS and IOSCO issued a consultative report entitled "Principles for
financial market infrastructures" last March and their guidance is expected to be
finalised in early 2012.
Another important initiative relates to the
enhanced oversight of Credit Rating Agencies
(CRA's) and the need to reduce the mechanistic reliance on external ratings. Ratings
are crucial to investors' decisions and are deeply embedded in the regulatory architecture. It
is therefore essential that ratings that are independent, objective and of the highest possible
quality, as shortcomings in rating activity can erode market confidence and adversely affect
financial stability. Moreover, the crisis has evidenced that ratings downgrades have
contributed to the pro-cyclicality of the financial sector.
In the EU, the Credit Rating Agencies Regulation was adopted in 2009 and regulators and
credit rating agencies are currently preparing for implementation of these rules. In our
Opinion, the ECB supported the need to reduce reliance on external credit ratings. This could
be pursued via two main avenues: first, firms should be required to undertake their own due
diligence and internal credit risk assessment. Second, supervisors should focus on
developing rules to appropriately combine internally developed credit judgment and external
input with varying weights depending on the specific characteristics of the credit exposures.
In addition, we fully support initiatives by the European Commission to enhance transparency
and disclosure of the rating process and in launching a debate on enhancing competition.
3. Introducing macro-prudential supervision
The aim of macro-prudential supervision is to mitigate and prevent systemic risks to financial
stability on the basis of identified vulnerabilities and systemic risk assessments. The financial
sector regulations before the crisis very much focused on limiting each institution's risk seen
in isolation rather than on aggregate or systemic risk. As a result, financial institutions were
encouraged to pass their risks around the system and to unregulated entities, increasing the
vulnerability of the system to large macroeconomic shocks. In Europe, in particular, the crisis
highlighted the absence of a proper framework for macro-prudential oversight.
Against this background, a new European System of Financial Supervision entered into force
on 1 January 2011. Alongside with national supervisory authorities, who will continue to be
responsible for day-to-day supervision of firms, three European Supervisory Authorities have
been created - respectively for the banking, insurance and securities markets. A new body,
the European Systemic Risk Board (ESRB) has become responsible for macro-prudential
oversight of the EU financial system. The primary task of this new body is to monitor the EU's
financial system as a whole identifying sources of systemic risk, and to issue risk warnings
and policy recommendations addressing systemic risks. The ECB President will chair the
ESRB and the ECB will provide analytical, statistical and logistical support to the ESRB, as
well as its Secretariat.
The establishment of the ESRB is a key milestone in how Europe deals preventively with
systemic risks. It forms part of wider initiatives across the world, including in the US with the
establishment of the Financial Stability Oversight Council.
The European System of Financial Supervision is still in the starting-up phase and it will need
time to establish itself. As regards the ERSB I believe that there are three key conditions in
order for it to reach its full potential. The first is the need for an adequate infrastructure to
identify and analyse systemic risks, which demands state-of-the-art analytical tools. And here
I believe the ECB is well-equipped to support the ESRB with its analytical expertise. The
second, given the non-binding nature of the warnings and recommendations, is building-up a
strong reputation. Indeed, credibility will be key in ensuring addressees implement the
recommendations. Also here, I firmly believe that the expertise of the members sitting around
the table, in particular the expertise of central banks in analysing financial stability will be
crucial in successfully building up this reputation. And finally the third relates to the need to
cooperate and exchange information effectively among all members of this new European
System of Financial Supervision. The experience of the European System of Central Banks
will also prove useful, in this context.
Conclusion
Let me conclude by mentioning that substantial progress has been achieved in key areas of
regulatory reform. However, our work is not finished and there is no room for complacency.
In order for the new regulatory regime to be effective, a coherent and consistent
implementation of the reforms at a global level is of paramount importance. Only then can
regulatory arbitrage be prevented and a level playing field ensured. At the European level the
three European Supervisory Authorities have an important task in ensuring a consistent
implementation of the regulations.
We cannot forget that the financial crisis and its aftermath have been one of the most
disruptive events in decades, causing massive economic and social costs. Tensions
originating from a relatively small segment of the international financial market evolved into a
global crisis, revealing deficiencies in the regulatory framework which must be addressed. In
the aftermath of the crisis, industrialized and developing nations pledged to adopt a common
approach to reinforce the resilience of the financial system and ensure its sustainable
contribution to growth.
We cannot lose sight of this shared mission and responsibility. Determination and
consistency in the implementation of these reforms is therefore now crucial.
I thank you for your attention.