Lorenzo Bini Smaghi: Going forward - regulation and supervision after
the financial turmoil
Speech by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central
Bank, at the 4th International Conference of Financial Regulation and Supervision "After the
Big Bang: Reshaping Central Banking, Regulation and Supervision", Bocconi University,
Milan, 19 June 2009.
* * *
Introduction1
Today, the European Council is expected to endorse significant changes to the institutional
set-up for financial supervision and regulation in the European Union. Undoubtedly these are
important reforms, particularly - but not only - against the background of the financial crisis
that started in August 2007. While the ECB has an interest in all these reforms, in particular
on the macro-prudential side, namely the establishment of the European Systemic Risk
Board (ESRB).
Macro-prudential supervision has its origin in the phenomenon of systemic risk. A particularly
illuminating account of the nature of and the need for a macro-prudential supervisory policy
was provided in 2000 by Andrew Crockett, then the General Manager of the Bank for
International Settlements and Chairman of the Financial Stability Forum.2 Crockett argued
a shift in perspective that is already taking place, complementing
that we should "consolidate
the micro-prudential perspective with increased awareness of, and attention to, the
macroprudential facet". He defined the objective of macro-prudential supervision as limiting the
likelihood of the failure, and corresponding costs, of significant portions of the financial
system (responding to systemic risk). In contrast, the micro-prudential objective can be seen
as limiting the likelihood of failure of individual institutions (responding to idiosyncratic risk).
From today's perspective the distinction seems as relevant as one decade ago. However, the
experience of the present crisis and the history of past crises, as well as the transformations
of modern financial systems, require us to go further. We should ask ourselves, for example,
what is the scope of macro-prudential supervision. I would distinguish two dimensions. The
first one is the analysis and monitoring of risk. The second one is the containment of the risks
that have been identified, which requires specific instruments. This raises the question of the
institutional set-up for conducting macro-prudential supervision.
1. Monitoring and analysing risk
The literature suggests three main considerations on the way in which systemic risks should
be monitored and analysed.3 A first one is that macro-prudential analysis needs to capture all
components of financial systems and how they interact. This includes all intermediaries,
markets and infrastructures underpinning them. In this respect, it is important to consider that
at present some of these components, such as hedge funds, private equity firms or over-the-
counter (OTC) financial markets, are not subject to micro-prudential supervision. But they
need to be part of macro-prudential analysis and risk assessments, as they influence the
overall behaviour of the financial system. To gain a truly "systemic" perspective on the
financial system, no material element should be left out. This includes, notably, large and
complex financial institutions.
The failure of Lehman Brothers in September 2008 and its consequences for the world
financial system could not illustrate better how important the individual viability and the
multiple connections to other intermediaries and markets of such large and complex
institutions are for systemic stability and therefore for macro-prudential risk assessments and
policies.4 At the same time, it illustrates well how micro-prudential and macro-prudential risk
assessments and policies interact and should not operate in isolation from each other.5
A second consideration is that macro-prudential risk assessment needs to cover the
interactions between the financial system and the economy at large. Many systemic banking
crises in history have been caused by macroeconomic downturns.6 The recent crisis shows
the magnitude of adverse feedback effects between financial stability and real economic
developments.7 Macro-prudential supervision needs to fully incorporate the two-sided
interactions between financial and real sectors and the mutually reinforcing spirals between
financial instability and real performance. This includes, but should in no way be limited to,
the assessment of the pro-cyclical behaviour of financial systems and the potential
reinforcing elements embedded in the regulatory systems.8 The framework for analysing the
interactions between the real and financial dimensions requires a substantial modification of
the traditional tools for assessing financial stability. A lot of work is required in this respect.9
A third element to be taken into account is that financial markets are not static and are
continuously evolving as a result of innovation and international integration. It is probably not
a coincidence that the first published official document that I could find that used the term
"macro-prudential policy" was actually a report dedicated to innovation in international
banking.10 Several financial crises in history have been a result of financial liberalisations or
innovations that were neither sufficiently understood nor managed. For example, one of the
origins of the present crisis is to be found in the use of certain securitisation techniques,
which were implemented in opaque ways.11 Again, determining the extent to which a fully
4
For a much more wide-ranging interpretation of the financial system as a complex network with influential
nodes and analogies to other sciences, like biology, computer science and medicine, see Haldane (2009),
"Rethinking the financial network", speech delivered at the Financial Student Association, Amsterdam, April.
5
See for example the European Commission communication on "European financial supervision" (27 May
2009).
6
See for example Gorton (1988), "Banking panics and business cycles", Oxford Economic Papers, 40, pp.
751781, and Demirgüç-Kunt and Detragiache (1998), "The determinants of banking crises in developing and
developed countries", IMF Staff Papers, 45, pp. 81-109.
7
See for example the ECB's June 2009 Financial Stability Review for a discussion of the adverse feedback
effects from the ongoing global downturn to financial stability risks.
8
See for example Borio, Furfine and Lowe (2001), "Procyclicality of the financial system and financial stability:
Issues and policy options", BIS Papers, 1, pp. 1-57, Kashyap and Stein (2004), "Cyclical implications of Basel
II capital standards", Federal Reserve Bank of Chicago, Economic Perspectives, 1st quarter, pp. 18-31, or
Rajan (2006), "Has finance made the world riskier?", European Financial Management, 12, pp. 499-533.
9
One example is the recently established new project and working group on transmission channels between
the real and financial sector by the Research Task Force of the Basel Committee on Banking Supervision.
10
See the so-called Cross Report on "Recent innovations in international banking" prepared by a study group of
the central banks of the Group of Ten countries (April 1986). It featured also a full chapter on "Global
integration of financial markets".
11
See for example Ashcraft and Schuermann (2008), "Understanding the securitisation of subprime mortgage
credit", Foundations and Trends in Finance, 2(3), pp. 191-309, in particular the chart on "The seven "deadly"
frictions of securitisation".
BIS Review 77/2009
developed macro-prudential function would have to take into account innovations shaping
instruments, institutions and processes in the financial system would go beyond regular
financial stability analysis.
On the basis of the above considerations, a key output of macro-prudential analysis would
ideally be a periodical graduated ex ante risk assessment measuring the amount of risk in
the overall financial system and its implications for the economy at large. This assessment
would also estimate the overall degree of instability that could result if certain unexpected
adverse events were to materialise, including scenarios of extreme shocks, ultimately also
assessing the resilience of the financial system and of the economy in general. Whereas
macro-prudential (and micro-prudential) supervision is mainly concerned with extreme events
such as financial crises ("tail risks"), the forward-looking approach required to prevent those
extremes implies that careful assessments also be made in more tranquil times, establishing
how far the system is from a crisis and which risks - if they were to materialise - could bring
it closer to a crisis.
What is needed to conduct such analysis and monitoring? The starting condition for
implementing a comprehensive macro-prudential function is an adequate information basis.
The first part of the information basis is a good system of continuous market intelligence,
which gives a hands-on picture of current market developments and expectations through
direct contacts. The second part consists of the regular collection of macro-prudential data
and statistics, such as those relating to the macroeconomic environment, financial markets
and related infrastructures, payment and settlement systems, regulated and unregulated
intermediaries, non-financial corporations and households, as well as to the relationships
between the main economic and financial sectors. The third part consists of the regular
collection of firm-level information and data, in particular for large and complex financial
institutions. This relates to specific items of information regarding on- and off-balance-sheet
items, with appropriate breakdowns of exposures related to the asset and liability sides
(geographical, sectoral, currency, etc.), including the identification of counterparties. For the
identification of interlinkages between major intermediaries and the assessment of contagion
risks, an international "risk map" - as proposed for example in the de Larosière Report -
would be particularly helpful.12 Lastly, for the large and complex groups, micro-prudential
information about liquidity and risk management models would be required.
The second instrument is a suite of analytical tools and models and a staff familiar with them.
Although formal models have their limitations, they do help structure the qualitative and
quantitative information that is collected for the regular risk assessments. Existing research
offers eight broad groups of approaches and models: financial stability indicators, contagion
and spillover models, early warning signal models, stress testing models, macro-financial
risk-based flow-of-funds accounts models, macro-econometric forecasting models, calibrated
general equilibrium financial stability models and other models (including models of firm and
household vulnerabilities). These models have their pros and cons, but some are more
promising or easier to implement than others. Each serves different purposes, but there are
also overlaps. Since financial stability analysis in general and macro-prudential analysis in
particular is much less understood than other policy areas, it is advisable to use a multiplicity
of approaches. How many of the overall list can be used and how much will depend on the
resources available to develop and maintain them. But the investment in the analytical toolkit
is likely to be significant. I expect most authorities having to develop a macro-prudential
supervisory function to extend or reallocate resources in order to meet these requirements.
2. Containing risks
If risks to systemic stability have been identified, the next step is to contain them. I would
consider three ways to achieve this. A first option is to communicate the risks and the
sources of these risks to financial market participants, with a view to alerting them and
inducing them to adjust their behaviour. A second option is to strengthen supervisory
oversight over financial institutions and markets, with a view to avoiding excessive
risktaking. The third option is to achieve the same objective through the use of regulatory
powers. The three steps can be summarised as follows: (i) alerting, (ii) supervising more
closely and (iii) regulating. The choice of which instrument to use may vary, depending on
the severity of the risk and on the circumstances.
A major challenge for macro-prudential supervision relates to the decision-making system
capable of accommodating these three options. Let me provide some illustrations. First of all,
addressing certain macro risks may require the adoption of regulatory measures across the
board, applying in particular to financial institutions and markets. This may blur the
responsibility between macro- and micro-prudential supervision. Alternatively, one can follow
the suggestion by Crockett I mentioned above and distinguish the regulatory and supervisory
actions between those conducted at the level of individual institutions and those affecting the
whole markets. The supervisory and regulatory measures aiming at containing aggregate
risk and externalities would be part of the macro-prudential toolkit, whereas measures aiming
at the stability of individual institutions would be part of micro-prudential policy.
Following this objective-oriented approach, the measures aimed at reducing pro-cyclicality of
financial systems would be part of macro-prudential policy. Some concrete ideas are being
discussed on how to reduce pro-cyclicality, such as adjusting capital requirements to the
business cycle (making them less stringent in bad times and more stringent in good times),
adding maximum leverage ratios or introducing dynamic provisioning rules (where reserves
have to be accumulated in good times and are drawn down in bad times).13 Measures aimed
at dampening pro-cyclicality may also affect compensation structures, transparency and
accounting rules, internal governance (e.g. related to the risk management function), the
design of certain financial instruments, and maturity mismatches.14
The macro-prudential toolkit would also include measures to reduce contagion and to limit
other transmission channels of financial instability. Much progress has been made in the last
two decades in the area of payment and settlement systems, but more needs to be done, as
suggested by the recent debate on central clearing counterparties for OTC derivatives. New
challenges have emerged as a result of the significant increase in wholesale funding of
financial intermediaries, the emergence of new institutions (some of them highly leveraged
and to which banks are very much exposed) and the increasing transfer of risks previously
concentrated in the banking sector to other agents, such as insurance companies.
A comprehensive framework for policy analysis is still lacking. A number of proposals for
specific macro-prudential measures have been put forward, following the objective-oriented
approach.15 But we need a broad framework for policy analysis and implementation. We
have been working on this at the ECB for some time.
To be sure, many of the risks that have materialised during the recent crisis had been
signalled earlier on, in the public communications by relevant policy authorities, such as the
ECB (in its Financial Stability Review and in speeches by Executive Board members), the
Bank for International Settlements (in its Quarterly Review of Financial Market Developments
and Annual Report), the Bank of England or the International Monetary Fund (in its Global
Financial Stability Report).16 With hindsight we can perhaps acknowledge that these
communications were not effective in changing the behaviour of financial market participants,
nor of the supervisory authorities. Furthermore, there has been an insufficient understanding
of the force with which the different risk factors have materialised and combined. For
example, had there been a much more developed monitoring system, covering also the
nonregulated financial sectors and the so-called shadow banking system, as well as a more
granular and frequent picture of the main exposures of and among the large and complex
financial institutions, a better insight could have been gained into the scope for the crisis to
erupt and to spread across financial systems. Had there been a more integrated assessment
of the impact of financial innovation, the risks developing in credit risk transfer markets would
have been better understood and monitored. However, the flow of information from the
micro-prudential supervisors was insufficient to undertake such an assessment.
3. The institutional framework
Having set out the main objectives and tools, I would now like to address the issue of the
institutional framework which should support the implementation of macro-prudential
supervision. Such a framework inevitably involves two main actors: the central banks and the
authority in charge of regulating and supervising financial institutions and markets. The latter
has the information on individual participants and market developments, and is responsible
for the stability of individual institutions, while the former has the analytical capabilities for
assessing macroeconomic risk and global financial market developments. A properly
functioning system requires a full flow of information: from the supervisory authority to the
central bank, with a view to providing all the relevant information to monitor and analyse risk
and, vice versa, from the central bank to the micro-prudential supervisor in order to provide
the result of the risk analysis and ensure that appropriate measures are implemented. Also
important are a clear allocation of responsibilities and proper accountability to ensure that the
right incentives are in place for the achievement of results in a cooperative manner rather
than inter-institutional fighting, which is a recipe for disaster.
To consider the options available let me refer for simplicity the Turner Review as a basis for
the analysis.17 In extreme synthesis, the Turner Review attributes to the central bank the
main responsibility for conducting the risk analysis, but when it comes to the policy
implications, three models are considered:
•
In Model 1, the central bank identifies systemic risks and makes recommendations to
the authority in charge of micro-prudential supervision, which sets out the main
actions to be taken to address these risks.
•
In Model 2, the central bank is not only in charge of identifying risks, but is also able
to take specific macro-prudential measures or to require the authority in charge of
micro-prudential supervision to do so.
•
In Model 3, a joint committee, composed of representatives of the central bank and
the supervisory authority, makes the final decision as to the appropriate policy
response.
In my view, the third model is a third best, because it risks blurring responsibilities and does
not ensure proper accountability of the central bank and the micro supervisor. Within the
proposed committee, no public disagreements between the central bank and the supervisor
could arise, as it would hurt the credibility of the process. This means that de facto the micro
supervisor has a veto right on the central bank. If instead the two components of the
committee are allowed to disagree in public, Model 3 would become quite similar to Model 1,
where the differences are made public and the supervisor would have to explain why it
disagrees with the central bank and does not take the suggested action. Another
disadvantage of Model 3 emerges when the supervisory authority is not independent of the
political authority. I will not elaborate on the need for such independence, but in my view the
recent crisis, if anything, has strongly confirmed it. Looking around Europe, it would be
interesting to verify the extent to which during the recent crisis bank solvency problems have
emerged mainly in countries where the supervisory authority is outside the central bank and
where the independence of the former (also in financial and institutional terms) is less well
protected than that of the latter. In these countries, Model 3 would create a channel to
influence the central bank. Furthermore, in the context of the European Union Model 3 would
be particularly difficult to implement, as it would require agreement between a multiplicity of
national authorities, unless we get to a situation in which the central banks and the
supervisory authorities are represented by one European-wide institution. While in the
current system the central banks can be represented by the ECB, the supervisors do not yet
have a similar system.
Models 1 and 2 ensure a clearer allocation of responsibilities, either to the central bank or to
the supervisory authority. In assessing the two models, a key issue to consider concerns the
conflict of interests, in particular within the central bank and within the supervisory authority,
respectively.
Let's consider first the conflicts of interest within the central bank, which would emerge in
particular in Model 2, between the objective of price stability and the objective of
macrofinancial stability. A conflict would arise if the central bank would have to address the two
objectives with only one instrument, i.e. the interest rate. The central bank could be pushed
to use the interest rate not only to achieve price stability but also to counter macro systemic
risks. For instance, it could have to increase interest rates prematurely, in order to stop a
financial bubble from developing, while the underlying economic developments do not
require it. The interest rate is not necessarily the most efficient way to prevent or to prick
bubbles. The conflict of interest would vanish if the central bank had two distinct instruments
to address the two objectives, with a clear assignment. The interest rate would be assigned
to achieving price stability, while macro-prudential measures would be aimed at
macrofinancial stability. During the current crisis, the ECB has shown that such a separation can be
achieved. On the one hand the interest rate has been used with a view to achieve price
stability, while, on the one hand, liquidity-injecting measures have aimed at stabilising the
money market. Each measure has been adopted and justified to the public in such a way as
to keep separate the two objectives. Overall, the experience suggests that the interest rate
and macro-prudential instruments are rather complementary and do not give rise to conflicts
of interest.
Let's consider now the potential conflicts of interest for the supervisory authority, between the
macro- and micro-prudential objectives. Supervisory authorities might have to make
tradeoffs to achieve both. For instance, it would be more difficult for a supervisor to decide to
tighten capital requirements and liquidity ratios in a booming economy if some banks are
individually experiencing difficulties. There might be an incentive to address these difficulties
with general, rather than specific, measures.
In the European framework, given that the micro-supervisory authority is exerted at the
national level, there is a problem of uniformity of action. In Model 1, in which the central bank
can only make recommendations, it is not clear how the various national authorities would
react and implement it. There could be a situation in which the implementation differs across
countries, without clear justification. Ultimately, the incentive to safeguard the
competitiveness of the national systems would induce the respective authorities to adopt a
minimalist approach, which would be to the detriment of overall stability.
On the other hand, national economies may develop in different ways, even in the euro area,
and the macro risks arising in some countries may not be as relevant for others. For
example, over the last ten years some euro area countries have experienced fast growth of
domestic credit and rising asset prices, while in others financial dynamics have been more
subdued. However, when looking at the risks taken by the banking system across countries,
they have emerged both in fast- and slow-growing countries. This implies that in Model 2 the
central bank should be able to adopt measures that take adequately into account different
macroeconomic developments across countries.
Overall, there seems to be greater conflicts of interest between the objectives of macro and
micro prudential supervision than between price stability and macro-prudential supervision.
This is the reason why I tend to consider that Model 2, in which the central bank is given two
instruments in order to achieve two distinct objectives is more appropriate, especially within
the European framework, and even more so for the euro area. This seems to be the model
that will be implemented in the US. The US administration has proposed to give the Fed
powers to address the build up of risks that threaten the financial system as a whole, with a
focus on core institutions and markets. The creation of a Council of regulators has been
proposed, but the Fed will not need to seek the council's approval to act against systemic
risks.
The de Larosière Report opted instead for Model 1. It suggests the creation of a European
Systemic Risk Council (ESRC), embedded in the ECB, corresponding to the General
Council. The General Council of the ECB is composed of the governors of the national
central banks of the 27 EU Member States, plus the President and Vice-President of the
ECB. The Council would be open to a series of observers, like the Commission, the three
authorities being created from the three Lamfalussy Committees (for banking, markets and
insurance), and the 27 national supervisors. The ESRC will be able to issue
recommendations aimed at identifying and correcting systemic vulnerabilities, while national
supervisors would be responsible for the implementation. As I mentioned previously, this
model raises the issue of uniformity of treatment across the single market. The experience
over the last years has shown that national authorities tend to use at their own discretion the
room for manoeuvre that is available in the transposition of European legislation. This would
also be the case for the recommendations of the ESRC. Finally, the de Larosière Report did
not foresee any separate arrangements for the euro area. We will thus be in the very peculiar
situation in which those countries that do not participate in the euro will have two levels of
discussion and decision on systemic risk, one at the EU level and one at the national level,
while the euro area countries will have only the EU level. Unless, of course, the ECB decides
to issue itself recommendations for the euro area. One key proposal contained in the de
Larosière Report is the obligation for the national micro-prudential supervisors to provide all
the necessary information to the ECB in order to support the latter's risk analysis for the
ESRC.
From the de Larosière Report to the European Council Conclusions that will be adopted
today, there has been a long discussion between the Member States, based on a proposal
by the Commission. The main contents of the proposal have been maintained. The European
Systemic Risk Board (rather than Council) has the powers to make recommendations but not
to implement policies directly. It will be supported analytically and logistically by the ECB.
The Commission will present legislative proposals this autumn that will further specify the
new institutional arrangements. Indeed, further work is needed to elaborate in detail the
institutional framework of the ESRB, as well as of the new European authorities for
microprudential supervision.
Conclusions
The recent crisis has shown the importance of macro-prudential supervision in promoting
financial stability. A lot of work needs to be done to equip the competent institutions with the
analytical instruments to assess and monitor systemic risk and with the toolkit necessary to
contain such risks.
Some concern may arise on whether the decision-making process, in particular within
Europe and even more so for the euro area, which is expected to be set up over the next few
months will be effective in the context of the single financial market, also in comparison to the
reforms which have been put forward in the US. Implementation will be key. Indeed, as time
goes by, and financial markets show some signs of stabilisation, there is a risk that the sense
of urgency for reform fades away and nationalistic tendencies and institutional jealousies
reemerge. The forces pushing towards maintaining the status quo are gaining strength. If these
forces are not firmly counteracted, this crisis could turn out to have been a wasted
opportunity. And the next crisis could move closer.