Fernando Restoy: Regulation and banking reform
Closing address by Mr Fernando Restoy, Deputy Governor of the Bank of Spain, at "The new
financial regulatory system and its implications" event, University of Oviedo, Oviedo,
28 October 2013.
* * *
Good morning. I would like to thank the Dean, Manuel González, for his kind words of
introduction and for inviting me to deliver the closing address at this event in the University of
Oviedo. I would also especially like to thank Julio Segura for "brokering" my participation in
this session today. I don't always have to say yes to everything my former mentor and boss
proposes to me, but I have never regretted doing so.
Given the academic profile of this forum, allow me to step back from the immediate
challenges of supervisory policy - which, as can be imagined, are numerous and complex in
the midst of a financial crisis - and to take this opportunity to reflect, from a more general
perspective, on the profound transformation taking place in the regulatory framework of the
banking sector in response to the international financial crisis.
As usually occurs with crises triggered by significant shocks affecting the stability of the
financial system, this crisis is very costly in terms of welfare. In the case of Spain, we have
suffered a double-dip recession associated with the collapse of the real estate sector against
a backdrop of profound macro-financial imbalances and marked turmoil in international
markets. This double-dip recession has pushed us off the growth path we were on just five
years back and halted the process of real convergence. GDP per capita in Spain currently
stands at 90% of the euro area average, after having exceeded 95% in 2007. Or, if you
prefer, production per capita, after rising notably in the pre-crisis years, today scarcely
exceeds the levels of a decade ago.
Fortunately, the latest data support expectations of a gradual recovery of the Spanish
economy, which might have already begun in the third quarter of this year according to data
published by the Banco de España last week. However, the task ahead of returning to
sustainable growth to place us back on track to regaining forgone prosperity remains
formidable. This includes progressing further with the major reforms already undertaken in
various areas, including the financial sector. In this latter field, nevertheless, the significant
measures to be adopted in our country are closely linked to the regulatory reforms designed
at European and international level.
In fact, the crisis has underlined noticeable deficiencies in the regulatory framework of
banking. I imagine that during today's seminar you will have analysed them in detail. In short,
I think that the regulatory system was not conducive to adequately measuring the significant
risks taken by institutions; to providing the necessary incentives for controlling them; to
ensuring sufficient capacity for absorbing losses when they materialised; and, finally, to
avoiding contagion to the sector and to the economic system as a whole with the subsequent
adverse consequences on public finances, growth and unemployment.
In response to these deficiencies, the main international authorities have agreed and, in
some cases, already implemented important reforms affecting nearly all significant aspects of
financial activity.
Allow me today to focus on what I consider are the three pillars of global regulatory reform of
the credit sector: first, measures to strengthen the solvency of banks; second, reforms to
facilitate the orderly resolution of non-viable institutions; and, finally, the structural measures
to set limits on credit institutions' business model.
Solvency legislation
Let us begin with the solvency rules. The new solvency rules, known as Basel III, introduce
significant changes in prudential requirements which envisage not only an increase in the
amount and quality of capital required, but also supplementary prudential oversight aimed at
strengthening the resilience of banks and the financial system as a whole. This new
framework has been incorporated, as you know, into European legislation through the
Capital Requirements Directive and Regulation which will be implemented on 1 January
2014.
Basel III includes far-reaching changes. First, it requires banks to considerably increase their
loss-absorbing capacity. The basic instrument used is the introduction of a minimum level of
top quality capital (core capital or common equity tier 1) which amounts to 4.5% of
riskweighted assets. On top of this minimum, an additional capital conservation buffer of 2.5% is
introduced, which must be built up once the transition periods envisaged have ended,
although it may be used in times of need. Thus, banks, as a rule, will have to maintain a
minimum level of top quality capital of 7% in terms of their risk-weighted assets.
This CET1 capital ratio is calculated, furthermore, using more stringent criteria than those
currently used. Thus, the admissibility requirements for eligible instruments have been made
significantly more restrictive and deductions have been increased; for example, those
relating to goodwill, qualifying holdings and deferred tax assets. For an idea of the overall
impact of these measures, it suffices to say that the minimum CET1 requirement of 2% under
the previous legislation could be, on average, around 1% if the new requirements are
applied. Therefore, effectively, the minimum CET1 requirement, increases by around six
percentage points in relation to risk-weighted assets. And this aside from the supplementary
requirements which may be made of each institution based on its specific risk profile under
the so-called Pillar 2 of the Capital Accord.
In this way, credit institutions will have more and better quality capital to withstand the losses
which might be caused by their activity. Nevertheless, as we have seen in the crisis, the
availability of a large volume of capital does not per se guarantee an institution's resilience in
the face of sufficiently adverse shocks. That justifies the introduction of further restrictions,
such as those setting a maximum leverage ratio and minimum liquidity, which are currently
subject to an observation period that will culminate in them being definitively parameterised
and incorporated into the new regulatory requirements.
Finally, the new legislation includes macroprudential tools which seek to complement the
requirements aimed at strengthening each institution's solvency with obligations directed at
protecting the system as a whole. Two measures stand out among the macroprudential
measures envisaged: those seeking to reduce the procyclicality of microprudential regulation
by introducing a countercyclical capital buffer, and those aimed at mitigating the systemic
effects of the possible insolvency of individual banks. The second set of measures includes
an additional capital buffer for systemically important banks, which is complemented by
supplementary requirements for those institutions with the capacity to affect the global
financial system. Further, the new legislation includes the adoption of additional
macroprudential controls (in the form of capital buffers, changes in risk weightings, etc.) for
banks on the basis of their exposure to specific sectors where marked imbalances can be
identified.
Undoubtedly, these regulatory changes will exert a noticeable positive effect on the capacity
of banks to withstand periods of stress and that will result in less frequent and milder crises
which, furthermore, should entail lower costs for the public.
That said, the new prudential legislation admittedly entails considerable challenges as to its
implementation, and its introduction will restrict the capacity of banks to run risks. For this
reason, it is appropriate, especially taking into account the relatively weak economic activity
in Europe at present, to consider prudent implementation timetables taking advantage of the
flexibility in the Basel Accord and in the new European solvency legislation.
We should apply the same prudence in the introduction of the new leverage and liquidity
requirements. The observation periods currently in force should be used to painstakingly
assess the resulting effects and, in particular, to better understand the possible interaction
between the two tools.
Finally, in the area of the implementation of Basel III, we should not forget that there is still
one issue to be resolved. It is important to ensure that the application of the new capital rules
yield results which are comparable and consistent across institutions and countries.
Specifically, the capital requirements for two institutions with a comparable risk profile should
be similar, irrespective of the jurisdiction or jurisdictions in which they operate. In particular,
although progress has been made recently in this area, additional effort is required to ensure
that the internal models used by institutions and authorised by their supervisors to calculate
risk weightings do not produce uneven results which question the robustness of the solvency
ratios and introduce competitive distortions.
Legislation on resolution
The second major reform I would like to comment on refers to rules on the resolution of
nonviable institutions.
Traditionally, the principle of constructive ambiguity has prevailed when action is taken by
authorities in the face of problems of bank solvency. Under this approach, financial
institutions' liabilities - except for guaranteed deposits - do not formally qualify for specific
legal treatment, aside from the seniority established in the case of bankruptcy in accordance
with conventional commercial law. However, the authorities have used discretionary power to
protect the holders of banks' debt instruments - through capital injections which have
prevented the winding up of such banks - when they have considered that their bankruptcy
could entail undesired systemic effects.
In the recent past, it has become evident that the systemic effects of banking crises can be
very marked, even when they affect institutions of no great size. Consequently, constructive
ambiguity has resulted, at least in the first stage of the crisis, in widespread public action to
assist ailing institutions. This has confirmed the existence of an implicit public guarantee of
bank liabilities which, when activated, has generated considerable costs for the public
finances of the countries most affected. Constructive ambiguity generates an incentives
system which makes it difficult for institutions and their creditors to manage risk
appropriately.
Thus, the restoration of an effective incentives system needs to limit confidence in public
support schemes being activated across the board. That requires striking a suitable balance
between measures to minimise the probability of the bankruptcy of systemic institutions - by
imposing supplementary capital buffers - and, in the case of more complex institutions, the
design of contingency action plans which ensure orderly resolution if a state of non-viability is
reached. This is, in essence, the content of the work undertaken recently by the Financial
Stability Board.
In any event, the essential ingredient of orderly bank resolution schemes is the specification
of a bail-in arrangement establishing a clear order of priority for the claims of shareholders
and the various types of creditors that can be activated before insolvency proceedings are
commenced and before any State aid is made available. The credibility of this framework will
favour the appropriate perception of the risk effectively entailed by each liability instrument
and will minimise the bill to be borne by taxpayers to prevent the disorderly winding-up of
banks.
In the European arena, we have progressed greatly in the definition of a regulatory
framework for the resolution of non-viable banks. There is already political agreement on a
proposed Recovery and Resolution Directive which will establish a clear burden-sharing
system for insolvent banks and thus minimise the possible cost of rescue for taxpayers.
This Directive is also a first step in the creation of a single resolution mechanism to
supplement the nascent single supervisory mechanism which will enable a real banking
union to be set up in Europe. This project is essential to overcome the problems of
fragmentation which still beset European markets and which cause the perception of risk
associated with banks' liability instruments to differ depending on the jurisdiction in which
they operate.
However, as you know, to ensure that non-viable banks are resolved in the same way in the
various Member States of the euro area, it does not suffice to have a set of common
regulations; rather, it is necessary to have a single resolution authority to ensure that the
regulations are applied uniformly in all countries.
Similarly, the financial support needed for orderly bank resolution must be available under
similar conditions whenever required. Clearly the lack of a full European resolution
mechanism (including uniform rules, a single authority and a common fund) would limit the
effectiveness of the single supervisory mechanism. In that case, the single supervisory
mechanism would have to resort to a complex system of interaction with the national
authorities (which would have to continue using their resources to cover the fiscal effects of
the problems of non-viability detected by the supervisor) to ensure financial stability.
In this respect the draft legislative proposal submitted by the European Commission (EC) last
July for the establishment of a single resolution mechanism is very timely. The EC proposes
the creation of a single resolution agency or authority, which would manage a common fund
fed by contributions from the industry and ultimately report to the European Commission.
It is true that some countries have expressed doubts as to the legal basis of the proposal.
Moreover, this initiative may possibly assign excessive protagonism to the EC in some
cases. Nevertheless, it is important that a political agreement be reached rapidly, allowing
the creation of a scheme which will contribute not only to remedying the current
fragmentation of the bank instrument market in Europe, but also, as I mentioned earlier, to
the effectiveness of the single supervisory mechanism.
Structural measures
Finally, the third pillar of global regulatory reform I wish to briefly inform you of is the
measures aimed at restricting the business model of financial institutions. Here I refer to the
Volcker rule in the United States, to the conclusions of the report drafted by an independent
commission chaired by John Vickers in the United Kingdom and to the proposals in the
European Union by a group of experts chaired by the governor of the Bank of Finland, Erkki
Liikaanen.
The rationale of these reforms leaves little room, conceptually speaking, for discussion. In
the years leading up to the crisis, banks devoted a substantial amount of funds to proprietary
trading and own-account investment activities which notably increased the size and
complexity of their balance sheets. This expansion of business may be partly related to the
ease with which banks can access funds in a setting in which, as I described earlier, bank
liabilities (and particularly the most traditional type, such as deposits) enjoy a kind of implicit
public guarantee. That is to say, some banks have been able to use the taxpayers'
guarantee to assume excessive risks which have made it increasingly likely that the
guarantee will be called upon. Structural measures are intended, in this respect, to prevent
risky activities such as proprietary trading from being pursued by banks which simultaneously
take deposits from the public.
Unfortunately, these initiatives have remained outside the bounds of international
coordination and, more specifically, lie beyond the remit of the Financial Stability Board
(FSB), which has given rise to a lack of uniformity across jurisdictions.
For example, although the US proposal permits deposit-taking institutions to engage in a
wider range of activities than the European proposal does (including market-making
activities), it does require the activities of unrelated entities to be totally separated. The
proposal currently under discussion in Europe would permit the creation of financially
independent subsidiaries to accommodate the activity of investment within a group also
authorised to engage in traditional commercial banking. We are therefore confronted with the
need to achieve closer international coordination to ensure the consistency of the reforms
under way in the various jurisdictions. Otherwise the cross-jurisdictional inconsistencies may
encourage regulatory arbitrage which would reduce the effectiveness of the reforms adopted
and put at risk the sought-after simplification of banking.
In any event, the implementation of measures of this type affecting the specialisation of
banking activity should be accompanied by an appropriate cost-benefit analysis. In this
respect, it should be kept in mind that the crisis has not demonstrated the superiority of any
specific model and that, by contrast, it has witnessed the collapse of all manner of
institutions, whether they be specialised in traditional business, in investment banking or in a
combination of the two. Moreover, given that the introduction of restrictions on banking
activity means forgoing the potential benefits of diversification, it is essential to ensure that
these are smaller than the risk of combining traditional banking and own-account investment
activities, even after the entry into force of solvency regulations which strengthen and step up
prudential controls. Finally, it is necessary to assess as precisely as possible the impact
structural measures may have on the location of risk outside the regulated sector and on the
liquidity and efficiency of securities markets.
More generally, we still lack an overall analysis of the diverse regulatory changes envisaged
in the three areas in question, of their internal consistency and of their combined impact on
the financial system and on the economy in general. For example, at the limit it could be
argued that structural measures (perhaps those having the greatest impact on the business
strategy of the main banks) are the least necessary if we are confident that the combination
of the new solvency requirements and the reform of resolution regimes will really minimise
the government support required to protect deposits. Furthermore, although the soundness
and solvency of banks tend to strengthen their capacity to grant credit, it is true that the
combined effect of all the measures will (by their very nature) tend to reduce the profitability
of banking and banks' ability to channel savings to business activities involving risk. Further
evidence on the quantitative importance of this effect would be useful for assessing the key
parameters of each measure.
Effects in Spain
Against this background, how do the regulatory changes affect the Spanish banking sector?
It is true that the regulatory avalanche represents a huge challenge for Spanish banks, but I
do not think that it is greater than that faced by other banking systems, especially after all the
financial reforms adopted in Spain over the past year.
Currently, we have confirmation that Spanish banks are reasonably capitalised, that they
have substantially improved their liquidity situation and that their leverage ratios are relatively
low, in comparison with those of other European banks. In addition, the bank business model
in Spain continues to be based on traditional commercial activity so that own-account
investment securities portfolios are generally moderately sized. As a result, the structural
measures that may be approved by the European Union will have a more limited impact on
Spanish banks than on banks in other jurisdictions. Moreover, international banks have
established a model of independent subsidiaries that is conducive to the application of simple
resolution arrangements.
At the same time, unlike in most jurisdictions, we have already had for more than a year very
advanced legislation on resolution that has been applied in the process of restructuring our
financial system and that has entailed a significant saving of public funds.
That said, it is true that some specific aspects (especially associated with the deductions
introduced for regulatory capital) could be specially demanding for certain Spanish banks,
which are already responding in their strategic plans. More generally, the pressure exerted
by the market on the availability of capital (beyond the new minimum regulatory
requirements) requires an on-going effort to preserve capital and, specifically, to maintain
prudent cost containment and dividend policies.
Also, it is clear that the productive specialisation of our economy and its dependence on
bank financing make it vulnerable to any adverse impact of the new regulation on the ability
of banks to finance the real economy. To counter this, all we can do is take advantage of the
timetables established to ensure our institutions gradually adapt to the new requirements
and, above all, work at the same time to promote the development of our capital markets in
order to increase their capacity to intermediate the economy's financial flows.
All told - and I will finish here - the main challenge we face, as I have already mentioned, is
the persistent fragmentation of European markets (despite the recent improvement) and the
consequent link between sovereign risk and banking risk. Accordingly, our financial system
will be significantly strengthened by the setting up of an effective banking union with all the
important components, including the single resolution mechanism. Once again, it is clear that
defence of the national interest requires unreserved support for initiatives that tend to deepen
and speed up the process of European integration.
Thank you very much for your attention.