Nout Wellink: Looking beyond the current reforms
Speech by Mr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel
Committee on Banking Supervision, at the Amsterdam Financial Forum, Amsterdam,
17 June 2011.
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The history of The Grand dates back to 1578, even before the establishment of the
Amsterdam Stock Exchange, which is the oldest in the world. In the course of the centuries,
the buildings of The Grand underwent quite a few architectural changes and additions. As a
consequence, they have not become outdated, and today they provide a great location for
the Amsterdam Financial Forum. It is easy to see a parallel between the architecture of this
site and the future global financial architecture, the topic of this session. We need to keep
financial system regulation up to date as well and make quite a few changes and additions to
it in the course of time.
My term as governor is coming to an end. In about two weeks time, I will hand over the
presidency of the Dutch Central Bank to my successor, Klaas Knot. In these last days, I am
not going to look back on the past 14 years. Neither will I focus on what is going on in the
financial system today. Instead, I will share some thoughts with you about the future of the
financial system. That future is being shaped by a broad set of new regulations addressing
weaknesses exposed by the financial crisis. In this speech, I will briefly highlight the main
elements of these reforms. After that, I will focus on the consequences for the financial
system - both the intended and the unintended ones. Looking beyond the current reforms, I
also have a few messages for regulators and for the financial sector.
Key elements of the current reforms
The financial system is currently being reformed. Some new rules are already fully in effect,
others are being phased in or are still being fleshed out. For some issues, the approach
differs per country. Nonetheless, several key common elements can be identified. I will
discuss the following four: capital requirements, liquidity requirements, measures to reduce
excessive risk taking, and resolution measures.
Capital requirements are a first key element. During the crisis, it turned out that banks had
insufficient buffers to withstand large losses. The Basel III framework therefore sets tighter
capital standards. Most importantly, it requires that the quality of bank capital be improved. A
larger part of capital must consist of common equity, the most loss absorbing type.
Furthermore, banks will have to increase the size of their capital buffer. The new regulations
involve a higher minimum capital ratio as well as heavier risk weights for specific activities.
For proprietary trading, which caused large losses during the crisis, and investments in
resecuritisations, a complex and relatively high-risk financial instrument, banks will have to hold
much larger capital buffers. Still, in good times, risks may again be underestimated.
Therefore the new regulations also set a limit for leverage regardless of risk weights.
To further ensure the build-up of additional buffers in good times and enhance the capacity of
banks to absorb losses in bad times, the Basel III framework introduces dynamic capital
requirements. These come on top of the minimum capital requirements that must be met at
all times and by all banks. The dynamic buffer consists of two parts. One part, the capital
conservation buffer, relates the build-up of buffers to the profits of an individual bank. The
other part, the countercyclical buffer, relates it to conditions in the economy at large. This is
truly a novelty: for the first time in history, a macroprudential element has been included in
international banking regulations.
On top of the minimum and dynamic requirements, there will be a capital surcharge for
systemically important banks. This will make those banks whose failure would pose the
greatest threat to the financial system yet a little bit safer.
The second key element of the current reforms concerns liquidity requirements. These are
essential to make the financial system more stable. Liquidity and maturity transformation is at
the core of the banking business and provides a large benefit to the economy. It enables
households and companies to earn interest on savings that they can access at any time,
while providing essential long-term financing to the economy. However, when excessive,
maturity transformation creates a vulnerability to market shocks and can become a source of
instability to the financial system. During the crisis, insufficient management of liquidity risk
emerged as a major problem. Even well-capitalised financial institutions experienced liquidity
problems and central banks needed to intervene, including with unconventional measures, to
provide large scale financing and thereby prevent further escalation.
Therefore the new liquidity requirements, introduced as part of the Basel III framework, are of
utmost importance. They require banks to hold sufficient high quality liquid assets to cover
net cash outflows for a period of 30 days under a stress scenario. In addition, they set
minimum requirements for the use of long-term and stable funding sources to finance
longterm lending. Together, these measures will help to prevent excessive maturity
transformation. Given the importance of these liquidity requirements, it is worrying that the
EU has not yet shown a clear commitment to implement them in full, without any
reservations.
Next to capital and liquidity requirements, there is a variety of other measures aimed at
reducing excessive risk taking. These are a third element of the current reforms. For
instance, in the US, the Volcker rule may impose direct restrictions on trading by banks for
their own account. For banks based in Europe, excessive risk taking will be discouraged by
remuneration rules. These rules require that traders with a significant risk-taking role will
receive part of their bonus in the form of shares with a delay of several years. Thus, if
highrisk trading results in large losses, then traders will share in these losses.
The fourth key element of the current reforms consists of resolution measures. The crisis has
shown that with the current regulatory tools large banks cannot be allowed to fail, because
the costs for society would be too large. However, a bank failure can never be fully prevented
- not even with the new rules for capital and liquidity and the other measures. It is therefore
essential that any bank failure can be resolved at minimal cost and, if possible, without
taxpayer support.
Resolution measures include the preparation of recovery and resolution plans, or living wills.
These plans provide detailed guidance for emergency measures and, if these were to fail, an
orderly restructuring or bankruptcy. In addition, in some countries there is a discussion about
precautionary measures such as ring-fencing of retail activities.
Regardless of the precise regulatory approach, to make the failure of a large international
bank - however unlikely it may be - a manageable event, some banks may need to change
their structure. Unfortunately, for the near future, resolution frameworks will remain focussed
on the national level, because an international resolution regime is not politically feasible. As
a consequence, resolution can be inhibited by the complex structure of large banks, many of
which consist of thousands of legal entities all over the world that are interconnected through
a variety of financial arrangements. To be able to quickly restructure a bank in times of crisis,
these interdependencies must be made transparent and reduced.
Consequences for the financial system
The current reforms will undoubtedly increase the resilience of financial institutions and
enhance the stability of the system as a whole. However, there will also be broader
consequences for the financial system. Some of those consequences are intended, others
are unintended. Looking beyond the current reforms, which will take years to be fully
implemented, I will now say something about the outcomes. What follows refers to the
financial system as a whole, not to specific countries or institutions.
First, besides reducing risks, the reforms will inevitably lead to unintended risk shifting. The
new regulations will increase resilience and discourage excessive risk taking in of most parts
of the financial sector, but elsewhere financial risks are likely to grow larger.
For instance, risks will shift to households. There is already an ongoing trend of insurers
providing less guarantees on new life insurance policies. This is largely driven by the lessons
that institutional investors learned from previous crises, but they may well be reinforced by
new regulations, such as Solvency 2. As a consequence, households are bearing more and
more financial market risks, even though they may not be very well equipped to deal with
those risks. That is an unintended consequence.
Like before the crisis, risks may also shift to unregulated entities that form a shadow banking
system. Maturity and liquidity transformation do not only take place within the official banking
system, but also outside it. To some extent, this is being addressed in the current reforms.
However, some part of financial innovation will always be aimed at circumventing existing
regulations. An unintended but likely outcome is therefore that over time, risks will again shift
to yet unregulated areas. The response should not be to control innovation, but to closely
monitor the main vulnerabilities in the financial system and adapt the regulatory framework
when necessary.
A second consequence for the financial system is that the reforms will induce changes to
business models. For banks and insurers, some activities and investments will become less
attractive due to the current reforms. Banks may move out of certain trades for their own
account, for instance, because the required capital buffers will reduce the return on equity.
Under Solvency 2, insurers may find it unattractive to continue investing in complex
structured products, because of the high risk weight and the detailed analysis that is required
of the underlying assets. Furthermore, retail deposits will become a favoured source of bank
funding, as a consequence of the new liquidity requirements. These are just some examples.
Such changes in business models are not merely side effects; they are a necessary outcome
of the current reforms. Changes in business models are a fully intended consequence. If
there would be no significant changes to business models, and if that would mean that risk
profiles remained too high and potential threats to the stability of the financial system were
insufficiently addressed, then we will need to see a further tightening of the rules.
The most profound changes to business models will probably not result from capital or
liquidity requirements or from other measures to reduce excessive risk taking. Instead, the
most profound impact will come from resolution measures. That is because effective
resolution measures will put an end to the "too big to fail" or "too big to save" status of
systemically important financial institutions. When they loose this status, large financial
institutions will also loose important competitive advantages over smaller and less
interconnected institutions.
At present, systemically important banks enjoy an implicit subsidy on their funding costs. This
is apparent in credit ratings, for instance. Credit rating agencies assign higher ratings to large
banks than their intrinsic financial strength would justify. The rating enhancement reflects the
probability of government support and can be as large as five notches. For smaller banks,
the enhancement is lower or even zero, because it is perceived that smaller banks are less
likely to receive government support when they get in trouble. Effective resolution measures
will thus eliminate the support-related rating advantage and lower funding costs of large
banks. A capital surcharge for systemically important banks fits with this reasoning and
compensates for the unfair benefits of being very large. This is a fully intended consequence
and will enhance economic efficiency and market discipline.
But there may be unintended consequences too. Ideally, governments would agree an
international resolution framework, but that requires international burden sharing in case they
would have to support the restructuring of a cross-border bank. At present, this is not a
realistic option. The alternative, national resolution regimes, imply that some degree of
autonomy for domestic retail operations may be a necessary precondition for effective
resolution. This comes at a cost. Financial integration can make financial markets more
efficient, especially within a common market like the EU. It enables banks to raise funds
where they are readily available and invest those funds where they generate the largest
return, even if that is in another country. In addition, banks can diversify their risks by
combining retail and investment banking. If the economic benefits from international and
universal banking operations cannot be fully realised, that would be an unintended and
indeed an undesirable outcome.
A third consequence of the current reforms is that they will have an impact on financial
markets. We know for sure that there will be an impact and we can almost be sure about the
direction of some changes. For instance, banks will need to attract more stable long-term
funding. At the same time, European insurers, which are important providers of bank funding,
show an increasing preference for investment in covered bonds because of the low capital
requirements under Solvency 2. Together with a range of other factors, this will give a boost
to European covered bond markets.
However, we cannot be sure how large and how permanent the changes will be. That is
because there are many different factors at work. Some market participants, such as pension
funds and other large investors, are much less affected by the current reforms. They will
respond to changes in market prices and this may partly offset the impact of new regulations.
This makes the overall impact on financial markets uncertain.
It is therefore important that major new regulations are phased in gradually. The new liquidity
measures for banks provide an example of this approach. They are phased in over four to
seven years to prevent large shocks to financial markets. In addition, they are subject to an
observation period to facilitate mitigation of undesirable outcomes.
A fourth consequence from the current reforms is that the financial system will continue to
suffer from important distortions. In other words, there will be incentives for financial
institutions to behave in a way that is not in the public interest. Of course, this will always be
the case. The perfect world of economists, without distortions or frictions of any kind, exists
only in their models. Still, it is worth pointing out a few important distortions that the current
reforms have been unable to tackle.
Perhaps the most important distortion is that high leverage will remain attractive for financial
corporations because interest payments are tax deductible. This makes it attractive for a
company to use more debt financing and less equity capital than would be desirable from a
social point of view. Of course, this distortion exists for non-financial corporations as well. Yet
in the financial sector it is more troublesome, because tax considerations do not just have an
effect on the funding choices, they also stimulate the design of tax-driven financial products.
Such products may add little economic value, but create leverage and complexity, increasing
vulnerabilities in the financial system and making them more difficult to monitor.
Another distortion is that the current reforms are not uniform across countries. For example,
countries with a large financial sector, such as Switzerland, will require large banks to hold
more capital than the international standard. Furthermore, EU remuneration rules will apply
to the global operations of banks headquartered in Europe and the US Volcker rule will apply
to the global operations of banks headquartered in the US. The lack of uniformity has the
unintended consequence that banks operating abroad in the same market, but
headquartered in different countries, will each have to observe different rules. This causes
unfair competition, induces arbitrage and creates complexity. However, just as with
resolution frameworks, it is a political reality that some reforms, however desirable they may
be, can only be passed at the national level.
Concluding remarks
Looking beyond the current reforms, there will be major changes to the financial system,
some intended and others unintended. Regulators will have to monitor the consequences
carefully and respond to what they see. Risks will shift away from where they are regulated
most tightly. Regulators will also need to evaluate the impact on financial markets and the
effects of market distortions. If they detect the emergence of new vulnerabilities, rules will
need to be adjusted. Furthermore, business models have to be adapted. If the largest banks
do not undergo a substantial transformation, a further tightening of banking regulations will
be required to produce the intended outcome.
One thing is certain: beyond the current reforms, further reforms will be necessary to
safeguard the stability of the financial system. It took ten years to develop the Basel II
framework. The current, more profound reforms will have taken shape in about half that
period. Future regulators should continue this trend and make sure that regulation of the
financial system keeps evolving, especially when public concerns about global financial
crises fade away. And ideally, the next round of reforms should be even more harmonised at
the international level, to reduce unfair competition and unproductive barriers to financial
integration.
I also have two messages for the financial sector. First, within the new regulatory framework,
it is important that financial institutions continue to strengthen their own risk assessments. To
all executives that are present here, I would say: you have a responsibility of your own as
well.
Second, risk shifting and financial innovation imply that the regulatory framework will
continue to evolve and will never be completed. Therefore your business models should be
sufficiently flexible and not fine-tuned to a current set of regulations. You have seen that
most of today's regulators are quick and determined to pass the necessary reforms. I am
confident that this will also apply to tomorrow's regulators, who will continue to make
changes and additions to the future global financial architecture.