François Villeroy de Galhau: Monitoring large and complex
institutions
Welcome address by Mr François Villeroy de Galhau, Governor of the Bank of France and
Chairman of the Autorité de contrôle prudentiel et de resolution (ACPR), at the ACPR Academic
Conference, Paris, 11 December 2017.
* * *
Good morning,
I am very pleased to welcome you to this high level academic conference jointly organised by the
Financial Stability Department of the Banque de France and the French Prudential Supervision
and Resolution Authority (ACPR). This year, the conference will focus on the challenges posed
by the monitoring of large and complex banking institutions.
It is true that large global banks might look complex. The 2008 Great Financial Crisis showed
how highly interconnected financial institutions that were exposed to overly complex derivative
products could spread and amplify domestic shocks. Since then, the "too-big-to-fail" issue has
been put high on the agenda of the Financial Stability Board and significant progress has been
made in this regard. However, there is evidence that some global banks are growing bigger and
perhaps becoming even more complex than before.
Complexity is not in itself a drawback. After all, the globalisation of trade might require a certain
dose of complexity either due to the nature of the financial products required to hedge against
traditional or newly emerging risks, or due to the organisational structures that result from
crossborder activities. Similarly, one should not preclude the diversification benefits associated with
large global financial institutions exposed to partially correlated domestic markets. The true
question is how to strike the right balance between the diversification benefits that arise from
multiple businesses financing the real economy and the potential weaknesses in risk
management caused by this increased complexity.
This morning, I will start by quickly reminding you of some key features of the complexity of the
global banking system before the financial crisis. Then, I will give a short overview of the strong
regulatory and supervisory actions undertaken to reduce inefficient levels of complexity. Lastly, I
will mention two important challenges we face today in shaping the global European banking
system.
A - Some stylised facts from the pre-financial crisis period: organisational complexities
and complex activities
Before the Great Financial Crisis, we observed a steady increase in the number of foreign banks,
1
from 784 in 1995 to 1,301 in 2007, according to Claessens and Van Horen (2014). At the same
time, the number of domestic banks decreased and, as a result, the relative importance of
foreign banks increased substantially, from a share of 19% in 1995 to 32% in 2007. This rise
might be attributable to structural factors such as technological advancements, capital market
2
liberalisations and economic integration. It was accompanied by the growing importance of
wholesale funding markets in financing banking activities and it resulted in a high degree of
interconnectedness between financial institutions.
Beyond the potential complexity of global banking's organisational structures, the financial crisis
was also preceded by increasing complexity in banking activities and financial products. For
example, the gross market value of the OTC derivative markets increased from USD 2 trillion in
1998 to USD 35 trillion at the end of 2008. The intensive use of complex and off-balance sheet
products distanced the final borrower from the final investor. As underlined by a recent IMF study,
most of the pre-crisis financial globalisation had taken place through cross-border activities with
little involvement from global banks in local retail activity. It ultimately led to a reduction in efforts
from banks to monitor the creditworthiness of their borrowers and mitigate the associated default
risks.
These two levels of complexities were exacerbated during the European sovereign debt crisis as
European banks were put under funding pressures by market participants concerned by the
opaqueness of their portfolio composition and the lack of credibility of the previous resolution
mechanism.
B - A comprehensive and strong policy response: both on the regulatory and the
supervisory sides
However, I just want to convince you of how strong the regulatory and supervisory responses
have been since then, in curbing the detrimental impacts that overly complex organisations or
overly complex activities might produce.
First, the new regulatory framework treats global and complex banks differently. Global
Systemically Important Banks (aka GSIBs) are subject to higher capital requirements explicitly
determined by the importance of their cross-jurisdictional claims and liabilities, their OTC
derivatives, and their Level 3 assets exposure. They will range from 1% and possibly up to 3.5%
of the CET1 ratio after the phase-in period (e.g. 2019).
We have seen in the past that complex financial institutions relied too much on wholesale funding
that could quickly evaporate in times of stress; the new liquidity ratios (LCR, NSFR) help to
promote the short-term resilience of the liquidity risk profile of banks and a sustainable maturity
structure for assets and liabilities. The recently agreed finalisation of Basel III reinforces the
monitoring of internal models and capital requirements on more complex activities, including the
3 4
FRTB, the CVA and the CTP on market activities.
Before 2008, we lacked the tools to implement an orderly restructuring of a bank that was failing
or likely to fail. The Bank Recovery and Resolution Directive now requires banks in Europe to
establish resolution plans (also called "living wills" by the US regulators) to anticipate the
restructuration needed in case of trouble. By defining ex ante the seniority of every creditor and
by making it possible to bail-in some of these creditors (including some senior unsecured debt)
in case of crises, we should have potentially limited the need for public funds to resolve private
bank failures.
Second, not only banking regulation but also the enforcement of its supervision have positively
reduced the detrimental effects of bank complexity. The new supervisory framework is more
consistent and harmonised. In the SSM area, large global banks are now subject to a single
supervisor, associating the ECB with national supervisors in JSTs, as is also the case for their
local foreign subsidiaries.
The euro area banks have been subjected to wide-ranging and harmonised supervisory
exercises. Stress testing exercises that apply a common methodology and common quality
assurance have been performed every two years since 2011 under the aegis of the EBA. A
transparency exercise is run every year by the EBA, generating lots of data on European banks.
Publicly disclosed asset quality reviews and comprehensive assessments have been performed
each time a bank is put under the direct supervision of the SSM since 2014. A large review of the
internal models used by the European banks (Targeted Review of Internal Models, or TRIM) is
currently performed by the ECB and aims at greater reliability and comparability of risk models
and capital.
In sum, we have set up a regulatory framework in Europe that penalises unnecessarily complex
banking activities by imposing higher capital requirements, allowing for more intrusive and
comprehensive supervision and fostering greater transparency. The new resolution mechanism
aims at extinguishing the implicit government guarantees, which provide an incentive for
excessive risk taking and levels of complexity in order to gain "too-big-to-fail" status.
C - Some challenges lie ahead: better coordination of the parties involved in the
resolution process and the necessity for cross-border consolidations in Europe
But we still face important challenges ahead. I want to stress two of them. The Single Resolution
Mechanism, the second pillar of the Banking Union, has just successfully passed its first real test
this summer with the orderly resolution of Banco Popular. However, there is still room for
improvement in the coordination between the numerous institutions and authorities involved in
these procedures. It means that every participant must know and very clearly understand its role
in the process to ensure an efficient resolution.
Second, Europe still suffers from overcapacity and cross-border consolidation is needed. In the
United States, the top five banks have a market share of more than 40% while this figure is barely
20% in Europe. Given the new regulatory and supervisory framework I described earlier, we
believe that the Banking Union should be considered - according to the criteria set up by the
BCSB - as a single geographic area. Furthermore, we are reaching the point in Europe where
facilitating healthy and well-designed cross-border mergers could actually improve financial
stability. It would make banks better able to diversify their risks, achieve economies of scale and
become more efficient. And as we have strengthened the single supervision and resolution of
significant institutions, we should not fear the "too-big-to-fail" issue. Cross border consolidation
would foster a more efficient allocation of savings towards productive investments in Europe and
it would place European banks in a better position in terms of international competition.
To conclude, interactions between policy makers, researchers and practitioners are very
valuable and I am certain that this conference will contribute to fuelling these interactions. We
strongly believe in the positive spillovers from the research function being closely intertwined with
the supervisory and financial stability divisions. In particular, empirical evaluations and theoretical
works on policy design - and we will see some of them presented today - are absolutely
necessary in order to fine tune and reinforce the regulatory reforms that have been implemented
not only in Europe but worldwide.
I wish you a very fruitful conference and I will give the floor right away to Henri Fraisse, who will
chair the first session. Thank you for your attention.
1
Claessens, Stijn and van Horen, Neeltje (2014), "The Impact of the Global Financial Crisis on Banking
Globalization", IMF working paper 14/197. Their data set covers 138 host countries for the period 1995-2013.
2
Focarelli, Dario and Pozzolo, Alberto (2005), "Where Do Banks Expand Abroad? An Empirical Analysis", The
Journal of Business, 78, Issue 6, pp. 2435-2464,
EconPapers.repec.org/RePEc:ucp:jnlbus:v:78:y:2005:i:6:p:2435-2464.
3
Credit Value Adjustment.
4
Correlation Trading Portfolio.