José Manuel González-Páramo: Reform of the architecture of the
financial system
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the Universidad del País Vasco, Campus de Leioa, Bilbao,
21 June 2010.
* * *
I am very grateful to Frank Dierick for his contributions to this speech and to Inês Cabral and Balázs Zsamboki for
inputs.
Ladies and Gentlemen,
I. Introduction
It is a pleasure to be in the city of Bilbao, which hosts one of the finest modern art museums
in Spain and Europe: the Guggenheim museum. With its very distinct architecture, this
museum is the city's world-famous hallmark. Much as I love the design of the building,
however, I will talk today about another type of architecture, namely that of the financial
system. And just like the Guggenheim building, the current reforms of the financial system
stir a lot of emotions.
We are dealing here with a very broad topic but I will approach it like a tourist visiting the
Guggenheim museum. I will start by giving you a broad overview, describing the landscape
as it were. I will briefly review the causes of the financial crisis and will run through the main
initiatives that are on the plate of policy makers to prevent a crisis of such magnitude and
severity ever recurring again.
Then I will turn to four eye-catching initiatives:
 first, the establishment of the European Systemic Risk Board or ESRB, a new body
that will for the first time become responsible for macro-prudential supervision in the
EU;

second, how policy makers are dealing with systemically important institutions;

third, the issue of procyclicality or the dynamic interplay between the financial sector
and the real economy;
 fourth
and last topic to which I will pay some more attention is the mandate of
central banks in the area of financial stability.
Let us now embark on our architectural walk!
II. Causes of the current crisis
Much has been said about the root causes of the current crisis over the past three years. I
will not expand on this topic but I will just mention specific factors - some of them of a macro-
and others of a micro-economic nature - which in my view were key in the run up to the
crisis.
In the two or three years before the crisis erupted, a constellation of factors, including very
favourable macro-financial conditions combined with strong growth, low inflation, ample
liquidity, exceptionally low volatility across virtually all financial markets and extraordinarily
low risk premia, had the effect of covering up the building up of significant imbalances.
Significant financial imbalances were in the making, at various levels of the global economy
and financial system. Among these were exuberant real estate prices, and a flourishing
securitisation business, which facilitated excessive credit growth. A group of countries
- including China, Japan, and oil-exporting economies - were saving too much, while others
- such as the US - were heavily borrowing to finance consumption and investment. These
developments were unsustainable in the long-run. At the same time, in an environment
characterised by low interest rates, a global search for yield may have led investors to take
on too much risk.
On the micro side, it became apparent that market participants' incentives were not aligned
with the risks they were taking, and that some investors were not fully aware of the extent of
their exposures, which contributed to the under-pricing of risk. In the banking sector in
particular, deficiencies in the design of the prudential framework for banks, in the supervisory
review of banks' risk management procedures and in the rules for compensation and pay
were some of the microeconomic factors leading to important vulnerabilities.
III. Regulatory and supervisory initiatives currently under discussion
After witnessing the first global banking crisis since the Great Depression, it became clear
that it was absolutely crucial to get the banking sector on a sound footing again. Policy
makers responded rather quickly and forcefully to the crisis, which resulted in a
wideencompassing reform agenda.
This reform agenda is very ambitious and time-wise rather tight, but before describing the
measures under discussion, let me first briefly introduce the main actors in this area. The
G20 provides the political and strategic impetus for the reforms, with the Financial Stability
Board (FSB) playing an important role in the policy coordination. Various committees and
working groups, of which the most prominent is the Basel Committee on Banking
Supervision, are charged with reviewing specific international standards.
As regards the reform agenda, the most important issues are the following:

the adoption of high-quality capital and liquidity standards for banks,

measures to reduce the financial system's procyclicality,

the introduction of a regulatory framework for systemically important financial
institutions,

the regulation of credit rating agencies and hedge funds, improving OTC derivatives
markets, and

finally, sound compensation practices that support financial stability.
These issues are comprehensively addressed by the Basel Committee's reform package that
aims to strengthening the banking sector's resilience and represents a cornerstone of the
response to the crisis. The package, which was released at the end of last year for
consultation, aims at improving the quality and consistency of bank capital. It also considers
the introduction of a non-risk-based leverage ratio as a supplementary capital measure. This
leverage ratio is expected to curb excessive balance sheet growth and to set a floor for the
Basel II capital requirements. In order to mitigate the inherent pro-cyclical nature of financial
Committee's
activities, to which I will return later, the Basel proposals also contain capital
buffers and forward-looking provisioning. Finally, the proposals include global minimum
liquidity risk requirements enabling credit institutions to withstand a short-term liquidity stress
and aiming to ensure longer-term stability in their funding requirements.
The objective of this comprehensive package is to enable financial institutions to better
withstand the adverse effects of economic shocks. In order to assess the cumulative impact
of the proposals, quantitative impact assessments are underway. The outcome will be
available in the coming weeks, and will assist decision-makers in properly calibrating the
measures. At this stage, therefore, it is premature for me to say anything about the desirable
calibration of the measures. Nevertheless, I am of the view that the measures are warranted
from a conceptual point of view, though their cumulative impact needs to be carefully
assessed. Indeed, it is important that the right balance is struck between enhancing banking
stability and maintaining a stable provision of credit to the economy.
IV. What has been done?
The main strands of the reform agenda I come to paint are at various stages of development.
It is therefore useful to briefly run through what has already been achieved, in particular in
Europe.
prudential framework for
Starting with the banks, most FSB members, including the EU
Member States, have fully implemented the more risk-sensitive Basel II framework.
Amendments to the trading book are due to be implemented no later than the end of 2011 to
address the problem of excessively low capital charges for trading activities in the pre-crisis
period. In the EU, the appropriate measures are included in amendments to the Capital
Requirements Directive, the so-called CRD3 package.
The FSB just finished its peer review on how its members implemented the agreed principles
for sound compensation practices. In the EU, the CRD3 has specifically included banks'
remuneration policies in the supervisory review.
An EU regulation on credit rating agencies - which will come into effect at the end of 2010 -
was adopted last year. The European Commission has recently proposed amendments to
the regulation which aim to introduce a centralised framework for supervision of the agencies
at the EU level. Under the new supervisory framework, an European Securities and Markets
Authority with oversight and supervisory powers over credit rating agencies will be
established. Efforts in this field aim to address some shortcomings of the credit rating sector
revealed by the crisis, such as conflicts of interest, poor rating quality and insufficient
transparency about the methods used for their evaluations and the procedures for rating
decisions.
A legislative proposal that establishes regulatory and supervisory standards for hedge funds
is also under consideration in the EU.
Finally the two major accounting standard setters, IASB and FASB, are continuing their
efforts to achieve convergence of accounting standards, though it might not be possible to
keep to the initially agreed time table.
I turn now to a very important response in Europe to the crisis, which is of particular interest
for the ECB: the establishment of the European Systemic Risk Board or ESRB. This new
body will be responsible for macro-prudential supervision in the whole EU. In contrast to
micro-prudential supervision, which focuses on the financial soundness of individual
institutions, macro-prudential supervision looks at the financial system as a whole.
Up to the late 1990s, the predominant view of policy makers was that if individual institutions
were financially sound, the financial system as a whole would also be fine. Unfortunately, this
is not always the case. Through various channels, institutions can be inter-linked so that
problems emerging from one or some of them may spill over to the rest of the financial
sector, setting in motion an adverse dynamic that affects all of them. A macro-prudential
perspective, looking beyond the conditions of each institution in isolation, should help to
detect and prevent such system-wide potential problems.
Of course, there were already in place mechanisms for the monitoring and assessment of
financial stability well before the financial crisis erupted, as evidenced by the financial
stability reports published by the various central banks. But the financial crisis also
demonstrated fundamental weaknesses in practices:

First, while various central banks engaged in their own financial stability analysis
there was not really a comprehensive analysis covering the whole EU and all
elements of the financial system.

Second, many of the analyses expressed serious concerns, such as the persistence
of global imbalances and the investors' hunt for higher yields, but these concerns
were not sufficiently followed-up by concrete action.
There is therefore a need to improve the interplay between micro- and macro-prudential
supervision since many tools to correct for possible risks are in the micro-prudential realm.
To this aim, the ESRB will be able to issue risk warnings and, where appropriate,
recommendations and follow-up on their implementation.
The legislative proposals for the establishment of the ESRB that are currently being
discussed among the relevant European institutions foresee an important role for the ECB in
the ESRB and we stand ready to take up this role. We will do this with the support of the
other members of the European System of Central Banks (ESCB), the constellation of the
national central banks of the European Union. The ECB will support the ESRB by providing
analytical, logistical and administrative support to the ESRB as well as the ESRB Secretariat.
Preparatory work at the ECB is underway so that the ESRB can take up its work right after its
formal establishment, which is expected for early next year.
The ECB is also in the process of enhancing its own capabilities for monitoring and
assessing financial stability risks, not least to provide high-quality analytical input to the
ESRB. In the pursuit of this objective, we also try to draw as much as possible from
synergies with existing work and resources both within the ECB and the ESCB, as well as at
the supervisory authorities.
I conclude on this point that the establishment of ESRB will be a watershed event in
developing a macro-prudential framework for Europe. Having said that, I should also say that
the ESRB does not have an easy mission and it certainly faces many challenges.
Macroprudential supervision is relatively new, which implies that a well-established framework with
a clear operational objective, as we know for monetary policy, must yet be set in place. The
ESRB will therefore have to develop its own thinking and strategy, and will probably have to
advance in a pragmatic way.
The interplay with the micro-prudential function will be crucial, not only because the ESRB
will have to rely to a large extent on micro-prudential supervisors for the information and the
data, but also because a number of the tools that can be expected to address potential
weaknesses in the financial system are of a micro-prudential nature. In that respect, I should
recall that the ESRB will not have any binding powers but will have to rely on moral suasion
and peer pressure for the follow-up to its risk warnings and recommendations. And finally the
ESRB will have to strive for effectiveness and efficiency in the pursuit of its tasks, given its
relatively wide composition (over 60 members).
V. A look into the future
Taking a forward-looking perspective, I am sure that one of the important topics that will be
on the ESRB's agenda is that of the systemically important financial institutions (SIFIs).
These institutions are major contributors to what in the financial jargon is known as "systemic
risk" and are, therefore, of great interest to macro-prudential supervisors. How to gauge the
contribution of a financial institution to systemic risk, in other words how to identify a SIFI, is
a very difficult task, not least because of data limitations. Nevertheless, there are a number
of factors that seem to be particularly relevant, such as the size of the institution, its
interconnectedness with the rest of the financial system and the degree of substitutability in
the event of a failure of the critical services they provide. It is clear that any such assessment
cannot be exclusively based on a quantitative approach. Rather, the informed judgment of
the relevant authorities, guided by internationally agreed principles, will play an important
role.
Indeed, the concept of systemic risk is fuzzy and still under debate, but, with a certain degree
of simplification, it can be defined as the risk of an impairment in the financial system that
has potentially serious negative consequences for the real economy. For example, the actual
default of a major bank may seriously affect depositors' savings (though reimbursement up to
the insured level of retail deposits is to be provided by deposit insurance schemes) and the
financing of otherwise profitable investment projects.
But even in case of no actual default, SIFIs may pose serious challenges. Because of the
potentially high damage to the financial system and the real economy in case of default,
there is the expectation that governments and supervisors would not let a SIFI fail. This
implicit support may provide an incentive to the institution to engage in profitable but risky
activities, giving rise to "moral hazard". It also means that a SIFI can finance itself at a lower
cost compared to other similar institutions, which are not deemed to be systemically
important. In short, incentives are misaligned and the playing field is distorted. These
problems have probably increased in the wake of the financial crisis following some of the
voluntary, and less-voluntary, marriages among institutions that have created even bigger
and more complex financial groups.
Reflecting these concerns, at the G20 summit of April last year in London, it was decided that
SIFIs should be subject to an appropriate degree of regulation and oversight. At the same
time, the G20 entrusted the FSB with the task of overseeing concrete regulatory steps and
monitoring their implementation. The FSB is now considering various policy options to
address the concerns I mentioned.
In general terms, there are two ways to address ex ante the problems that SIFIs pose: you
can restrict the scope of their activities or force them to internalise the costs they pose to the
system. The clearest illustration of the first approach is the discussion on the "Volcker rule" in
the United States. Under this rule, banks that receive deposits would be prevented from
engaging in proprietary trading, and investing in or sponsoring hedge funds and private
equity funds. I do not believe this is the most fruitful way to pursue in Europe, given the
traditional strength of the universal banking model in a number of Member States. Also, there
may be challenges associated with defining the borderline between the proprietary trading
and servicing clients. But more importantly, the activities that are seen as deserving special
attention may move outside the intensively regulated and supervised banking business, but
stay within the same group.
One could argue that the same effect of controlling for risks stemming from the trading
business can be reached by imposing higher capital requirements on banks' trading book
activities, and this seems to be the way that is being pursued internationally. The Basel
Committee has already increased the capital requirements for a number of trading book
activities, and a fundamental review of the trading book is planned for next year.
The Basel Committee is looking as well into how to get the SIFIs to internalise the potential
costs they pose to the financial system. This can include a variety of measures, such as
higher capital and liquidity requirements, more intense supervision, concentration limits, etc.
Work is still under way on defining such possible measures. The FSB is expected to provide
recommendations to the G20 summit of November in Seoul.
An alternative way to make banks internalise the externalities they pose on the financial
system is through a bank levy. A levy responds more directly to the need to raise a
contribution from the financial sector in order to pay for the cost of past or future financial
crises, depending on whether the levy is imposed ex-post or ex-ante. For instance, the
proceeds raised by a levy can be destined to finance a dedicated fund to be activated in the
future for the orderly winding down of distressed banks. The EU Commission is moving
forward in this area, with the aim of establishing a common framework for a levy in the EU
member states. The IMF is also finalising a report on this topic for the G20 summit later this
month in Toronto. In my view the discussion should be properly framed in the overall reform
of the prudential framework, including the quantitative impact assessment of the various
initiatives I mentioned earlier. Such a careful assessment is warranted, inter alia, to avoid
imposing an undue burden on the banking sector and, ultimately, hamper the flow of credit to
the real economy.
Another important element of the Basel reform package is the introduction of a range of
measures designed to mitigate the inherent pro-cyclicality of the financial system. In this
context, mechanisms that enhance prudent and forward-looking provisioning of banks as well
as the building up of sufficient capital buffers in years of economic expansion that can be
drawn down at times of stress, are all under consideration. Overall, these measures aim at
ensuring that the financial system functions as an absorber, rather than an amplifier of
shocks, thus smoothing the volatility of the financial and real economic cycles.
In setting up a more forward-looking provisioning framework, the Basel Committee works
closely together with the accounting standard setters with a view to developing a sound
operational framework for expected loss provisioning. In this context, let me mention as very
important the collaborative efforts under way between the Basel Committee and the IASB to
develop a revised expected loss model that proves operational.
Concerning measures on capital buffers, the Basel Committee set forth a proposal on a
capital conservation buffer that would establish certain restrictions for undercapitalised banks
with regard to the distribution of earnings in the form of dividends, share buy backs and
bonuses. In addition, the introduction of a counter-cyclical buffering mechanism is also
considered. It would require banks to build up additional capital buffers when excessive
credit growth is identified in the economy.
The last topic I want to pay some attention to is the role of central banks in financial
stability. The experience of the financial crisis was not only an important trigger to set in
motion supervisory and regulatory reform. It also drew attention to the need to develop
comprehensive financial stability frameworks in which identification and assessment of
system-wide risk are translated into macro-prudential policy action. Considerable efforts are
being put in place at the European and global level in discussing such a framework and how
to make it operational.
Central banks, on account of their experience in financial stability should be important
players in the macro-prudential analytical and policy fields, as reflected in the composition of
the ESRB. This should not interfere with the primary responsibility of central banks, which
should inflexibly remain the maintenance of price stability. To the contrary, the successful
pursuit of the primary objectives of monetary policy and macro-prudential policy should
reinforce each other.
In particular, measures that enhance the resilience of the financial system or that address
rising financial imbalances are likely to contribute to increase the effectiveness of monetary
policy by reducing the impact of financial frictions on the supply of credit. Conversely, as
demonstrated in the run up to the crisis, price stability is not sufficient to safeguard financial
stability, but it is certainly a necessary condition for it. Indeed, it reduces the system's
vulnerability to the build-up of financial imbalances and the scope for risk mispricing.
The financial crisis has well illustrated how the monetary policy transmission channel can be
seriously hampered in the absence of financial stability. This points to the many benefits from
leaning against the build-up of financial imbalances, while pursuing the price stability
objective. To some extent, successful macro-prudential policy could alleviate the need for
monetary policy to "lean against the wind" as regards unsustainable financial trends. The two
policy areas should however operate with a clearly distinct set of tools. Effective governance
arrangements need to be in place, so as to maximise credibility and preserve institutional
independence.
IV. Conclusions
Ladies and gentlemen, I started my talk with a reference to architecture and, as we
progressed, I reviewed the many building sites - at various stages of development - of the
reforming financial system. It will be very challenging to keep momentum in the reform
agenda and to keep the activities of the many building sites on track as "battle fatigue"
inevitably settles in. But the crisis has also painfully demonstrated that sound foundations are
indispensable to withstand the occasional blows that hit the financial system. Therefore, it is
all the more important to continue vigorously pursuing the ambitious financial reform agenda.
I thank you for your attention.