Nout Wellink: Basel Committee initiatives in response to the financial
crisis
Remarks by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel
Committee on Banking Supervision, before the Committee on Economic and Monetary
Affairs of the European Parliament (ECON), Brussels, 30 March 2009.
* * *
Thank you, Madame Chairwoman and members of the Econ Committee, for this opportunity
to share with you the Basel Committee's strategy and initiatives to respond to the present
financial crisis as it relates to the regulation, supervision and risk management of the banking
sector. The work of the Basel Committee is consistent with and supports the initiatives of the
Financial Stability Forum and the Leaders of the G20.
In formulating responses to the financial crisis, it is necessary to address both the near term
challenges related to the weakening economic and financial situation and the long term
regulatory structure issues. The two are linked and we need to manage carefully the
transition from current measures to a more sustainable long term framework.
With regard to the near term situation, it is clear that the banking sector has been at the heart
of the adverse feedback loop between the financial and real side. We have moved from what
I would call the mark-to-market and illiquidity phase of the crisis related to legacy assets to
the fundamental credit cycle part of the crisis. This is associated with large write downs from
corporate and retail lending books, and I believe this phase will continue to play out over the
medium term.
It is critical that supervisors have a comprehensive strategy to deal with both phases of the
crisis and their associated impact on banks. That is essential if we are to restore stability to
our financial systems and economies. When it comes to the long term, we need to establish
a clear target for the future regulatory system which substantially reduces both the probability
and severity of a crisis like the one we currently are working though. By providing clarity
about the future regulatory framework, we will help re-establish near term confidence, reduce
the risk of competitive distortions and limit the degrees of uncertainty for the public and
private sector. Also, by emphasising that these reforms will be phased in over an appropriate
horizon, we reduce the risk that our own actions contribute to procyclicality in the system. In
this regard our plans are closely aligned with the views expressed in the de Larosière
Group's report. This group's report has been strongly appreciated by the Basel Committee.
Let me now say a few words about the steps the Basel Committee has and will be
undertaking to produce a more robust supervisory and regulatory framework for the banking
sector. Such a framework needs to have four key components:
1. Strong regulatory capital,
2. Robust standards for bank liquidity,
3. Enhanced risk management, governance and supervision, and
4. Better transparency
I would like to say a few words about each of these components.
Regulatory capital
The Basel Committee, in a press release issued on March 12th following its recent quarterly
meeting, underscored the importance of a strong capital base as a necessary condition for a
strong banking sector. It stated that the level of capital in the banking system needs to be
strengthened to raise its resilience to future episodes of economic and financial stress. The
Committee will do this through a combination of initiatives, which I will describe momentarily.
Our press release also noted that the Committee will review the regulatory minimum level of
capital, taking account of these initiatives. Our objective will be to arrive at a total level and
quality of capital that is higher than the current Basel I and Basel II frameworks and
appropriate to promote the stability of the banking sector over the long run. This effort will be
phased in over a time frame that will not aggravate the current stress.
Building on the three pillars of the Basel II framework, we need to develop a more resilient
capital framework that has multiple safeguards built into it.
First, we need to improve risk coverage.
One of the most procyclical dynamics has been the failure of risk management and capital
frameworks to capture key exposures in advance of the crisis. For example, risks arising
from securitisation activities - especially so-called resecuritisations - as well as certain
trading book exposures were not sufficiently captured. I could also point to exposures to
complex financial instruments that experienced severe declines in value because of impaired
liquidity. The Basel Committee's response therefore is to enhance the Basel II framework so
that risks are more comprehensively and more accurately covered.
Second, there needs to be a solid capital base backing these risks.
We will achieve this by strengthening the quality, consistency, and transparency of the
highest forms of Tier 1 capital. It must be based on a clear definition of capital that needs to
be transparent and it must be global to ensure competitive equality. The Basel Committee
already has a strong foundation for such a definition, namely common equity and reserves.
We now need to deal with the many differences related to definitional issues, such as
deductions from capital and the treatment of prudential filters.
Third, we need to address procyclicality.
Procyclicality is a complex issue and it is the product of many factors. At the most basic level,
it is the result of animal spirits, which produce exuberant behaviour in the upswing of the
cycle, and fear during the downturn. We cannot change this behaviour, but we can seek to
dampen the channels through which it manifests itself. These include accounting and capital
frameworks, liquidity regimes, risk management and compensation, margining, basic
infrastructure, transparency, and the way supervision is carried out. In the case of the
regulatory capital regime, we need to address any excess cyclicality in minimum
requirements over the credit cycle while maintaining appropriate risk coverage and
sensitivity. The Basel Committee has put in place a process to systematically assess the
quantitative impact of Basel II on the level and cyclicality of capital. We will take appropriate
steps if the results of our capital monitoring suggest the capital framework is unduly
procyclical.
But even more importantly, we need to build countercyclical buffers into capital frameworks
and provisioning practices. This will help ensure that reserves and capital are built up during
periods of earnings growth, so that they can be drawn down during periods of stress. The
Committee is working to translate this important principle into a concrete proposal. The
approach needs to have robust standards that can be applied at the global level and
translated into national contexts.
Finally, the capital framework needs to be underpinned by a non-risk based supplementary
measure. This is particularly important as the Basel I-based floors are phased out. Just like
we expect banks to manage to a variety of measures when they assess risk (such as net and
gross exposures, VAR and stress tests), we as supervisors also must not constrain
ourselves by evaluating risk through the lens of a single, risk based measure. We need the
risk based measure to interact with a simple metric that can act as a floor and help contain
the build up of excessive leverage in the banking system, one of the key sources of the
current crisis. The Basel Committee is working to develop by year end a specific proposal in
this area. Key principles guiding this work are that the measure must be simple and
transparent, and it must address issues related to accounting differences and off-balance
sheet exposures, among others. Finally, it needs to interact with the risk based measure in a
prudent but sensible manner.
Once these different streams of work are further advanced, taken together they will form the
basis for the Committee's assessment of the appropriate level of minimum capital that should
be put in place over the long term.
But whatever we do - and this gets back to my link between the near and long term - we
must not raise global capital requirements in the middle of this crisis. Capital buffers are
there to be used and we must provide a clear road map where we are headed.
Liquidity
Let me now say a few words about our work on liquidity. Capital is a necessary condition for
banking system soundness but by itself is not sufficient. Of equal importance is a strong
liquidity base. Many banks that had adequate capital levels got into trouble because they did
not manage their liquidity in a prudent manner.
In response to these shortcomings, the Basel Committee last September issued its Principles
of Sound Liquidity Risk Management and Supervision. This was a significant step toward
setting a new global soundness standard for what constitutes robust liquidity risk
measurement, management and supervision. But this was only the first step. The next step is
to monitor implementation of the principles and we have put in place a process to do just
that. We also are developing benchmarks, tools and metrics that supervisors can use to
promote more consistent liquidity standards for cross-border banks.
Better risk management and supervision
I have discussed the importance of having stronger global standards for capital and liquidity,
but this is not enough. If firms have poor governance and risk management cultures or if
supervision is weak, then we could again find ourselves with the types of problems we are
now facing.
We propose to build on Basel II's supervisory review process - Pillar 2 - to raise the bar for
risk management and supervision practices. This past January, the Basel Committee
published for comment supplemental Pillar 2 guidance. The purpose of this guidance is to
address the flaws in risk management practices revealed by the crisis, which in many cases
were symptoms of more fundamental shortcomings in governance structures at financial
institutions. The Committee will strengthen its supervisory guidance and the links to the Pillar
2 review process. It is focusing on firm-wide governance and risk management; capturing the
risk of off-balance sheet exposures and securitisation activities; more effectively managing
risk concentrations; and providing incentives to better manage risk and returns over the
longterm, including compensation practices.
Moreover, we need to move towards a macroprudential approach to supervision. What does
this mean? In our discussions in the Basel Committee, we have emphasised the need to
focus supervision not just on the soundness of individual banks but on broader financial
stability objectives. This should inform where we focus our limited supervisory resources and
how we develop our supervisory and regulatory tools.
Transparency
One of the main amplifiers of the crisis was the lack of transparency regarding the risk profile
of institutions and structured products. Moreover, the process by which these products are
valued often lacks rigour. Lack of transparency about the risk profile of products and financial
institutions caused a massive retrenchment by investors and counterparties further
amplifying the deleveraging process.
To help mitigate this behaviour, the third pillar of the Basel II framework - market discipline -
sets out a series of required disclosures that are intended to complement the other two pillars
of the Basel II framework. This should allow market participants to assess capital adequacy
of a bank through key pieces of information on the scope of application, capital, risk
exposure and the risk assessment process. The Committee's January proposals for
enhancing Pillar 3 are focused on disclosures related to securitisation, off-balance-sheet
exposures and trading activities. We believe that these proposed enhanced disclosure
requirements will help to avoid a recurrence of market uncertainties about the strength of
banks' balance sheets related to their capital market activities.
Conclusion
Taken together, the recent and planned initiatives of the Basel Committee should promote a
more robust banking sector and limit the risk that weaknesses in banks amplify shocks
between the financial and real sectors. Because our measures are far reaching and
ambitious, they will need to be phased in over a reasonable timeframe.
I should also note the invitation to join the Basel Committee that we have extended recently
to the BRIC countries - Brazil, Russia, India and China - as well as Australia, Korea and
Mexico. The expansion of our membership will help enhance the global reach and
acceptance of our standards.
The efforts of the Basel Committee need to occur in a broader context of achieving the right
balance between the scope and depth of regulation. Failure to produce adequate regulation
for other "bank like" activities means that we in the banking sector will just be "pushing on a
string", and the activity will simply migrate elsewhere. I therefore strongly welcome the
activities of other bodies like the G20, the Financial Stability Forum and the Joint Forum to
ensure that all sectors are subject to an appropriate degree of regulation, oversight or
transparency commensurate with their systemic significance. The Committee will actively
contribute to these other efforts
Finally, Madame Chairwoman, I would like to thank you and the ECON Committee for
holding this important meeting. The official sector is at a critical juncture and the actions we
take in response will have a far-reaching and long-lasting effect.