Axel A Weber: The G20 agenda on financial regulation
Dinner speech by Professor Axel A Weber, President of the Deutsche Bundesbank, at the
International Conference on Financial Market Regulation, Berlin, 19 May 2010.
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1. Introduction
Ladies and gentlemen,
These days it is hard to find a topic that is suitable for a light-hearted dinner speech. One
could either choose to talk about a crisis-related topic, which would mostly be unpleasant, or
one could choose to talk about something completely different and run the risk of appearing
slightly out of touch with reality. As a compromise, I have decided to talk about one of the
more positive outcomes of the crisis - assuming that "positive" is not a misnomer. As
devastating as the crisis has been, it has set in motion a process of reform that will
eventually lead to a more stable and resilient financial system in the future. Originally, I
wanted to give you a short overview of the state of these reforms. And even though I will
stick to that plan, current events have to be acknowledged and I will do this at the end of my
speech.
2. Major issues of reform at the micro and macroprudential level
The reform of financial regulation was initiated by the G20 during various meetings in
London, Washington and Pittsburgh. Having devised the general objectives, the G20 then
commissioned the Financial Stability Board and the Basel Committee on Banking
Supervision to draw up proposals as to how these objectives could be met. The overarching
principle of reform is to create a financial system that is more stable, more resilient and thus
more capable of absorbing potential shocks.
Any attempt to achieve this objective has to begin with the individual institution - that is, at
the microprudential level. Preventing individual institutions from failing would serve as a first
line of defence against systemic crises. Regulation at the microprudential level centres on
the Basel II framework, which was launched in 2004 and has been implemented by a large
number of countries. In a nutshell, the Basel II rules require banks to provide risk-adjusted
capital and liquidity buffers. These buffers serve to absorb potential losses and help to
prevent failures. Thus, an enhanced Basel II framework would further strengthen the first line
of defence against future crises.
Relevant proposals were put forward in December 2009, including, among other things,
measures to raise the quality, consistency and transparency of the capital base, a global
standard for funding liquidity, and the introduction of a leverage ratio. Throughout 2010 the
proposed measures will be calibrated on the basis of an extensive quantitative impact study.
The fully calibrated set of measures will then be issued by the end of 2010 and the new
standards will be phased in by the end of 2012 provided that economic recovery is assured.
The proposed measures will certainly help to reduce the likelihood of individual bank failures.
However, even though such events have proven capable of destabilising the whole financial
system, totally eliminating the risk of failure would be highly detrimental to growth and
efficiency. Regulation at the microprudential level therefore has to be supplemented by a
macroprudential stance that takes into account the stability of the financial system as a
whole, thus constituting a second line of defence against systemic crises. A major concern in
that respect is the treatment of systemically important institutions, as their failure might lead
to system-wide disruptions.
When approached at a more detailed level, the concept of systemic relevance proves to be
rather complex. Contrary to common perception, systemic relevance is driven by more than
the sheer size of an institution. Factors such as interconnectedness, substitutability and the
state of the markets also determine whether the failure of an individual institution will have a
systemic impact - the banks that played a core role in the crisis were actually often not that
large. Consequently, we need to put some effort into finding a reliable way of identifying
systemically important institutions, and we might also have to accept that systemic relevance
is not a zero-one criterion.
The difficulties do not stop there. Once an institution is defined as systemically relevant,
moral hazard problems might occur. As the institution in question would most likely be aware
of the fact that it cannot be allowed to fail, it would have every incentive to engage in
riskprone behaviour and gamble on being bailed out as soon as it gets into trouble. Any
measures aimed at systemically important institutions must therefore take into account the
moral hazard dimension.
The reform of the Basel II framework is certainly part of the solution to this problem, as it will
help to improve the capacity of systemically important institutions to absorb losses without
creating moral hazard. However, what is required is a more comprehensive approach which
specifically ensures that accountability is brought back into the game. Major proposals that
go beyond the reformed capital and liquidity framework include capital surcharges for
systemically important institutions, better resolution regimes and a strengthening of the
financial infrastructure. Commissioned by the G20, the FSB is already working towards that
goal.
3. Some thoughts on the most recent backslide on the financial markets
I could have closed my speech with this rather positive outlook not even two weeks ago.
However, since then the crisis has again raised its head, this time exposing the weak
position of government budgets in some euro-area countries. At first sight, the current
problems seem to be rather different from what we experienced during the financial crisis.
However, a second glance reveals that the underlying causes are quite similar, and so are
the remedies.
Just like the financial crisis itself, the current problems can be traced back to a limited
number of factors. First, a credit boom due to lower interest rates once the countries in
question had joined the euro area. Second, insufficient or totally absent risk management in
economic policy, which should have been much more countercyclical. And third, the Stability
and Growth Pact was not applied as strictly as it should have been, or was weakened by
questionable accounting practices and faulty statistics.
Given these similarities with the root causes of the financial crisis, the responses of
economic policy are similar, too. The first challenge has been to stabilise the situation. The
relevant steps towards that goal were taken by the Eurosystem and the Ecofin ten days ago.
In particular, the commitment of fiscal policy to stepping up frontloaded consolidation efforts
shows the will of the member states to tackle the current crisis at its root.
What must follow are structural reforms in a similar vein to those that I have just described
with regard to the financial sector. It is essential to strengthen the existing fiscal rules to
prevent individual countries from running into budgetary difficulties. Relevant proposals to
enhance the Stability and Growth Pact have already been put forward. They could be
complemented by national fiscal rules similar to the national debt brake in Germany. In
addition, we might - over the medium-term - also think about devising mechanisms to limit
the systemic impact of sovereign debt crises that might still occur. However, particular
caution is warranted in this regard given that adverse incentive effects would most likely be
even more severe than in the financial sector. For example, a permanently available support
scheme would only exacerbate these problems and therefore should not be a policy option.
4. Conclusion
Ladies and gentlemen
Three years into the crisis, the necessity for a reform of financial regulation has been well
understood at a global level. Until now, a number of relevant proposals have been put
forward by international bodies such as the Financial Stability Board and the Basel
Committee on Banking Supervision. Once implemented, the proposed measures will help to
create a more stable and more resilient financial system. The events that reached their
climax ten days ago emphasised the need for ambitious consolidation efforts and reforms in
the fiscal policy framework in order to deliver sustainable public debt levels. In both cases,
policymakers now have to muster the political will to take the necessary steps, however
contested and painful they might be.
Thank you for your attention.