Axel A Weber: Lessons learnt - the reform of financial regulation and its
implications
Speech by Professor Axel A Weber, President of the Deutsche Bundesbank, to the
University College London (UCL) Economics and Finance Society, London, 10 March 2011.
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1. Introduction
Ladies and gentlemen
I would like to thank you for giving me the opportunity to share with you some thoughts on
the challenges of reforming financial regulation. The financial crisis that we have been
experiencing over the past four years has held a mirror up to all of us - academics and
policymakers alike. It has provided new insights and opened up new perspectives that will
have a lasting impact on both economic analysis and economic policy. The overhaul of
financial regulation is a case in point. The reforms we have embarked on will lead to a much
more elaborate regulatory framework and to a more resilient financial system - a perspective
that is of particular relevance for the United Kingdom, which hosts one of the most important
financial sectors worldwide. Just to give you an impression of the numbers: in the United
Kingdom the financial sector contributed 91⁄2% to gross value added in 2009, compared to
51⁄2% in the euro area and just 4% in Germany.
Looking back to the origins of the crisis, there is little doubt that an inadequate regulatory
framework was its most important cause. Thus, our task is to strengthen the rules to allow for
a more stable financial system. In this context, it is essential that the reforms are not just
guided by the lessons learnt from the current crisis, since the next one might emerge from a
completely different angle. At the same time, it is imperative that the reform is internationally
harmonised. The financial system is global, and to prevent regulatory arbitrage national
frameworks have to satisfy certain common standards. Acknowledging the need for a global
approach, the G20 has drawn up a comprehensive plan to reform international financial
regulation with the general objective of making the financial system as a whole more resilient
to potential shocks. Nevertheless, we have to bear in mind that the main task of the financial
system is to support the real economy and to promote economic growth. This is the backdrop
against which the reform of financial regulation has to be discussed. But let us begin by
taking a look at the envisaged reforms before tackling the question of how they might
influence the real economy.
2. The reform of financial regulation ...
2.1 Towards more stable banks: Basel III
The natural starting point for a reform of financial regulation is the individual bank. Making
this basic element of the financial system more stable will be an important step towards more
systemic stability. In essence, there exist two elements of protection for the individual bank,
one being capital and the other liquidity. Capital serves as a buffer against potential losses,
and during the crisis it became obvious that regulatory capital provisions were not adequate.
Hence, in the future, banks will have to hold more capital of better quality. Another major
problem during the crisis concerned liquidity. When, after the Lehman insolvency, financial
institutions stopped lending money to each other, a number of banks experienced severe
liquidity shortages. Their only remaining options were either to sell assets, thereby disrupting
the markets further, or to approach central banks as lenders of last resort. In fact, had the
central banks not supplied the financial system with liquidity it would have collapsed.
On the basis of these experiences the Basel Committee on Banking Supervision (BCBS)
proposed far-reaching reforms regarding capital and liquidity provisions. These rules, known
as Basel III, will make individual banks more stable and will constitute a first line of defence
against systemic crises. In November 2010, Basel III was endorsed at the G20 Summit in
Seoul. Now, it needs to be transposed into national law and applied without falling behind the
agreed timetable.
2.2 Too big to fail: handling SIFIs
Basel III will certainly make banks more stable, but it will never be possible to entirely rule out
the failure of individual institutions. Thus, a second line of defence is needed to prevent the
failure of individual banks from triggering a systemic crisis. In this context, systemically
important financial institutions (SIFIs) are a special issue. SIFIs are banks which are so big or
so interconnected that their failure might provoke a chain reaction which could eventually
lead to a systemic crisis. Thus, SIFIs have an incentive to engage in risk-prone behaviour
and gamble on being bailed out whenever they get into trouble. Consequently, regulation has
to be designed to counter such moral hazard behaviour. An initial step could be to introduce
some capital surcharge as well as more intensive supervision for SIFIs in order to enhance
their stability. However, since failure still cannot be ruled out entirely, minimising moral
hazard ultimately requires a system that allows an orderly restructuring of SIFIs. Only then
will it be possible to credibly bail-in investors and thus impose the necessary market
discipline on SIFIs.
In my view, only globally active institutions should be addressed by an international SIFI
regime. A pragmatic approach would be to start with a limited number of institutions which
are indisputably of global systemic relevance. The Financial Stability Board is currently
developing a methodology to accurately define global SIFIs based on criteria such as size,
interconnectedness or substitutability. First results of this exercise are expected by mid-2011.
The outcome, that is the specific members of this group of global SIFIs, will probably not be
much of a surprise. But the issue of how to properly identify systemically relevant institutions
becomes increasingly complex and contentious when turning to a lower - for example the
national - level and will keep regulators and supervisors busy for some time to come. For
this reason, it is a good strategy to focus on the least contentious and at the same time most
systemically relevant candidates first.
2.3 Into the light: the shadow banking sector
Basel III and special rules for systemically important institutions are certainly important
instruments in safeguarding the stability of the financial system. However, the best dike is of
little use when there is a whole ocean at your back. This ocean is the so-called shadow
banking sector: the part of the financial system that is not subject to regulation, that has been
inviting regulatory arbitrage and that has been a significant amplifier of risk during the
financial crisis. With stricter rules for the regular banking sector, there is a clear danger that
more and more activities will flow around the newly erected dikes and add to the ocean of
unregulated activity at our back, thereby increasing systemic risk. Thus, we have to turn our
heads, take a close look at the shadow banking sector, understand what is going on there
and ultimately control the systemic risks that we have identified.
As a first step it is necessary to define the shadow banking sector. Here, a broad approach is
warranted for two reasons. First, the broader the regulatory view, the less room for regulatory
arbitrage remains - provided regulation is internationally coordinated. Second, only a broad
view allows the regulators to keep track of the constant evolution of the shadow banking
sector. For the same reasons, it is imperative to define the shadow banking sector not in
terms of entities but in terms of activities. The central characteristic of shadow banks is that
they replicate the classic activities of banks: they conduct credit transformation, liquidity
transformation and maturity transformation. Given that shadow banks pursue similar activities
as regular banks, they accumulate similar risks which might easily become systemic, flooding
back into the regulated part of the financial system.
Consequently, as a second step it is necessary to monitor the shadow banking sector to
identify potential systemic risks - a task that requires first and foremost enhanced
transparency requirements for this part of the financial system, for example with respect to
trade in derivatives. As a third step we have to draw up an adequate regulatory framework.
One option would be a direct approach whereby the activities of shadow banks are regulated
via instruments such as capital, liquidity or disclosure requirements. Another option would be
an indirect approach which regulates banks' interactions with shadow banking entities.
Potential regulatory instruments could be tighter consolidation rules, higher capital
requirements for exposures to the shadow banking sector or limits on the size of banks'
exposure to shadow banks. The Financial Stability Board is currently discussing all the
options regarding the definition, monitoring and regulation of the shadow banking sector.
However, as this is a complex subject and a number of unresolved issues exist, it might
prove to be a lengthy process. But I am confident that eventually we will be able to
adequately monitor and regulate all potential sources of systemic risk.
3. ... and its implications: more stability, less growth?
Ladies and gentlemen, I have just sketched the main fields of regulatory reform: new capital
and liquidity requirements as well as systemically important financial institutions and shadow
banking. However, making the financial system more stable is not an objective in itself.
Rather, it has far-reaching implications for the real economy. After all, the financial crisis led
to the most pronounced downturn since World War II. Nevertheless, if we wish to make a
sound and comprehensive judgement on the future perspective of economic growth, we have
to take a long-term view and look beyond the current crisis. In this context, the concept of
potential output permits a calm and objective view of the matter. Abstracting from cyclical
fluctuations, it covers the medium to long-term trend of GDP and links it to the driving factors
for such a time horizon.
To be more specific, it helps to take a simple textbook model of economic growth as a
starting point. In such a stylised model, growth is determined by three factors: capital, labour
and technical progress. Now, how are these three factors, in turn, affected by the financial
system? The first factor - capital - points perhaps most obviously to the importance of the
financial system. After all, the financial sector is not only a part of the economy with a distinct
value added - although this value added can be quite significant, as in the United Kingdom.
Even more importantly, the financial system also plays a crucial role in capital accumulation.
However, especially in highly developed economies that typically boast sizeable and
sophisticated financial sectors, the role of the financial system goes far beyond that of mere
capital accumulation. In such economies, the financial system plays a key role in identifying
and funding innovations, thus helping to advance the state of technical knowledge and
promoting technological progress. For these reasons alone, an efficient financial system is
indispensable for growth. In a sense, even the crisis with its massive repercussions for the
real economy and its enormous costs illustrates how important the financial system and its
stability are for economic performance and welfare.
With that in mind, it becomes obvious that the reform of financial regulation will not only have
a profound impact on the financial system itself but will also influence the real economy. The
question at issue is whether the reforms strike the right balance between financial stability
and economic growth. In fact, the development of Basel III has been accompanied by
concerns that tighter regulation might have a negative impact on economic performance by
severely restricting access to credit. However, a comprehensive cost-benefit analysis by the
Basel Committee on Banking Supervision has revealed that fears of a significant negative
impact on growth are unfounded. This is all the more the case given that there will be an
adequate transition period before the new requirements enter fully into force, which will give
banks sufficient time to strengthen their capital base. This favourable overall assessment of
the macroeconomic impact of well-designed regulatory reform highlights the fact that there is
no inherent conflict between the objectives of a more stable financial system and of ensuring
strong and sustainable growth.
4. Conclusion
Ladies and gentlemen, the crisis has certainly been a devastating event. But it has also
presented the chance to make the financial system more resilient. Trimmed down, where
necessary, to activities with an unquestionable positive net social value added, it can once
again be an important driver and catalyst for economic growth. And, in terms of the general
future outlook for growth, we should bear in mind that the financial crisis has not impaired
major growth drivers. Emerging markets, for instance, will still make great efforts to catch up,
and technical progress will continue. Thus, the crisis certainly does not mark the end of
economic growth. Rather, what it has done is to highlight the importance of sustainable
growth and the need for supportive policies - in financial regulation, but in many other policy
areas as well.
Thank you for your attention.