Rethinking the prudential regulation of banks

Panel remarks prepared for the DNB - Riksbank - Bundesbank, Macroprudential
Conference

31.08.2023 I Stockholm I Claudia Buch

Check against delivery.

I. How is the banking environment changing?
Il. How should supervisors respond?
Ill. Is there a need to reform regulation?

IV. Summing up

Many thanks to the Riksbank for organising this year's Macroprudential Conference and for launching
this series of conferences back in 2015. By the time the Bundesbank joined as a co-organiser in 2018,
this event had already established itself as a forum for high-level exchange between policymakers, the
private sector, and academia. [1]

The recent episodes of bank stress in the United States and Switzerland bear testimony to the
importance of this exchange. They revealed the potentially destructive forces of poor risk management
at the bank level coinciding with stress at the macroeconomic level. The stressed banks had weak
internal control mechanisms, poor governance, and preexisting conditions.[2] Moreover, supervisors
could have taken more forceful action and escalated critical findings more rapidly. Higher interest rates
and heightened macrofinancial risks acted as significant amplifiers. Financial stability was at risk, thus
triggering forceful interventions by fiscal and monetary authorities.

Looking ahead, the lessons that I believe we should learn from these episodes are that maintaining a
resilient financial system requires ...

* ... responding to changes in the external environment in which banks operate - changes in terms of
both macroeconomic stability and the nature of competition;

* ... cooperating closely in macro- and micro-prudential supervision in a forward-looking and
preventive manner, and;

¢ ... fully implementing the financial sector reforms that have been agreed upon while making targeted
adjustments based on sound impact assessments and in an internationally coordinated manner.

I. How is the banking environment changing?

The environment in which banks operate is changing rapidly. Competition is becoming more intense.
The macroeconomic environment has become more volatile, interest rates have increased markedly.
These trends can have effects that mutually reinforce one another. Preexisting vulnerabilities can
become exposed; stress events could become more frequent.

Digitalisation is an important driver of intensified competition. It puts pressure on banks' margins and
requires investments into IT infrastructure and the reorientation of business models. Depositors using
digital banking services can move their savings from one bank to another more quickly. Banks may lose
one of their main competitive advantages over other financial institutions: access to relatively stable and
relatively cheap funding through retail deposits. Banks' "franchise value" may decline.

Bank managers and owners need to respond to these challenges presented by digitalisation -
supervision cannot and should not take over their roles. However, supervisors need to assess how
changes in the competitive environment affect business models and incentives to take risks: How are
banks' main drivers of revenue and risk changing? Do market dynamics change? Are entries and exits in

the financial sector more likely? Do we need to change the regulatory perimeter?

The second main trend affecting the banking sector is the changing macroeconomic

environment. Monetary policy has shifted from quantitative easing to quantitative tightening, interest
rates have increased, and liquidity conditions on financial markets have changed. Climate change
requires adjustments in the production and use of energy. This can affect sectoral credit risks and banks'
loan portfolios. Non-performing loans may rise. Choices in fiscal policy to guide the green transition
have an impact on the speed of transition and the likelihood of policy reversal. This affects transitional
and physical risks. Geopolitical risks require reassessments of credit risk and exposure to fragile value
chains.

In short, uncertainty has risen, thus making it more difficult to quantify risks going forward. Policy-
making has to adjust to this "age of shifts and breaks" .[3]

Il. How should supervisors respond?

Supervisors need to analyse how changes in the macroeconomic and competitive environments affect
banks. The Basel core principles make clear reference to the macroeconomic and competitive
environments, stressing the forward-looking nature of supervision.[4] In Europe, the Supervisory Review
and Evaluation Process (SREP) of the Single Supervisory Mechanism (SSM) has identified internal
governance and exposure to macroeconomic risks as areas of concern.[5]

A forward-looking assessment of risks is needed but we are, at the same time, facing a "forecast
paradox". Whilst assessing future trends has become more important, existing models do not capture
these new trends particularly well. Models typically assess risks in a backward-looking way. At present,
models implicitly assume a macroeconomy with a strong fiscal support factor and accommodative
monetary policy. In addition, we are emerging from a period of historically low volatility.[6] Heightened
macroeconomic volatility affects correlations[7] and the measurement of risk in banks' internal models.

Assessing future risks requires, first of all, good and reliable data within the banks. Yet, risk data
aggregation and reporting have been supervisory concerns for a number of years now. Weaknesses in
this area may imply that banks might not be able to capture their overall exposure to a specific
counterparty or country and respond to heightened risks in a timely manner. As supervisors, we take
this topic very seriously, and we will take appropriate measures if banks do not respond adequately to
supervisory findings.[8]

Banks' credit risk provisioning can take macroeconomic risks into account through prudential overlays. A
recent survey by the SSM found that banks are making efforts to design overlays to capture new risks,
such as climate-related and environmental risks. However, not all banks use overlays and their practices
can vary.[9] For example, overlays make up a significant part of the stage 1 and stage 2 provisions.
Furthermore, many banks do not distinguish between probabilities of default and loss given default.
This may reduce risk sensitivity. Looking ahead, banks need to make appropriate use of risk-sensitive
overlays to address novel risks, and supervisors need to monitor these practices.

Macroprudential authorities likewise need to find ways of assessing new risks. There are, indeed, many
areas in which macro- and micro-prudential supervision can cooperate in a forward-looking, preventive
manner. Macroeconomic scenario analyses can be useful tools to identify vulnerabilities of the system to
macroeconomic risks. This information, in turn, is relevant for microprudential authorities. The design of
macroeconomic scenarios can, at the same time, benefit from bank-level information on the responses
of banks to the changing environment. Such closer cooperation between the micro- and the macro-
levels would be in line with an SSM recommendation and an external review also recently commissioned
by the SSM.[10]

Finally, responding to the new external environment implies reviewing early-warning mechanisms and
stepping up crisis preparedness. At an operational level, mixed teams with experience in operating
under different macroeconomic and stress conditions need to be put together. Early warning indicators
need to be readily available. At a regulatory level, remaining gaps with regard to crisis management and
resolution frameworks need to be closed. The European Commission has recently made proposals as to
this effect,[11] and the too-big-to-fail evaluation of the Financial Stability Board (FSB) has identified
relevant gaps as well.

lll. Is there a need to reform regulation?

The turmoil observed in March has also triggered a discussion on the potential regulatory response. The
calibration of liquidity regulation has received particular attention. Liquidity regulations are tools for
crisis prevention, not crisis management. The liquidity coverage ratio (LCR) ensures, for example, that
banks hold a minimum level of highly liquid assets to remain liquid under stress for a period of 30 days.
The net stable funding ratio (NSFR) requires available stable funding to be greater than required stable
funding. But liquidity stress is often only the symptom of underlying weaknesses in governance and
business models. Supervisors thus use qualitative measures to assess banks' liability management.

Given changes in the macrofinancial environment, the calibration of liquidity risk needs to be

reviewed. The liquidity of a bank captures its ability to meet its payment obligations as they come due.
The liquidity of an asset - the ease with which it can be converted into cash without causing a loss -
depends on the state of the world.[12] Hence, the macrofinancial environment needs to be considered,
in particular for banks strongly relying on market funding.

I see the following priorities for a structured review of liquidity requirements.[13] First, banks must be

able to liquidate high-quality liquid assets (HQLAs) immediately and at any time. Second, relevant
liquidity indicators, including the concentration of funding sources, could be monitored more frequently.
Advances in digital technologies would mitigate reporting costs. Third, it needs to be assessed whether
assumptions on the stability of deposits adequately reflect effects of social media and new digital
banking services.[14]

Capital ratios can be a lagging indicator when it comes to identifying bank stress. Ex ante, banks in the
US and Switzerland reported capital adequacy ratios above the regulatory minimum until shortly before
the stress events occurred. [15] Ex post, after experiencing losses and facing liquidity runs, their capital
levels were not sufficient to stop the rapid erosion of trust in the viability of the banks. Should bank
capital regulation therefore be reviewed and, if so, what should be at the focus?

At the current juncture, the priority should be the faithful implementation of Basel Ill. The package
closes regulatory gaps that became apparent during the global financial crisis of 2008, as agreed at the
international level. At the end of June 2023, a provisional agreement on amendments to the Capital
Requirements Regulation and the Capital Requirements Directive has been agreed, which needs to be

confirmed by the Council and Parliament to come into effect in 2025. Deviations from Basel Ill or further
delays in its implementation could have negative implications for trust in the European financial system.
Any deviations may also lead to excessive complexity. In this sense, faithful implementation of Basel III
will yield long-term gains in terms of stronger growth and greater stability: impact assessments by the
Basel Committee show that higher capital requirements are not associated with weaker growth or a
decline in bank lending.[16]

Implementation of Basel Ill does not preclude a structured and internationally coordinated assessment
of potential modifications. In this context, I believe the priorities should be as follows. First, the
treatment of interest rate risk in the banking book (IRRBB) should be reconsidered, including an
assessment whether a Pillar I approach could promote greater international consistency in
implementation. [17] Second, under the Basel rules, national authorities can determine which
institutions, apart from global systemically important banks (G-SIBs), are covered.[18] As the failure of
mid-sized banks could have cross-border effects, making the guidance for dealing with domestic

systematically important banks (D-SIBs) more concrete and more binding could be an important step
forward towards addressing potential cross-border risks.[19] Third, excessive complexity of regulation
should be reduced. [20] Bank capital regulation is complex because banks' business models and the
associated risks are complex. However, a high degree of complexity also implies high costs of
implementation and the possibility of regulatory arbitrage.[21] Hence, we need to explore ways of

reducing complexity that strengthen rather than weaken the resilience of the system.

IV. Summing up

Banking crises have one feature in common: they often happen where changes in the macroeconomic
environment intersect with poor risk management at the bank level. This needs to be reflected in the
supervisory lessons that we draw from recent episodes of stress. We need to focus on banks'
governance mechanisms and adapt to changes in banks' external environment. Banks' business models
are under stress due to digitalisation and the entry of non-bank financial institutions into the market,
and the macroeconomic environment has changed.

Heightened risks and uncertainties need to be reflected adequately in the capitalisation and liquidity
requirements of financial institutions. The recent stress episodes would have had a much bigger impact
without the timely fiscal and monetary support that was provided. Financial institutions need to be
resilient to absorb adverse shocks. This minimises the risk of financial dominance.

In terms of regulation, the implementation of internationally agreed rules should be the priority. This can
go hand in hand with an evaluation of gaps and new risks that need to be addressed, as well as a
targeted review of existing regulations based on a structured process.

Finally, assessing the implications of the macrofinancial environment can benefit greatly from the
interaction between public authorities, academia, and the private sector. I thus look forward to the
macroprudential conference next year, which will be hosted by the Bundesbank. This exchange is
particularly important at the current juncture: future economic developments are highly uncertain. Our
models and heuristics do not always provide adequate guidance. We therefore need practical
information on what is happening on the ground, coupled with the conceptual and theoretical thinking
of academia. From this, we need to draw lessons for forward-looking and preventive supervisory action
in order to keep banks and the financial system as a whole safe and sound.

This version: September 1, 2023

References
Basel Committee on Banking Supervision (2012). A framework for dealing with domestic systemically

important banks. October 2012. Basel.

Basel Committee on Banking Supervision (2016). Standards. Interest Risk in the Banking Book. April
2016. Basel.

Basel Committee on Banking Supervision (2021). Early lessons from the Covid-19 pandemic on the Basel
reforms. July 2021. Basel.

Basel Committee on Banking Supervision (2022a). Buffer usability and cyclicality in the Basel framework.
October 2022. Basel.

Basel Committee on Banking Supervision (2022b). Evaluation of the impact and efficacy of the Basel III
reforms. December 2022. Basel.

Basel Committee on Banking Supervision (2022c). Basel Committee Work Programme and Strategic
Priorities for 2023/24. 16 December 2022. Basel.

Basel Committee on Banking Supervision (2023a). Core Principles for Effective Banking Supervision.
Consultative document dated July 2023. Basel.

Basel Committee on Banking Supervision (2023b). Basel Committee discusses recent market
developments, agrees to consult on Basel Core Principles, and advances work on cryptoassets. Press
release dated 6 June 2023. Basel.

Board of Governors of the Federal Reserve System (2023). Review of the Federal Reserve's Supervision
and Regulation of Silicon Valley Bank. April 2023. Washington D.C.

Dahlgren, Sarah, Ryozo Himino, Fernando Restoy and Carolyn Rogers (2023). Assessment of the
European Central Bank's Supervisory Review and Evaluation Process. Report by the Expert Group to the
Chair of the Supervisory Board of the ECB. Frankfurt am Main.

Enria, Andrea (2023), Monitoring the Euro Area Banking Sector in the Aftermath of the March 2023 US
Bank Failures. Opening remarks at the Exchange of views of the Committee on Economic and Monetary
Affairs of the European Parliament. 21 March 2023. Brussels.

European Central Bank (2023). Aggregated Results of SREP 2022. Frankfurt am Main.

European Systemic Risk Board (2021). Report of the Analytical Task Force on the overlap between
capital buffers and minimum requirements. December 2021. Frankfurt am Main.

Federal Deposit Insurance Corporation (2023). FDIC's Supervision of Signature Bank. April 2023.
Washington D.C.

Financial Stability Board (2021). Evaluation of the Effects of Too-Big-To-Fail Reforms. Final report. 1 April
2021. Basel.

Forbes, Kristin J. and Roberto Rigobon (2002). No Contagion, Only Interdependence: Measuring Stock
Market Comovements. The Journal of Finance 57 (5): pp. 2223-2261.

Gai, Prasanna, Malcolm Kemp, Antonio Sanchez Serrano and Isabel Schnabel (2019). Regulatory
complexity and the quest for robust regulation. Reports of the Advisory Scientific Committee No 8 / June
2019. European Systemic Risk Board. Frankfurt am Main.

Hellwig, Martin (1998). Banks, Markets, and the Allocation of Risks in an Economy. Journal of
Institutional and Theoretical Economics 154: pp. 328-345.

Lagarde, Christine (2023). Policymaking in an Age of Shifts and Breaks. Speech at the annual Economic
Policy Symposium "Structural Shifts in the Global Economy". 25.08.2023. Jackson Hole.

McCaul, Elisabeth and Stefan Walter (2023). Overlays and in-model adjustments: identifying best
practices for capturing novel risks. The Supervision Blog dated 26 May 2023. Frankfurt am Main.

Reis, Ricardo (2022). The Burst of High Inflation in 2021-22: How and Why Did We Get Here? BIS.
Working Papers No 1060. Basel.

Rose, Jonathan (2023). Understanding the Speed and Size of Bank Runs in Historical Comparison.
Economic Synopses. Number 12. Federal Reserve Bank of St. Louis.

Swiss National Bank (2023), Financial Stability Report 2023, Bern/Zurich.

Footnotes:

1. I would like to thank Karen Braun-Munzinger, Marcel Heires, Martina Hemsath, Friso van der
Meyden, Kamil Pliszka, Sabina Pradkhan, Kerstin Radtke, Sonja Reinhard, Tilmann Roth, Jorg Schafer,
Beate Sonnenberg, Jiayi Sun, and Marina Zaruk for their most helpful comments and input to an
earlier draft. Any remaining errors and inconsistencies are solely my own.

2. See Board of Governors of the Federal Reserve System (2023), Federal Deposit Insurance
Corporation (2023) and Swiss National Bank (2023).

3. See Lagarde (2023)

4. See Basel Committee on Banking Supervision (2023a).

5. See European Central Bank (2023). Governance issues were, for instance, related to IT landscapes
and the handling of climate-related and environmental (C&E) risks in risk management
frameworks. Regarding the macroeconomic environment, the SREP cycle points to latent credit risk
and an elevated risk of a correction in property prices.

6. See Reis (2022).

7. See Forbes and Rigobon (2002).

8. See https://www.bankingsupervision.europa.eu
[https://www. bankingsupervision. europa. eu/press/pr/date/2023/html/ssm.pr230724~d8dd3ad9ad.en.htmil]

9. See McCaul and Walter (2023).

20.

21

. The SSM has recently commissioned an external review by a "wise persons group". The report

recommends combining information on banks' risk scores with information on the external
environment. In addition, the report suggests establishing closer dialogue with macroprudential
authorities when determining capital requirements in the system. See Dahlgren, Himino, Restoy and
Rogers (2023).

. See https://ec.europa.eu/commission/presscorner/detail/en/ip_23_2250

[https://ec.europa.eu/commission/presscorner/detail/en/ip_23_ 2250].

. See Hellwig (1998).

. The Basel Committee for Banking Supervision has recently reviewed experiences from this year's

turmoil on banking markets. See Basel Committee on Banking Supervision (2023b).

. For an historic account of bank runs, see Rose (2023).
. See Board of Governors of the Federal Reserve System (2023) and Swiss National Bank (2023).
. See Basel Committee on Banking Supervision (2021, 2022a and 2022b) and https://www.bis.org/

frame/cap_liq/overview.htm /https:/www. bis. org/frame/cap_liq/overview. htm].

. The information in this paragraph is based on Basel Committee on Banking Supervision (2016, 2022

and 2023).

. See Basel Committee on Banking Supervision (2012).

. Currently, how domestic systemically important banks (D-SIBs) are regulated and the information

available about them vary significantly across jurisdictions. See Financial Stability Board (2021).

See Gai, Kemp, Sanchez Serrano and Schnabel (2019).

. For example, the interaction between different requirements, such as minimum capital

requirements, leverage ratios, and resolution requirements, including MREL and TLAC, as well as
capital buffers may increase the complexity of the capital framework and could impact its
effectiveness. See European Systemic Risk Board (2021).