Jean-Claude Trichet: Taking stock on financial reform
Opening speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the
Frankfurt Finance Summit, "The future of risk management and regulation: smarter
regulation, safer markets", Frankfurt am Main, 23 March 2011.
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Ladies and Gentlemen,
I am very pleased to be able to open this conference here at the House of Finance in
Frankfurt.
Frankfurt now hosts three European institutions: the European Central Bank (ECB), the
European Insurance and Occupational Pensions Authority (EIOPA) and the European
Systemic Risk Board (ESRB).
This city is now the home not only of Europe's monetary authority, but also of important
supranational responsibility for supervisory matters. With the EIOPA and the ESRB,
Frankfurt hosts half of the European bodies in the new European System of Financial
Supervisors, with the other two European Supervisory Agencies (ESAs) - the European
Banking Authority (EBA) and the European Securities and Markets Authority - based in
London and Paris respectively.
I have looked with great interest at today's programme, which is of exceptional quality.
In my opening remarks, I would like to lay out a scheme of the building blocks of the financial
reform that is still in progress.
I believe that when we look back in a few years on the financial reform following the global
crisis, we will identify three main building blocks:
The first is banking regulation. The global community is making a big step forward here. It
has made the right diagnosis and, in the Basel III framework, drawn the appropriate lessons.
My friend Nout Wellink is chairing the Basel Committee; I myself have the privilege of
chairing the Committee of Governors and Heads of Supervision, which provides guidance to
the Basel Committee.
The second building block is regulation of the financial markets. Here, reform must ensure
much greater transparency for the various market segments and products, ensure sufficient
competition in all markets, and attenuate as much as possible the pro-cyclicality that derives
from information asymmetries, structural features such as ratings and market phenomena
such as herding.
The third building block is macroprudential oversight. This new discipline focuses on the
interactions between the various parts of the financial system and between the financial
sector and the real economy. New institutions, including the ESRB and equivalent oversight
committees around the world, will pursue the task of identifying sources of systemic risk,
issuing early warnings and recommending remedial action.
The birth date of macroprudential oversight in Europe will probably be identified as the start
of this year but it was originally conceived in 2009 through the work of Jacques de Larosière
and his high-level group, which included my friend Otmar Issing. Eighteen months from
policy design to institutional establishment is a remarkable achievement. It was made
possible by thorough groundwork as well as excellent transposition by the Commission and
very rapid decisions by the European Parliament and the European Council. I feel very
honoured to chair this new body, the ESRB.
Let me focus on each of these three building blocks in turn, starting with banking.
I. Banking regulation and Basel III
Basel III, which constitutes the cornerstone of regulatory reform for the banking sector,
provides for higher minimum capital requirements, better risk capture, a stricter definition of
eligible capital elements with a particular focus on common shares and more transparency.
The revised regulatory framework allows appropriate transition periods for financial
institutions to adjust to the new standards, thereby ensuring a smooth phasing-in of the new
regulatory requirements without compromising the nascent economic recovery. By 1 January
2015, the minimum capital requirements for common equity Tier 1 and total Tier 1 capital will
gradually be raised up to a level of 4.5% and 6.0%, respectively. This gradual phasing-in of
minimum requirements will be complemented by an appropriate observation period for the
non-risk-based leverage ratio and the liquidity standards. The ESRB, together with the EBA,
will play an important role in policy setting and implementation, with the former contributing to
ensuring consistent implementation of the policy framework throughout the EU. We are just
beginning that process.
In addition to the necessary transposition into national or European law of the Basel III rules,
there are two issues that still need to be addressed: systemically important financial
institutions; and capturing the so-called shadow banking system within the regulatory
framework.
Work is in progress on systemically important financial institutions, in particular in the
Financial Stability Board. The main objectives are to reduce the probability of failure of such
institutions and, in case a failure occurs, to reduce the impact on the financial system.
In September 2010, the Governors and Heads of Supervision agreed that systemically
important financial institutions should have additional loss absorbing capacity. Work is
currently underway on how to define institutions that are systemically important, and how to
determine the capital surcharges, contingent capital and other elements to limit systemic
fallout.
With the shadow banking system, we have to ensure that tighter regulatory rules do not
provide incentives for financial institutions to shift their activities to unregulated areas.
Oversight of the shadow banking sector needs to be improved. The FSB has already done
valuable work - supported by the ECB - on shadow banking. In this context, the ECB is
providing the Financial Stability Board (FSB) with flow of funds data on the composition of
the financial sector concerning the euro area. The concrete challenges lie in the
establishment of a suitable definition of shadow banking and outlining possible regulatory
options to address the risks posed by this sector.
Given the background of the crisis, regulatory effort on financial institutions has focused on
banking, but there is important work underway also for other financial institutions, such as the
further specification of the capital adequacy regime for insurance companies ("solvency II").
II. Market regulation
Let me turn to the second building block, namely regulation of financial markets. This area is
as challenging and as complex as banking.
The main observation we have to draw from the crisis is that the risks in market returns were
not mainly exogenous, coming from the stochastic variation in the real economy. They came
from financial risk itself. The financial structures that we thought were in place to assess,
absorb and neutralise risk were either dysfunctional or worked to magnify volatility.
Key factors in creating this risk were opaque financial structures, particularly vulnerability to
contagion and domino effects, and pro-cyclicality in financial markets.
The lack of transparency in many financial instruments meant that some market players
could exploit - for their own, private benefit - information that was not generally available.
Pro-cyclicality acts as a formidable accelerator of financial trends. Two important factors that
drive such amplification are distorted incentives and herd behaviour.
The role of distortions in economic incentives is probably better known as it had traditionally
been widely appreciated even within neo-classical modelling. By comparison, herd behaviour
as a driver of pro-cyclical patterns in financial markets still needs a thorough explanation.
It is difficult to rationalise herd behaviour. There are two possible explanations. One is the
significance of a market player's evaluation of his or her performance relative to the rest of
the market. This is reminiscent of Keynes' famous beauty contest analogy. To be successful
in this environment, individual participants do not form their own opinions, but follow the
general mood prevailing among market participants. Everybody seeks to ride the wave
created by general sentiment, hoping to step off before the general sentiment turns.
The second explanation is that global markets are in fact less atomistic than we think.
Indeed, despite globalisation, increasing market concentration was already a long-term trend
before the crisis. Derivatives activity in the US banking system, for example, is dominated by
a small group of large institutions. And, of course, the market for credit ratings is famously
dominated by three signatures, which act as standard-setters for an enormous volume of
transactions.
Many regulatory initiatives are underway to remedy these issues, including work on OTC
derivatives, ratings agencies and alternative investment vehicles. But addressing these
challenges could also be supported by reorienting significant resources in research. In
particular, I would welcome an enrichment of thinking in economics and finance, by including
new approaches that do not necessarily rely only on the notions of equilibrium, universal
rationality and efficiency.
Inspiration from other fields, such as the natural sciences, may be particularly pertinent. I am
thinking for example of market movements from stability to instability, from tranquillity to
turbulence. In physics such phenomena are described as phase transitions. When some
factors exceed a critical level, a system behaves qualitatively differently from a situation
when the factors stay below this level.
Let me now turn to the third building block of regulatory reform, macroprudential supervision.
III. Macroprudential oversight
As my earlier remarks have suggested, the financial crisis has been revealing in many
respects. It has revealed the fallout from the failure of large financial institutions. It has
revealed the fragility of the financial system to features and trends that cut across institutions,
markets and infrastructures. And it has illustrated the amplitude of the consequences of the
adverse feedback loop between the financial system and the real economy.
All these three elements are key features of systemic risk: first, contagion; second, the
buildup of financial imbalances and unsustainable trends within and across the financial system;
and third, the close links with the real economy and the potential for strong feedback effects.
The crisis has revealed the fundamental importance of systemic risk. Of the three elements I
have mentioned, contagion and the link to the real economy are the least novel in the current
episode. The most unexpected element has been the rigour with which systemic risk has
been triggered by the collective behaviour of financial institutions and the ways in which they
interact in financial markets.
The main new avenue to explore is therefore to improve our understanding of
interconnectedness in the financial system, both via the direct links between financial
institutions and the indirect ones created in financial markets. Everybody now sees that
major risks can emerge from within the financial system itself. It was not the real economy
that threw the financial system into disarray, but the reverse.
Endogenous risks - risks that emerge from within the financial sector - can have many
causes. They may arise, for example, because large parts of the system rely on the same
sources of funding, or because they have similar exposures - to rising financial imbalances,
to currency mismatches and to widespread mis-pricing of risk.
We have also seen that turbulence can arise from relatively modest initial shocks. The
system is so interconnected that what looks stable can turn out to be "meta-stable", which
means potentially highly instable. Snow on mountain slopes can be meta-stable, looking
pristine and tranquil yet turning into an avalanche after only a minor disturbance.
For all these reasons, we have established a new framework of macroprudential supervision
as have our counterparts elsewhere, including in the United States with the new Financial
Stability Oversight Council. In the case of Europe, there is still one more reason for
macroprudential oversight, and that is the single European market.
Cross-border and cross-sectoral financial integration within the EU is fostered by competition,
freedom of establishment and the free flow of capital. The single financial market is a crucial
component of the overall single market project, and macroprudential supervision should
enhance the resilience of this market.
So how exactly will the new discipline of macroprudential oversight be conducted? Financial
stability is not an issue exclusively for central banks. Micro-prudential supervisors have a key
role, because stable institutions are an essential and necessary condition for achieving
financial stability. This is why the ESAs and national supervisors together with the central
banks are members of the ESRB and why the ESRB and the ESAs form the European
System of Financial Supervisors.
The ESRB's main tasks are threefold: to identify and prioritise systemic risks; to issue early
warnings when significant systemic risks emerge; and to issue policy recommendations for
remedial action in response to the risks it identifies.
The ESRB will not focus on individual institutions, individual countries or individual
macroeconomic issues - it will take a strong horizontal focus, across countries, across
sectors and across the boundaries between the financial sphere and the real economy.
Interlinkages and spillovers should be key terms in its analysis.
To achieve these tasks, the ESRB is drawing on information from many sources, including
strong analytical input from its members; intelligence gathered from financial system
participants; and the data necessary to understand the nature of interlinkages that define the
financial system. ESRB analysis must be broad-based covering potentially any aspect of the
EU's financial system - markets, institutions and infrastructure.
The ESRB is being established at a time when the concerns of markets and policy-makers
about short-term vulnerabilities seem to prevail over perceptions of medium- and longer-term
risks. This confronts the ESRB, as well as other macroprudential bodies around the world,
with specific challenges. The ESRB needs to consider what activities to initiate, well before a
fully-fledged macroprudential policy framework is developed in the medium term. At the same
time, it must develop this policy framework, for which no template exists and for which the
analytical background captures only parts of the tasks.
In the medium term, the ESRB and the macroprudential authorities of the 27 EU countries
will need operational policy frameworks with specific instruments. The ESRB is ready to
support - at a technical level - the work that European institutions have started to design the
implementation of countercyclical capital buffers. Other macroprudential instruments are also
desirable. Work on these issues has been initiated. For example, new rules on margins and
collateral should counteract the fluctuations of the cycle. The specific capital requirements for
risk-weighted assets might also be adjusted over the cycle.
When these macroprudential instruments are established, possibly around the middle of this
decade, the authorities will finally have tools to mitigate the pro-cyclical behaviour of financial
players. Authorities will set part of the regulatory requirements not against the solvency or
liquidity situations of single institutions, but taking a view of the macroprudential cycle.
Other instruments will be needed to address interconnectedness, including the most complex
and innovative elements of market functioning. One specific focus of authorities is to ensure
that efficient and secure central counterparties are created to reduce risks in OTC markets.
Concentration risks produced by increasingly large financial institutions in trading and
posttrading will also need to be addressed. Finally, authorities will need new regulatory
instruments to keep pace with the impact of new technologies - including high frequency
trading, algorithmic trading and the new universal trading platforms, which are gaining
ground very rapidly.
Last week, the ESRB selected the members of its Advisory Scientific Committee to provide
advice on analytical issues. We have also established the Advisory Technical Committee,
which assembles experts from all central banks. The institutional set-up is completed and the
ESRB will now focus on its substantive tasks, of which we will have a substantive review in
June this year. Combining a focus on short-term risks with the medium- and longer-term
perspective will be the major challenge.
Conclusion
Let me conclude. I believe we are now about halfway through the comprehensive reforms
that the crisis has called for. We have achieved a blueprint of more stringent bank
regulations that includes more loss-absorbing capital, better risk coverage and limitations for
undue leverage. Countercyclical capital buffers are meant to lower pro-cyclicality.
The oversight of financial institutions as well as markets and market infrastructure are being
strengthened, and the organisational structure of financial supervision is being overhauled.
But much remains to be done. The most important aspect is the implementation of these
reforms. Moreover, the issue of systemically important financial institutions requires further
reflection, and oversight of the proper functioning of financial markets in a way that avoids
undue volatility, excessive influence of dominant players and oligopolistic market structures,
while reinforcing transparency, needs to be addressed resolutely.
Such understanding would be enhanced by greater focus in academic research on analysis
of the intricate interactions in complex financial systems.
The appropriate benchmark for the financial system is whether it is providing appropriate
financing to the real economy in a stable and sustainable way. Thereby, and thereby only,
will it make a valuable contribution to our economy.
Thank you for your attention.