Nout Wellink: The importance of banking supervision in financial
stability
Keynote address by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the
Basel Committee on Banking Supervision, at the High Level Meeting "The Role of Banking
and Banking Supervision in Financial Stability", Beijing, 17 November 2008.
* * *
Introduction
I would like to begin by thanking the FSI and EMEAP for organising this very timely event as
well as the People's Bank of China for their warm hospitality. I am grateful for the opportunity
to discuss the Basel Committee's response to the financial market crisis. This morning I
would like to present our strategy for addressing the fundamental weaknesses with respect
to the regulation, supervision and risk management of internationally-active banks that have
been revealed by the rapidly evolving crisis. Our work programme is well advanced and
provides practical responses to the financial stability concerns raised by policy makers
related to the banking sector, which is at the core of the global credit intermediation process.
Successful implementation of this strategy requires a global effort and the Committee will
reach out to countries that are critical to this process.
Background on crisis and emerging lessons
Before I talk about the Committee's response, I think it is important to provide some context
as to how we have arrived at where we are today. From a supervisory perspective, the main
contributing factors that came together to form a perfect storm include:
•
a large amount of pre-crisis, system-wide liquidity, which led to excessive risk
taking;
• inadequate measures to contain leverage, maturity mismatches, risk concentrations
and the erosion of liquidity buffers over the credit cycle;
• regulatory gaps, which left important segments of the financial system under
regulated;
• poor incentives in regulatory frameworks;
•
poor underwriting standards;
•
outsourcing of the due diligence process to the rating agencies; and
•
fundamental shortcomings in financial institution's governance, of which the current
risk management shortcomings are just a symptom.
The crisis, which has re-concentrated risk in the banking sector, has resulted in financial
market stress and massive deleveraging of historic proportions, with increasing spillover to
the real economy. The speed and scale of these developments have been nothing short of
astonishing.
The response by the official sector also has been unprecedented, covering a wide range of
measures. These are now helping to stabilise the banking sector and financial markets. But it
is clear that we continue to face significant challenges as real economic activity slows. The
official sector, including supervisory authorities, continues to work nationally and collectively
to promote an orderly deleveraging process.
We also need to develop a coordinated strategy to put the banking system on a sound
footing over the longer term. Such efforts will further reinforce near term confidence-building
measures and provide a long term target around which national and global policy making
efforts can converge. They also will provide the basis for an exit strategy from the increased
official sector engagement in the banking sector. I would like to focus the remainder of my
remarks on how we can go about achieving this longer term strategy.
The Basel Committee's response
The primary objective of the Committee's strategy is to strengthen capital and liquidity buffers
and help contain leverage in the system arising from both on- and off-balance sheet
activities. It also will promote stronger risk management and governance practices and limit
risk concentrations within and across banking institutions, and strengthen market
transparency. Ultimately, our goal is to help ensure that the banking sector serves its
traditional role as a shock absorber to the financial system, rather than an amplifier of risk
between the financial sector and the real economy. The Committee will promote multiple and
reinforcing lines of defence in supervisory and risk management frameworks to enhance
bank resilience.
Let me discuss in more depth the key building blocks of our strategy.
Strengthening capital buffers
I will start with the Committee's initiatives to strengthen the regulatory capital framework. I
would note up front that regulators need to be extremely cautious about adding to the already
severe procyclical behaviour in the market place. As such, we do not propose to raise global
minimum capital ratios during a crisis. However, banks need to ensure they have adequate
buffers above the current regulatory minimum that reflect the nature of their portfolios and
their exposure to a plausibly severe economic downturn scenario.
With that background, I will now provide you with more clarity about the Committee's
approach to strengthen the capital regime, building on the three pillars of the Basel II
framework. Any enhancements will be introduced in a manner that promotes the near term
resilience of the banking sector and its ability to provide credit to the economy. Moreover, we
cannot set long term capital requirements on the basis of market reactions in the midst of the
most severe deleveraging process we have seen in our lifetime. This effort needs to be
carried out as part of a considered process that balances the objective of maintaining a
vibrant, competitive banking sector in good times against the need to enhance the sector's
resilience in future periods of financial and economic stress.
Risk capture
Let me begin with the issue of the risk capture of the Basel II framework. The move to Basel
II addresses many of the risks that were not captured under the Basel I framework and helps
reduce a number of the perverse incentives that contributed to the crisis. The three pillars of
Basel II will help ensure that capital regulation is better positioned to handle periods of rapid
innovation and the new products that such periods produce. Moreover, Basel II will ensure
that all contractual exposures to off-balance-sheet vehicles are subject to regulatory capital
requirements. Non-contractual exposures and implicit support will be addressed through
enhancements to the Pillar 2 framework.
Last April, the Committee announced a number of steps to enhance the risk capture of the
Basel II capital framework. These measures are an important part of the Financial Stability
Report on Enhancing Market
Forum's response to the crisis that was set out in its April 2008
and Institutional Resilience. For example, the Basel Committee's efforts strengthen the
capital treatment for off-balance sheet exposures and securitisations. The Committee
expects to issue proposals for the capital treatment of these exposures in early 2009. The
proposals are subject to public consultation and we will carefully consider all comments
received.
We also have issued a proposal to strengthen the capital framework for the trading book. In
particular, we will address the risks of less liquid credit products, which have produced the
majority of losses in the banking sector to date. While the proposals reflect the inherent risks
already embedded in banks' trading books, they will be phased in over an appropriate period
to give the banking sector time to adjust to the new requirements.
We are strengthening the disclosure requirements for banks' risk exposures and the
adequacy of capital to support these exposures. We are focusing in particular on trading,
securitisation and off-balance sheet activities.
Finally, we will review the role of external ratings in the Basel II framework. I should point out
that the use of external ratings is limited to the simple Standardised Approach for credit risk
and the Securitisation Framework. Our review will include how any unintended
consequences could be mitigated.
Quality of capital
Let me now turn to the issue of the quality of capital. The Committee has been reviewing the
key elements of Tier 1 capital and the importance of ensuring strong core capital. A strong,
high quality capital base is critical for banks to be able to absorb losses and maintain lending
during periods of severe economic and financial stress. The Committee will continue to
provide global leadership on what the key elements of a strong capital base should be,
reflecting the lessons of recent developments. Such an effort will ensure that both prudential
and competitive equity objectives are maintained in the future.
Procyclicality
The crisis shows that banks need to build strong capital buffers and provisions in good times
so that they can be drawn upon in periods of stress. This in turn dampens the risk of spillover
from the financial sector to the real economy. Reflecting the lessons of the crisis, there are a
number of steps the Committee is considering to dampen the potential procyclicality of the
Basel II framework. It is important to note that the crisis built up under the Basel I regime,
while Basel II only became effective in most countries at the beginning of this year.
We will explore promoting strong capital buffers above the minimum levels and how those
can be used during a downturn to dampen shocks and encourage continued lending. The
Committee also is assessing ways to strengthen prudential filters, promote through-the-cycle
provisioning, and contribute to efforts to strengthen accounting standards for financial
instruments. Finally, the introduction of the incremental risk charge in the trading book should
help dampen the cyclicality of trading book capital.
Supplemental measures
Supervisors are reviewing the need to supplement risk-based prudential and risk
management approaches with simple, transparent gross measures of risk. In combination,
such risk-based and gross measures may provide a further check on the build-up of leverage
at financial institutions and the underestimation of risk during rapid periods of credit growth or
in new business lines that have not experienced a downturn. Moreover, in periods of stress a
large gap may open between what the risk-based metric requires, and what the market
expects through simpler metrics. I hasten to add that simple metrics alone can and will be
gamed, as the recent experience under Basel I has shown, particularly related to the growth
of exposures to off-balance sheet vehicles. Both risk-based and simple measures therefore
may be needed going forward.
Strengthen liquidity risk management and buffers
A second key building block of our strategy is raising the bar on liquidity risk management
and supervision.
The Committee recently issued Principles for Sound Liquidity Risk Management and
Supervision. This guidance sets a higher soundness standard for banks and supervisors to
meet. We will put in place a process to ensure that the principles set out in the paper are
implemented in practice. However, we also need to redouble our efforts to develop more
consistent benchmarks for sound liquidity at global banks. This includes benchmarks for
liquidity cushions, maturity mismatch, funding liquidity diversification, and resilience to stress.
The mandate of the Committee's Working Group on Liquidity has been expanded to deal
with this next set of issues.
Strengthening risk management practices
A third area of high priority focus is on strengthening governance and risk management
practices. Most of the risk management shortcomings revealed by the crisis related to the
failure to implement the basics of firm-wide risk management. This points to weaknesses in
governance at the top of the firm. What can we do differently in the future?
First and foremost, it remains the responsibility of the private sector to take the lead in
strengthening firm-wide governance and risk management frameworks. As far as supervisors
are concerned, we are enhancing our supervisory tools and standards to reflect recent
lessons, especially in areas like securitisations; management of contractual and
noncontractual exposures to off balance sheet vehicles; stress testing and the management of
firm-wide concentration; and sound valuations. We will be issuing additional guidance on
these topics around the new year. We also need to do a much better job following up on our
guidance in a coordinated global manner.
Finally, we can use the leverage of Pillar 2 - the supervisory review process - to promote
improvements in firm-wide governance, risk management, and controls, and to establish
clear links to the assessment of capital adequacy. Pillar 2 also can be used to promote better
alignment between long term risk management and control objectives and the incentives
created by compensation schemes. Such coordinated supervisory follow up efforts will be
critical to ensure that industry and supervisory sound principles are sustained when
competitive pressures reassert themselves.
Strengthening counterparty credit risk
Another building block of the Committee's strategy is strengthening counterparty credit risk
practices. The Committee will review the treatment of this risk under the three pillars of Basel
II to strengthen minimum capital, risk management, and transparency inside and outside
banks. This effort can help individual banks and the system better withstand the failure of
one or more major counterparties. It also can help contain leverage outside the banking
sector, and it can reinforce efforts to strengthen the infrastructure for OTC derivatives,
possibly using Pillars 1 and 2 as inducements. This forms part of a broader effort to assess
the scope of regulation and oversight beyond the core banking sector.
Strengthening bank resolution and the supervision of cross-border banks
Let me also say a few words on our work to strengthen bank resolution practices and the
supervision of cross border banks. The Committee's Cross-border Bank Resolution Group is
assessing key issues and global incompatibilities in the resolutions of global banking groups.
This effort should strengthen supervisory understanding of the challenges that can arise
when resolving a global banking institution and possible ways to manage through them more
effectively.
We also need to deepen the work of the Committee to promote effective supervisory colleges
at cross-border banks, building on the extensive work of the Accord Implementation Group in
this area. In practice, this means dealing with concrete issues like capital, liquidity and the
division of responsibilities between home and host supervisors in good times and in stress.
Strengthening the system-wide approach to supervision
Finally, we need to strengthen the system-wide approach to supervision, another building
block for our strategy. It is important that we move to embed institutional level supervision
into a broader context that seeks to make the overall financial system more resilient to
stress. The Committee, through its central bank and supervisory membership and outreach
efforts, is in a unique position to translate broader concerns of central banks, supervisors,
and others into concrete, coordinated bank supervisory and regulatory responses at both the
national and global level. Focusing resources in this way can help make the regulatory,
supervisory and risk management infrastructure more resilient to emerging pockets of stress
in an environment of rapid innovation and change.
There are a number of practical ways we can make this link.
•
One approach - that I talked about earlier - is the establishment of a capital
framework that promotes strong buffers in good times and ways to dip into them in
bad times.
•
Another is through coordinated global reviews to contain deterioration in global
underwriting standards and to address imbalances in risk controls and business
growth in competitive environments.
•
An assessment of gaps in global regulations and ways to correct them is a third way
to strengthen a system-wide approach to supervision.
•
Assessing different ways to promote better risk management of participants in major
payment systems, derivative markets, and clearing houses is another.
•
And finally, establishing stronger links between the objectives of central bank
liquidity operations and liquidity regulation and supervision is another way to
strengthen system-wide supervision.
Conclusion
Financial markets, individual firms and supervisors have all been severely tested by this
financial crisis. We have put in place a comprehensive strategy to address the lessons as
they relate to the banking sector, and we are well along in executing on it. Our efforts will
strengthen capital and liquidity buffers; improve risk management practices; enhance
transparency; and strengthen the supervision of banks and the system-wide approach to
supervision. It is important to note that this is a longer term strategy. Some elements need to
be tackled now while others will take more time. The Committee is mindful of the need to
introduce these enhancements in a manner that promotes both near term confidence and
longer term financial stability.