Andreas Dombret: What is "good" regulation?
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, at the 16th Euro Finance Week, Frankfurt am Main, 19 November 2013.
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1. What is "good regulation"?
I would like to thank the hosts of the Euro Finance Week for raising this important topic of
"good regulation" - even though fifteen minutes is not very much time to give a
comprehensive report on the topic. The first question that occurs to me in this context is: who
is regulation supposed to benefit in the first place? Regulated parties are likely to have a
different take on the matter to supervisors and society at large. Instead of focusing on the
theory, I therefore want to take a pragmatic approach to the topic, and to explain three key
aspects from the regulators' point of view - although I cannot, of course, give an exhaustive
account in this speech.
First, "good regulation" of financial markets pursues a clear objective, in my opinion: to create
a sound framework for the financial system and thus ensure its stability. A stable financial
system ought to be able at all times to fulfil its core task of allocating capital efficiently. In
other words: efficient funding of the real economy should be constantly assured. That is the
main yardstick we should use to measure regulation.
To keep the financial system stable, it is therefore important to apply a fundamental principle
of market economies - incentive and punishment mechanisms - to regulation: risk-taking
and liability have to be consistent with one another. This means that those who take risks in
order to make profits also have to shoulder the risks involved - irrespective of their
institutional form or size.
2. Put an end to "too-big-to-fail"
This principle, however, was nullified during the crisis. Several banks facing the threat of
bankruptcy had to be bailed out by governments with taxpayer funds. These banks were
regarded as too complex, too interconnected or simply "too big" to fail. There were fears that
their failure would have a dramatic effect on the financial system and the real economy.
Regulatory policy considerations took a back seat, and taxpayers were ultimately on the
hook for risks on banks' balance sheets. The implied government guarantees for such
institutions, which were already thought to exist before the financial crisis, were thus de facto
confirmed.
That goes against the principles of a market economy. Private funds should be used for the
recovery of a distressed bank. If shareholders are not willing to take that step, the institution
should be resolved - without destabilising the entire financial system in the process. The
option of a credible resolution is the only way to eliminate implied government guarantees for
systemically important banks.
We are on the right track with regard to dealing with the systemic importance of banks, but
the finish line is still a long way off. The new international agreements on resolution regimes
developed by the Financial Stability Board (FSB) are a crucial step. Applying them globally
will make the orderly resolution of a big bank a more realistic option and thus also a more
credible threat. Intensive work is being carried out at the European level on the
implementation of these principles. Negotiations on the European Recovery and Resolution
Directive are scheduled for completion by the end of this year.
In Germany, the Bundestag already adopted a restructuring act in 2010 which anticipated the
European rules. That was followed up by German lawmakers with the passage of the Act to
Strengthen German Financial Supervision in 2012. Not only the new resolution regime but
also, for instance, higher capital requirements, or the obligation to trade derivatives via
central counterparties, represent a distinct improvement on the situation before the failure of
Lehman Brothers. These are all key first steps, but they are not enough to make the financial
system a safer place.
However, it is not only banks that can be systemically important. In July 2013, the Financial
Stability Board published a list of global systemically important insurers, or G-SIIs. Much like
systemically important banks, these nine institutions will be made subject to recovery and
resolution planning requirements and capital surcharges. These measures, too, are designed
to strengthen market economy principles.
It is clear that we have to shape and transpose the new rules agreed at the international level
consistently across national borders and sectors alike. This is not such a simple matter in
practice. However, it is the only way to create a "level playing field" and prevent regulatory
arbitrage. And that is also the only way we can make progress in containing the
"too-big-tofail" risks.
3. The banking union - an important and welcome step
In my opinion, strong institutions are the second component of good regulation. Good
regulation requires more than just well-thought-out legislation; good institutions are crucial.
And this brings me to the European banking union. The single supervisory mechanism
(SSM) has finally been adopted, and the European Central Bank (ECB) has begun to set up
the necessary structures - including recruiting the staff required. The Bundesbank is
supporting the ECB in these efforts.
The aim of joint supervision is for banks everywhere to be supervised according to the same
high standards. In addition, cross-border effects can be covered better through joint
supervision than by national supervisors. The financial system is likely to become more
stable under European supervision. But, if push comes to shove, banks supervised at the
European level will have to be resolved at the European level, too.
For this, we need a centralised European resolution authority for banks which is based on
sound legal foundations. The debate on this single resolution mechanism (SRM) is in full
swing, and several proposals are on the table. I believe the best solution is one that promises
to be effective and enforceable in a crisis event while at the same time avoiding potential
conflicts of interest on the part of the resolution authority from the outset. It is clear to me,
too, that the SRM for banks should be launched as soon as possible after the SSM. I am for
the beginning of 2015 as the kick-off date.
4. Strengthen macroprudential supervision
The third and final aspect of "good regulation" I wish to mention is the macroprudential
perspective. After all, "good regulation" must never lose sight of the "big picture". The
financial crisis swept away any lingering doubts that we need to broaden our regulatory
perspective beyond individual banks. This means that we need macroprudential oversight
alongside microprudential supervision.
This has now been enshrined in German law: the Financial Stability Act has been in force
since the beginning of this year. The institutional framework for macroprudential oversight
has thus been established in Germany. The newly formed Financial Stability Committee
started its work at the beginning of the year. The Bundesbank is a member of this committee
and has been tasked with the ongoing analysis of developments relevant to financial stability
and with identifying threats. Where appropriate, we can propose that the committee issue
warnings and, if necessary, specific recommendations for action.
5. The "cobra effect" and the preferential regulatory treatment of sovereign debt
Having mentioned these, to my mind, important three aspects of "good regulation", I would
like to touch briefly on a core problem: complexity. In my opinion, complexity is one of the
central challenges in both the design and the implementation of new - and, hopefully, good -
regulation. And nobody would dispute the fact that financial markets and their participants
have become very complex.
There are many levers which supervisors and/or lawmakers can pull. In some cases, pulling
only one single lever the wrong way is enough to threaten the stability of the system. This
can lead to unintended consequences such as regulatory gaps, duplication or arbitrage.
Let me discuss, at this juncture, a phenomenon known as the "cobra effect". The cobra
anecdote goes back to colonial India. In order to contain a plague of cobras, the British
colonial administrators offered a bounty for every dead cobra. The plan initially seemed to
work; the colonial administrators were presented with a large number of dead cobras.
Unfortunately, however, this failed to bring the plague under control. Most of the snakes
delivered were actually not wild animals, but had instead been bred by entrepreneurial
Indians in order to collect the bounty. Once the governor caught wind of it, he cancelled the
premium, and the breeders then released the now-worthless snakes into the wild - thus
making the plague worse than before...
Regulatory measures, too, can have undesired and unintended consequences. When the
first Basel Capital Accord was introduced 25 years ago, industrial countries ́ government
bonds, for instance, were classified as safe because nobody thought a government could
default. Bank regulators thus regarded government bonds as an anchor of stability for banks'
balance sheets. As a result, banks today do not need to hold capital against the risks on
OECD countries' government bonds. In addition, rules to limit concentration risk do not need
to be applied to government bonds.
It is therefore no big surprise that this exception in the Basel Framework had unintended
consequences. Banks poured massive funds into government bonds - especially domestic
bonds. This created a kind of "doom loop" between the solvency of sovereigns and the
solvency of domestic banks. We have to break this dangerous loop by ending the preferential
regulatory treatment of government bonds.
However, as the story of the cobra effect shows, abrupt changes carry dangers too.
Immediately prescribing that a certain amount of capital be held to back the risks on
government bonds could lead to another set of unintended consequences. But that does not
alter the fact that the existing rules need to be changed in order to break the "doom loop"
between sovereigns and banks. Such change will never be popular, and it is clear that we
need an appropriate transitional phase, such as by gradually phasing in new rules. Additional
measures may be needed in order to avoid adverse effects on banks and sovereigns alike.
6. Conclusion
Let me conclude by summing up what I believe to be the indispensable elements of "good
regulation". The aim of "good regulation" is to maintain the stability of the financial system,
thus ensuring that the financial sector has the tools it needs to completely fulfil its role for the
real economy. It is therefore important that market economy principles - such as the unity of
liability and control - also apply to the financial sector. Moreover, strong institutions are
needed to implement and apply regulation. Lastly, a macro perspective is needed. This
means that we need not only the existing microprudential regulation but also a new,
systemically-oriented regulatory framework. The two must go hand-in-hand.
On top of all this, we need to be highly vigilant towards potential design flaws and unintended
consequences in all of these regulatory projects. And we also need the wisdom to make
corrections if need be. After all, the financial system is evolving relentlessly. "Good
regulation" will thus always be a work in progress.
This marks the end of my introductory remarks. I look forward to our discussion.