Klaas Knot: Simplicity in the financial sector
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the 20th RiskMinds Global
Risk Regulation Summit, Amsterdam, 2 December 2013.
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Ladies and gentlemen,
Thank you for inviting me to speak at the Risk Minds conference today, also as this enables
me to congratulate you on its 20th edition.
Twenty years have passed since the first Risk Minds conference, and I'm glad to say that risk
management has made substantial progress during this period. The past few years have
certainly underlined the importance of proper risk management.
As I see it, risk management is a key building block for ensuring sufficient capital and liquidity
buffers in the financial system. Strong and reliable financial institutions are one of the vital
elements of financial stability.
And financial stability in turn is of prime importance to De Nederlandsche Bank as a central
bank and prudential supervisor. And that is because central banks have a mandate to
promote financial stability. And we've seen in recent years, that this is not an easy task. In
hindsight, we can say that the financial sector had become too complex and non-transparent.
Technological advances had created various new financial products and instruments whose
risks were often unclear.
This particularly held for products and instruments involving the packaging and repackaging
of exposures, the sale of CDOs (Collateralized Debt Obligations) and CDO2s, and the use of
SIVs (Structured Investment Vehicles).
The financial sector's increasing globalization has also made it more difficult to assess risks
properly. It was because of Lehman Brothers' global presence that its failure had such an
impact on the world. In every country where Lehman Brothers had a branch, its bankruptcy
had to be filed for and resolved.
The financial environment that we faced in the run-up to the crisis - and, by "we", I mean the
public, investors, counterparties, supervisors and regulators - was non-transparent, and the
risks were getting more and more complex. And then it all went wrong, and many financial
institutions had to be bailed out by governments. It was no wonder that the public's
confidence in the financial sector fell sharply. And it still hasn't recovered.
How can we regain the public's trust? For one, by making the financial sector less complex
and more transparent. The crisis has highlighted various fundamental problems in the design
of the financial system. The level of complexity, the mutual dependence - where everyone is
dependent on everyone else - and the rapid speed of transactions - where there is no time
to resolve problems that may arise - all these factors together make the system more prone
to failure.
In existing and new regulations, including the forthcoming Basel III framework, regulators
have focused on the problem of institutions being Too Big To Fail. This is because of the
pressure that having to rescue financial institutions has put on public finances.
But, actually, we should be more worried about banks being Too Complex To Fail. If
institutions are too complex, it's even more difficult and therefore perhaps more expensive to
resolve them.
The need for change is obvious. And responsibility for this change lies in your hands, too! I
see three areas where you can contribute to achieving this change.
First of all, banks' business models must not be unduly complex. In the past, we have seen
financial institutions offering lending services, participating in trading activities, setting up joint
ventures and combining their activities with insurance companies or businesses outside the
financial sector.
The products they offered ranged from traditional loans and lend-to-invest structures to all
kinds of complex off-balance sheet derivatives. Their activities were spread all over the
world, while the risks and rules varied from one country to another. The big picture was
therefore often lost.
At the same time, the benefits of diversifying their activities in these different ways and at
these different locations have proved disappointing. Experience has shown that combining
banking and insurance activities is not as effective in offsetting cash flows and exposures as
was once thought. Risks run on one side of the world are difficult to monitor from the other
side of the world.
And, this time around, the crisis has not been confined to one country or region, but has
been felt all over the globe. A clear and simple business strategy and a streamlined business
model will help reduce complexity. Banks need to focus once again on their traditional roles
of maturity transformation and lending to the real economy. This ties in closely with the
question of how best to structure the banking sector. This is a relevant issue when we're
discussing the activities a bank should engage in.
Committees all around the world have examined this issue, as the Volcker Rule in the US,
the Vickers Report in the UK and the European Commission's Liikanen report show. All of
them have one thing in common. They argue for a simpler banking sector focusing on
traditional banking activities. These reports have resulted in calls for traditional banking
activities to be separated from trading operations by being held in different entities. This will
make banks less complex and improve their stability.
However, complete separation may not be efficient if these trading operations also provide
services to the bank's clients, like market-making services. That's why the Liikanen Report
suggests that trading activities should be separated from the other parts of the bank only if
these trading activities exceed certain limits.
Although this debate is far from over, the direction of the change needed is clear. In other
words, we need to move towards a less complex sector, with more focused activities.
A second way to increase simplicity and transparency in the sector is to simplify the internal
organization of financial institutions. The financial sector in general, and banks in particular,
can be seen as one of the most complex areas in today's world. But we all know that
complex organizations are hard to manage.
Having complex internal structures and many management layers can make it more difficult
for organizations to respond to external developments. Complex organizations are like oil
tankers: it takes a long time to turn them around. And that may mean they miss out on
business opportunities.
A simpler organization, by contrast, can take decisions more quickly. This enables it to
respond more flexibly to new business opportunities, and also to risks that arise. It can also
help staff feel more involved in, and committed to, change.
Thirdly - and this may be the most difficult one - people working for financial institutions
need a prudent mindset. It's ironic, isn't it, that, instead of using sophisticated financial risk
models to identify risks, "smart" people in the financial sector used these models to
circumvent financial regulation.
Remember the trend towards moving exposures off balance sheet? What about the way
benchmark rates were manipulated, and separate legal entities were used in the shadow
banking sector? This behavior was obviously encouraged by the fact that variable benefits
were based on achieving short-term results. This is all changing. And I am happy to see this
happening.
De Nederlandsche Bank, for instance, now explicitly includes "organizational culture" as a
separate aspect in its risk assessment of institutions. In a clear, open environment,
employees should have the interests of their clients at heart. And having a prudent mindset
will also make it easier for them to be transparent. For simpler institutions, regulation and
supervision can be simpler as well. The more complex an organization and its business
model are, the more complex its risks will be. The rules that are meant to capture these risks
will then be at least equally complex.
The reverse is also true. In other words, the regulatory rules for banks engaging only in
traditional lending and funding needn't be as complex as those for banks specializing in more
sophisticated products. The volume of regulations applying to less complex institutions can
also be more limited. Banks that don't have investment operations, for example, can skip
many of the trading book regulations.
Greater regulatory simplicity also has other advantages. Detailed rules may make it more
difficult for supervisors and financial institutions to spot actual risks. The requirements
applying to risk models, for example, are quite detailed. Institutions spend a lot of time and
resources on them. You might think that if a model complies with all these requirements, the
outcomes it produces will also be right. But it is still only a model, and you have to look at
risks in more depth.
Overly detailed rules may also make decision-making less effective. For decisions may be
based on compliance with rules instead of being true risk trade-offs.
Simple rules, by contrast, could help focus on the major risks. Take, for example, a simple
rule that states that all exposures must be covered by some form of capital. Such a rule
would automatically also apply to any new products or instruments.
in my view, unjustifiably
And it would include exposures that now - so- have a 0% risk
weighting, such as certain exposures to governments. A leverage ratio used as a backstop to
these risk models would also achieve this, while still being easy to calculate and understand.
And this is why supervisors are now taking leverage ratios into account when assessing
institutional risk, in addition to the standard risk-weighted ratios. This allows for a
multiangled view of institutions' risk profiles.
Other rules, such as limits on LTV ratios, may set clear limits on loan portfolios' risk profiles.
That way, a smart combination of simple rules can help to highlight risks in an institution's
balance sheet. To be sure, risks should obviously be regulated in similar ways, whatever the
sector. Otherwise, risks will simply shift to less or non-regulated entities.
Simple rules can also offer guidance for the future. Problems we experience in the future are
unlikely to be exactly the same as in the recent past. We also cannot foresee exactly where
new risks will arise.
Simple rules can form a clear benchmark in uncertain situations, and there is a lot of
academic theory to back this up. The economist Frank Knight introduced the concept of
"Knightian uncertainty" by making a distinction between uncertainty and risk in the sense that
uncertainty cannot be quantified.
Indeed, we don't know where we are heading, or what we will encounter along the way. We
simply have to learn to live with unknown unknowns.
Another economist, Hayek, also saw imperfect knowledge as a central issue. Simple, robust
rules can make a difference in such an uncertain and imperfect world. In a complex
environment, we cannot possibly consider or measure all the conceivable outcomes. As well
as being too expensive from an information point of view, it is also too complex to weigh up
all the different options.
Although we like to assume our economic models are rational and omniscient, this is
certainly not the case in reality. It would be more accurate to describe our world as having
bounded rationality and imperfect information.
Simple rules are a way of reducing a complex problem with many unknowns to simpler
tradeoffs, like yes or no, above or below, or left or right. It's as in traffic: in the vast majority of
situations, driving on the correct side of the road is good advice. Or reducing your speed in
misty weather.
If we can progress along the road of simplicity, I'm sure we can also stop the pace of
is the ultimate sophistication".
regulatory expansion. As Leonardo da Vinci said, "Simplicity
Simplicity and transparency can help restore the public's trust in the financial sector.
Financial institutions can achieve this by switching to clear business models, with
streamlined structures and a prudent mindset.
If they do so, the amount of regulations to be complied with can be reduced and the
remaining regulations can be simplified, if and where applicable.
In addition, simple rules can help us focus on key risks, as well as forming a guide for the
future. Greater trust, increased transparency and less complex risks will ultimately make the
overall financial system more robust.
And that in turn will make it easier for central banks to promote financial stability.
Thank you!