Sabine Lautenschläger: Ten years after the crisis - risks, rules and
supervision
Speech by Ms Sabine Lautenschläger, Member of the Executive Board of the European Central
Bank and Vice-Chair of the Supervisory Board of the European Central Bank, at the 13th
ASBABCBS-FSI High-Level Meeting on Global and Regional Supervisory Priorities in Nassau,
Bahamas, 30 October 2018.
* * *
Ten years have passed since the financial crisis erupted - an entire decade. But it is still very
present in our minds, and no one wants to go through it all again. So, the key question is: how
can we prevent such crises in the future? To answer that question, we need an intimate
knowledge of the things that led to the crisis in the first place.
As you are probably only too familiar with these things, I will spare you the long version of events.
The short version is that risks were too high, rules were too soft, and supervision was too lax.
Ten years on, this has changed - or has it? Are banks now better regulated and supervised? Are
risks under control?
Let's take a look at whether we have really succeeded in making the banking sector a safer
place.
Tougher rules - but implementation is key
Over the past ten years, a lot of brainpower has gone into untangling the complex web of factors
which led to the crisis. But analysis is just the first step, of course; the second step is action. And
action was and is still needed to ensure the resilience of the financial system.
We all know that it's this second step where one can easily stumble. Moving from analysis to
action always requires a lot of political will and consensus. And this time, it was even more
difficult. The financial crisis had revealed how interconnected the financial system had become.
So any action to make the system more resilient had to be taken at the global level too. This
added another layer of complexity.
But with memories of the crisis still fresh, countries from around the world managed to agree on
a large set of reforms, with Basel III being the cornerstone. It took some time to finalise these
reforms, but it is still a remarkable achievement.
A remarkable achievement, for sure. But let us not forget that the proof is in the pudding, as they
say. Basel III needs to be implemented. And since the banking system is global in scope, Basel III
needs to be implemented on a global scale.
Banking might have become a bit more national here and there, ring-fencing a bit more en vogue
and the idea of withdrawing from the global stage a bit fashionable. But banks are so closely
connected across borders that no national approach will ever be able to deal with the risks
involved.
Against this backdrop, I am a bit worried that we are losing momentum on this front. There
seems to be less and less drive to follow through on the reforms that were agreed in Basel.
Europe is no exception here, by the way. Lawmakers are reviewing the related legislation, and
we are seeing some proposals which would mean that European rules deviate from the
standards agreed upon in Basel. This would affect the net stable funding ratio and the leverage
ratio, for instance.
It would also affect the way in which we deal with market risk. The fundamental review of the
trading book is important here. It is meant to address the shortcomings of the previous market
risk framework and is thus an important part of the reform package. However, it seems that we
might get caught in a global cycle of postponing its implementation. This would not be good:
market risk in particular is global in nature and requires global rules.
We seem to be seeing an old story unfolding before our eyes. In times of crisis, everyone agrees
that tougher rules are needed. But as soon as things start to get better, rules are suddenly seen
as preventing banks from doing good business and the economy from growing.
Consequently, rules are softened, banks are "freed", the economy grows, and the seeds for the
next crisis are sown - because such growth cannot be sustained in the long run. Sustainable
growth needs to be financed by stable banks that price risks correctly and cover them with
adequate capital. It's a simple lesson, but it seems to be quite a hard one to learn.
Failing to implement the rules is a clear risk. But given the global scale of the banking sector,
another risk is that the rules will be implemented unevenly. This would enable banks to go
wherever the rules are softest. In the worst case, some countries might try to turn this into a
business model. But let me assure you: light-touch regulation is not a viable business model. We
have seen it before, and we know what comes next.
The only way to go is to implement Basel III and to do so faithfully. We need to fight the
misguided attempt to sacrifice global stability in order to make national banking sectors more
competitive. The risks involved outweigh the returns. And what's more, those who reap the
returns are often not those who bear the risks.
But even if the rules were faithfully implemented everywhere, that would not be the end of the
story. Banks still need to adjust to the new rulebook, and they might do so in the wrong way.
It is a fact of life that banks will look for room to manoeuvre, and experience tells us that they will
find it. It might take some time as the framework is still new, but it will happen. And this will
undermine the purpose of the rules and increase risks.
That's why we keep an eye on regulatory arbitrage. And here we quite often see something that
could be termed regulatory maturity "optimisation". For example, some banks exploit the fact that
prudential requirements are tied to the timing and maturity of transactions. This kind of arbitrage
happens around the world and can take many forms.
One prominent example is window dressing around quarter-end dates. This affects the leverage
ratio in cases where it needs to be disclosed on a quarterly basis. Banks might thus "dress up"
their balance sheets just four times a year. So, it might well be a good idea to switch to daily
average reporting, at least for some components of the leverage ratio.
In other cases, banks artificially reduce the regulatory maturities of transactions through the use,
or restructuring, of derivatives. This allows them to exploit loopholes in the capital and liquidity
standards. We keep a close eye on these trends, including the growth of the
settlement-tomarket model.
In order to deal with arbitrage, we need to cooperate across borders; the loopholes should be
closed everywhere. Only then can we ensure the sustained effectiveness of the post-crisis
reforms.
Better supervision - a new approach
Ladies and gentlemen, rules are important and they need to be implemented. But rules alone are
not enough. You also need people to check whether banks are following the rules. You need
supervisors.
And this leads us directly to the first "supervisory" issue. Before the crisis, supervisors often did
just that: they checked whether banks were complying with the rules. This compliance-based
approach proved to be too limited, though. It didn't require supervisors to truly understand the risk
profiles of banks, and it didn't require them to think ahead and look out for new risks.
So supervisors needed to change their approach. Dealing with a global banking sector that is
constantly evolving requires supervisors who know when it's time to act, who are willing to act
and who are able to act. From this, everything else follows.
First of all, supervisors must take a risk-based and forward-looking approach. The days of mere
box-ticking are over.
Supervisors must understand the business models of banks and the economic environment in
which they operate. They must understand banks' internal control systems and their governance
structures. And in all of this, they need to have an eye on the future: it's not just today's risks that
count; it's also those of tomorrow.
Next, supervisors must be adaptive. The banking sector is steadily evolving. It evolves quickly
and not always in a straight line. Supervisors need to keep pace and be aware of any new risks
that might emerge along the way.
In addition, supervisors must be intrusive. They must dig deep to obtain an intimate knowledge of
their banks. This knowledge then allows them to be sceptical. They do not have to rely on what
the banks tell them. Instead, they can form their own opinion and challenge the banks' views.
But it's not just about digging deep. It's also about broadening the perspective and using all the
available tools to spot trends and anomalies in the behaviour of banks as well as to identify best
practices.
The ECB, for instance, benchmarks banks that pursue the same line of business. Supervising
the 118 largest banking groups from across the euro area means that we benefit from a deep
quantitative and qualitative analysis. This allows us to challenge banks in a more credible
manner.
And speaking of credibility brings me to a very important point. Supervisors must be independent!
They must be able to take their own decisions. They must be free from pressure from banks or
other stakeholders - and they must be free from political trends. But it's not just about formal
independence. Supervisors must also be independent of mind. They must avoid groupthink and
other biases.
And finally, supervisors must acknowledge that they are dealing with a banking system that is
global in scope. This means they must reach out to others; international cooperation has
become crucial for good supervision.And here the Financial Stability Institute plays an important
role; it helps to bring together supervisors at all levels from around the world.
Ladies and gentlemen, I have now listed a few of the traits that help supervisors to do a good job.
But there is one trait that I have left out so far. It is probably one of the most important traits, but it
is also one that makes us a bit less likeable.
We supervisors must be the spoilsports. We must be the ones who force banks to prepare for a
storm when the sun is shining brightly. Do the banks like that? Probably not - at least in my
experience. Should we care? No. As you recently put it, Agustín: "...we have come to appreciate
how unrewarding it can be to flag risks when markets are running hot". And we cannot help it: it is
our job to look out for clouds on the horizon and draw attention to them.
So, let's do just that. Let's try to spot the clouds; let's take a look at some of the risks that are out
there.
Risks - what's looming on the horizon?
Of course, not all risks are relevant for all people and in all places. But the crisis taught us that
we cannot turn a blind eye to the risks of others because they might quickly become our own.
Looking at the risks we currently face, there are some well-known ones, of course: geopolitical
uncertainties related to trade tensions and Brexit, for example, and legacy assets such as
nonperforming loans. But there's more - unfortunately.
There are many things that banks have to adjust to. And the risk is that some will either fail to
adjust at all, or they will go about it the wrong way.
For quite some time now, banks have operated in an environment that is kind of special. There
has been a long period of loose monetary policy, low interest rates, abundant liquidity and solid
economic growth. All this may have come to feel normal, but it isn't. There are many things that
could trigger a sudden change.
When that happens, risk and term premia in financial markets will snap back and emerging
markets might be affected. And all this could cause trouble for banks. The value of
mark-tomarket assets might go down, costs of funding might go up, interest income would go down, and
so on.
We supervisors must ask whether banks are prepared for such change. Are they pricing risks
correctly? Are they mindful of the fact that historical data now include a long period of special
circumstances? Have they cleaned up their balance sheets? I think I already mentioned that
these preparations should be made as long as the sun is shining.
Another source of change is technological, and it's already happening: digitalisation. In itself this
is both a risk and an opportunity. Which of the two will become more relevant in the end depends
on how banks adjust to the new digital world. Are they investing in their IT systems, stepping up
their protection against cybercrime and finding ways to hold their own against new competitors?
If they do these things, digitalisation offers great opportunities to unlock new business and cut
costs. If they don't, others will take over: small and agile fintech start-ups or the big and powerful
tech giants, for instance. And if that happens, it would add to one of the problems some banks
already have: profitability.
It has become more difficult for banks to make money - not least due to low interest rates. In
Europe, a number of banks struggle to earn their cost of capital. And again, there is the danger of
adjusting in the wrong way.
Banks might embark on a search for yield and take on too much risk. Some observers have
recently identified leveraged loans as an area of potential concern in this context. In 2017, the
issuance of leveraged loans indeed reached a new high. The worrying thing is that investors
seem to be ready to accept lower protection. They have become more lenient in their credit
policies - the share of covenant-lite loans has become quite high.
Against this backdrop, the ECB issued guidance on such loans which entered into force at the
end of 2017. This was followed by relatively low volumes of leveraged loans being issued in the
first few months of 2018. But this doesn't mean that we can relax just yet. Non-banks might step
in and become more active in the market.
And this brings me to another risk: shadow banking. This part of the financial system has grown
quite big in recent years. In the EU alone, it accounts for 40% of assets in the financial system.
However, we do not have a clear picture of the shadow banking sector. In the EU, almost half of
all assets in the shadow banking sector are held by institutions for which we lack a detailed
statistical breakdown.
But why should we, as banking supervisors, care about non-banks in the first place? Well, we
should care because there are close links between banks and non-banks. And close links mean
mutual exposures. Take funding as an example. In 2017, wholesale funding to euro area banks
from entities in the shadow banking sector reached a staggering €2.2 trillion. So, there is another
source of risk.
To be able to monitor this risk, we need to close the data gaps. We need more data to bring
shadow banking out of the shadows. We need more data to examine and understand this large
part of the financial system more thoroughly. Otherwise, we might overlook risks that could spill
over to banks and threaten their stability.
So, supervisors need to have a broad perspective and they need to look ahead. And if they want
to be truly forward-looking, they have to step out of their comfort zone. They need to monitor risks
which are not fully clear today, but may become an issue in the future. Risks related to climate
change are a perfect example.
I am aware that some see climate change as a matter just for scientists and politicians. And in a
way, they are right. But then again, we all share this one planet. And a changing climate affects
us not only as inhabitants of this planet, but also as bankers and supervisors. Fortunately, many
authorities have realised we need to do more in this field, but work is still in the early stages.
I see three challenges for banks. First, there are physical risks. More frequent and more severe
storms, floods, droughts, heatwaves and rising sea levels have already caused losses for
businesses. When these risks were uninsured, they had very direct effects on banks' credit risk,
for example through damaged collateral.
Second, "green finance" is a growing area of business. As all supervisors know well, financial
innovation can bring a lot of good - but it can also spin out of control. So, we must monitor green
finance just as we would monitor any other type of financial innovation.
Third, there is the transition to a low-carbon economy. Policies to encourage a more sustainable
way of doing business will have far-reaching consequences. For one, they could impact the
banks' customers. Think of car manufacturers or energy suppliers. And they could affect
commodity and energy prices. This in turn could change market risks for banks. I know this is an
apparent paradox. The policies required to shift to a more sustainable economy could at the
same time upset financial stability. But this should not scare us into inaction. Because again, the
true risk is that banks do not adjust or adjust in the wrong way.
As supervisors, we should keep on doing what we have learned to do since the crisis: expand
our horizons. In practice, this could mean encouraging banks to recognise the potential impact of
climate risk on their exposures. I am well aware that longer-term trends are hard to incorporate
into risk analyses. But ignoring them is not the answer at all.
Conclusion
Ladies and gentlemen,
Let us return to the initial question: has the banking sector become a safer place? Yes, it has.
However, we are talking about a moving target; the business of banking constantly evolves and
changes. What is safe today might not be tomorrow.
Thus, we must keep a close eye on new developments and the risks that might accompany
them. And we need to exchange views. We need to meet; we need to discuss; we need to learn
from each other's experiences; and we need to sharpen our analysis. As I said before, other
countries' risks can quickly become our own.
That's why I'm happy to be here. I am sure that we will have very interesting debates, and that we
can all learn from each other.
Thank you for your attention.