Federal Reserve Bank of New York and Banca d'Italia
Post crisis financial regulation:
Experiences from the two sides of the Atlantic
Keynote address by Valeria Sannucci
Deputy Governor of Banca d'Italia
New York, 30 November 2018

Ten years have passed since the default of Lehman Brothers, which was
a turning point in the global financial crisis that had started earlier on, in the
summer of 2007. The crisis spread rapidly from the structured products market
linked to US subprime mortgages to all financial markets, and ultimately to
the real economy, sparking the worst global recession since World War II.
makers'
The policy reaction to these extraordinary developments was
quick and remarkably well-coordinated. Central banks around the world
rapidly lowered official interest rates, and injected liquidity in unprecedented
quantities and through a wide range of monetary policy instruments. Fiscal
policies became expansionary and supportive of the real and financial sectors,
and more serious negative consequences were avoided.
Although some of the long-lasting consequences of those events are still
-
apparent today in many economies in Italy, for instance, GDP as of last
-
December was still 5 per cent lower than in 2007 a decade later we are finally
exiting from the exceptional policy measures taken since then. Central banks
in the major advanced economies have gradually started to normalize their
monetary policy stance, albeit with different timing reflecting the differences
in cyclical conditions across the major economies.
The response to the crisis has led to important changes in the rules of
the game for banks and financial firms, which are the subject of the analyses
presented in the two workshop sessions today. In the immediate aftermath of
the crisis, the G20 Leaders established the Financial Stability Board (FSB),
building upon its predecessor, the Financial Stability Forum, to promote the
repairing of the financial system through a broad agenda of reforms of the
international regulatory framework. The reforms were intended to address
the imbalances that had gradually been accumulating in the global financial
system well before 2007, by strengthening the resilience of financial
intermediaries, markets and infrastructures, tackling moral hazard issues and
reducing procyclicality in the financial system. In particular, for institutions
which pose systemic risks, reforms were aimed at enhancing their capacity
to absorb shocks and, in the event of failures, making their resolution easier.
To date, substantial progress has been made towards a more stable and
banks'
resilient global financial system. First, capital has been substantially
increased, and ad hoc capital buffers have been built by systemically important
banks'
banks. Second, liquidity positions have also been strengthened with
the introduction of rules such as the Liquidity Coverage Ratio and the Net
Stable Funding Ratio. Third, the vulnerability of the financial system to
contagion on a global scale has been curtailed, by providing incentives to
clear over-the-counter (OTC) derivatives centrally. And fourth, the market
-
for complex and opaque securitizations a form of financial intermediation
-
which played an important role in the run-up to the crisis has virtually
disappeared. In Europe, new rules have been approved in order to promote
simple, transparent, and standardized securitizations.1 However, cases such
as the recent strong growth of the collateralized loan obligation market in
the United States need to be kept under strict scrutiny to avoid repeating past
errors.
In spite of such progress, significant challenges remain ahead of us and
we must maintain the momentum of reform.
A significant source of potential vulnerability concerns the non-bank
financial sector. Post-crisis reforms of the regulatory framework have been
much less advanced in this sector than in the banking sector. Perhaps also
as a consequence of this, the share of non-bank financial intermediation has
grown seamlessly since the end of the last decade, with non-bank financial
intermediaries often performing functions typically carried out by banks,
without being subject to comparably stringent regulation and supervision.
According to the Financial Stability Board, at the end of 2016, non-bank fi-
nancial intermediaries held $160 trillion in total assets, about one and a half
banks'
times the level at the end of 2008, while over the same period assets
have risen only marginally. The non-bank financial intermediaries perform-
ing bank-like functions in 2016 held $45 trillion of assets. The asset manage-
ment industry, the largest sector of non-banking intermediation, has almost
doubled in size over the past decade.
The growth of non-bank financial intermediation is increasing the
sources of finance for the economy, reducing dependence on bank lending
system's
and strengthening the financial resilience. In this respect, it is a
welcome complement to bank intermediation, in particular in many European
economies, including Italy, which have traditionally been characterized by
a bank-centric financial system, with limited room for market-based finance
and non-bank financial intermediaries.
At the same time, we cannot neglect the risks it may create for financial
stability. Some risks are similar to those faced by banks, as non-bank
financial institutions are also exposed to risks related to liquidity/maturity
transformation and leverage.2
Other risks, however, are of a different nature. The spread of high-frequency,
quantitative/automated trading and passive management strategies contributes
to making the highly concentrated asset management industry vulnerable
to procyclical behaviour, which in turn has the potential to amplify market
reactions to macroeconomic news, sometimes in destabilizing ways. A case in
point is what happened at the beginning of last February, when some apparently
innocuous news on US wage growth led to a stock market crash, with a sudden
unwinding of crowded trades, and hugely negative consequences for some
market players (who had bet on low volatility). Fire sales and contagion can
take place during this kind of events, which could end up having unsettling
effects on financial stability, to the extent that they could threaten the resilience
of financial intermediaries.
Other significant developments that need to be monitored closely due
to possible financial stability implications concern technology and financial
innovation. The profound changes in financial technology are enabling new
institutions, often operating outside the banking system, as well as large
technology corporations to offer services which challenge the traditional
role of bank intermediaries. These changes blur the distinction between the
financial and technology sectors, raise questions concerning the perimeter of
current financial regulation, and give rise to new risks, such as those deriving
from an increasing dependency on third-party service providers.
As the adoption of digital technologies for the provision of financial
services spreads, policy makers need to continue monitoring the risks from
a financial stability perspective, and consider whether FinTech should be
regulated, who the regulator should be, and what type of regulation would be
appropriate. In addressing these issues, we should be guided by the principle
'same
of business, same risks, same rules'. In Italy, the banking law has
recently been updated in order to bring the regulatory framework for finance
companies, investment firms and other non-bank finance intermediaries
more in line with the regime applicable to banks.3 The rationale behind this
reform was, among other things, to avoid new forms of potential regulatory
arbitrage stemming from the differences in the regulatory frameworks for
institutions with similar types of business.
A related area is that of crypto-assets. Their financial stability
implications are currently limited given the size of the market, as observed
by the FSB report published in October. However, this assessment could
change over time, as suggested by some experiences, such as the very large
swings in their prices, the very rapid expansion in some countries of initial
coin offerings,4 the growth of crypto-asset exchanges, and the emergence
of crypto-asset funds, futures and similar financial products. Wider use
and greater interconnectedness with the core financial system could pose
financial stability risks if they occurred without material improvements in
the resilience of crypto-asset markets.
To support a timely identification of emerging financial stability risks
and to explore the possible policy options to pre-empt the build-up of risk
and to ring-fence the financial system if risks from crypto-assets become
significant, a strengthening of the analysis of the crypto-asset market structure
is necessary.
Yet the challenges that are facing us today are not only about dealing
with the new risks (and opportunities) of financial innovation. After the
intense, prolonged reform effort, we need to ensure that the new framework is
effectively implemented, thereby providing regulatory certainty and stability
so that the financial system can operate in support of economic growth.
3
The reform is based on Legislative Decree 141/2010, which amended the TUB (Consolidated Law on
Banking); it was completed by Ministerial Decree 53/2015, which identified the activities subject to
reserve. Supervisory regulations for financial intermediaries and groups of financial intermediaries are
set out in Banca d'Italia Circular No. 288 of 3 April 2015.
4
Initial coin offerings (ICOs) are public offerings of crypto-assets in exchange for sovereign fiat
currencies or popular private crypto-currencies (e.g. bitcoin) through which companies raise capital to
fund the early stage development of projects or businesses. ICOs are conceptually analogous to initial
public offerings for stocks.
A key issue concerns the need for consistent implementation by all
jurisdictions, in order to prevent fragmentation of the financial system. In
principle, rules commonly agreed upon by the FSB and the Basel Committee
on Banking Supervision (BCBS) should lead to a more stable and resilient
financial sector and to a better integrated financial system. However,
differences in reform implementation across countries might increase
the fragmentation of financial systems. An example taken from banking
supervision concerns ring-fencing practices adopted by host authorities on
banks' international branches. This is rational from the single regulator's
perspective but could lead to more fragmented global banking and liquidity.
Hence, efforts should also be made in the direction of assessing reform
implementation, with the aim of achieving a more homogenous application
of the agreed rules across regions, including through truly open cooperation
and coordination.
The large scale of the post-crisis reforms requires a thorough and
honest assessment of their effects and of the possible implementation
challenges. Work on this front is ongoing in several forums. The FSB has
recently prepared two different reports to evaluate the effects of reforms on
infrastructure finance and on incentives to clear OTC derivatives centrally.
A new project has been started to assess the effects of reforms on SME
financing and another is planned to evaluate the implications of the reforms
aimed at addressing the systemic and moral hazard risks associated with
global systemically important banks (G-SIBs). The FSB is also planning an
initiative to explore ways to address the risk of market fragmentation.
Reform evaluations naturally entail an appraisal of their unintended
consequences. For instance, analyses of the effect of the leverage ratio on
banks'
provision of client clearing services have been carried out by the
Financial Stability Board together with the relevant standard-setting bodies,
and are informing the ongoing effort by policy-makers to improve the
regulatory framework.
Implementation challenges can also arise in relation to what I see
as a trade-off between the ex-ante desire for perfection and the ex-post
effectiveness of new regulations. Let me give you two examples.
We have had the Bank Recovery and Resolution Directive (BRRD)
in Europe since 2014. In the spirit of the Key Attributes for Resolution
Regimes agreed by the FSB, this directive aims to strengthen and harmonize
bank crisis management in the EU, as well as to minimize the cost to the
'minimum
taxpayers. Among other provisions, the new directive sets a
liabilities' -
requirement for own funds and eligible (MREL) similar to the
Total Loss-absorbing Capacity (TLAC) requirement for global systemically
-
important banks to ensure that, in the event of resolution, banks will have
sufficient own funds and other liabilities to absorb losses and reconstitute
capital. At the same time, its introduction could substantially raise bank
funding costs and reduce bank lending. While estimates of these costs are
highly uncertain, there are risks of a non-negligible impact on GDP growth.
d'Italia
Banca has stressed the need to alleviate the adverse effects of the
banks'
rules on loss-absorbing liabilities by ensuring that the amount and
quality of funds are proportionate to the actual demands of the resolution,
and that the transition period is long enough to allow the banks to build up
the requirement gradually. Yet when looking at the initial experiences with
the application of the new bank resolution regime in Europe, it is clear that
more flexibility in applying the available tools would help make the crisis
management framework more effective in dealing with problem banks. A
useful lesson in this regard can be that of the United States, where flexibility
and pragmatism are key ingredients of the policy decisions in this realm.
However, for the lesson to be learned, the members of the European Union
- a relatively young union - need to reinforce mutual trust, which is the
essential glue of any union, but that nevertheless has recently been weakened
more than once. All in all, implementation challenges could well lead to
some regulations being reconsidered.
A second example of the trade-off between an ex-ante desire for perfection
and ex-post effectiveness is given by looking at specific components of
banks'
the capital. Capital is a key element of bank regulation and it has
therefore been a main target of the post-crisis reform, as will be discussed
in the second session of today's workshop. A major innovation of Basel III
is the possibility granted to banks to compute the Contingent Convertible
bonds (CoCos) as 'Additional Tier 1' capital. The favourable regulatory
treatment of this instrument has spurred a very strong growth in the CoCo
market in Europe. However, while CoCos are designed to strengthen bank
solvency on a going concern basis, their use may ultimately come at the
cost of increasing financial stability risks. Recent research by Banca d'Italia5
has shown that the adverse dynamics of the CoCo market that occurred in
2016 following worrying news about an issuer cannot only be explained
banks'
by the fundamentals and hence that CoCos might in fact themselves
be a source of financial instability. Although some of the instability may
have been transitory, the analysis suggests that this market should be closely
monitored and that authorities may need to rethink the role of CoCos, should
they prove unable to provide for a smooth bank recapitalization.
This brings me to my final remark. There is a concrete risk of losing
the reform momentum and conceding ground to calls that are not always
disinterested and to mounting pressure to roll back the existing regulations.
As recently pointed out by the International Monetary Fund, this pressure
should be resisted. We need to learn from the past. Each and every time
either regulation or supervision has become lax, excessive risks have been
taken and leverage has increased, often leading to abrupt and recessionary
swings in the financial cycle. So, during economic expansions we should be
aware of the possible illusory perception of things looking more benign than
they actually are.
To conclude, central banks have emerged from the trial of the financial
crisis with a strengthened responsibility in the area of financial stability,
which needs to be honoured. High quality analyses and meetings like this
one represent a unique opportunity to compare experiences and continue
the debate, thus helping policy makers to carry out their mandate more
effectively.
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