Yves Mersch: International financial centers after the crisis
Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at a
LunchConference of the BLC (Business Club Belgo-Luxembourgeois en Suisse), Zurich, 23 May
2011.
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Ladies and Gentlemen,
It is my pleasure to talk in front of this distinguished audience about the challenges of
international financial centers after the crisis. I would therefore like to thank Business Club
Belgo-Luxembourgeois en Suisse for inviting me to this conference breakfast.
The worldwide scenery of international financial centers is in transition. The respective
locations face massive upheaval as global competition and the post-crisis reforms in
regulation and supervision begin to bite. In order to overcome the challenges of a changing
environment and to identify the potential opportunities, it is important to distinguish between
the different drivers.
A large part of the challenges financial centers are facing, are due to regulatory changes,
which result from the reform in the aftermath of the financial crisis. In addition there are
global trends that have been going on already before the outbreak of the financial crisis and
which continue to have an impact.
I will refer to these major sources of change in more detail in the course of my talk, provide
some experience from Luxembourg, and will discuss the shortcomings and remaining
challenges of the new regulatory framework.
International financial centers - hit hard by the global crisis
The high degree of integration and interconnectedness of financial markets contributed to the
amplification and spread of the financial crisis around the world. The crisis had devastating
effects on both the banking sector and the real economy, in particular in international
financial centers with a high concentration of activities in banking, trading etc. They are the
nodes of a global network.
By consequence, the global financial crisis hit Luxembourg's open economy and
internationally-integrated financial center - although relatively less than the neighboring
countries, such as Germany and France.
Luxembourg is the world's second largest investment fund center in terms of size (after the
United States) and the largest in terms of interconnectedness, the most important private
banking center in the euro zone and Europe's leading center for reinsurance companies.
Moreover, Luxembourg is among the 25 most systemically important financial centers in the
world.
At the height of the crisis, Luxembourg's sizeable investment fund industry endured
substantial redemptions and its foreign-subsidiary dominated banking system experienced a
sharp drop in the aggregate balance sheet as well as in the off-balance sheet positions. This
led to a 20 percent contraction in the aggregate balance sheet of the foreign-subsidiary
dominated banking system in Luxembourg. Banks have also seen a 30 percent drop in their
off-balance sheet positions as assets under management dwindled. About 8 percent of the
financial sector's work force lost their jobs, only a part of which could be re-employed by
other institutes.
Still, Luxemburg was less scathed by the financial crisis than countries with a highly
leveraged home banking sector that sometimes had expanded excessively abroad.
Moreover, the overall situation has since stabilized. No bank rescues were required since
2009 and investment fund assets have rebounded beyond pre-crisis peaks. In 2010, the
number of investment funds that have been registered in Luxembourg increased by
5.9 percent to 3,463. The net asset value in turn rose by around 20 percent to 2.2 billion
Euros.
Thanks also to the global recovery and developments in neighboring countries, growth
resumed early in the second half of 2009 and labor markets showed initial signs of recovery.
Last year, Luxemburg's Gross Domestic Product expanded by 31⁄2 percent - compared to an
average of 1.7 percent in the European Union.
The global financial crisis, nonetheless, will leave a lasting imprint on the Luxembourg
economy.
Global trends increase competition
Even before the outbreak of the crisis in the summer of 2007 the worldwide scenery of
international financial centers was in motion. At first glance, however, the picture looked
rather static.
While the traditional financial centers in the industrialized world were prospering in an overall
growing environment, and managed to defend their relative positions, emerging financial
centers, particularly from Asia, were able to improve their competitiveness dramatically. It
was therefore apparent that the top dogs would be facing increasing pressures to maintain
their dominant positions.
As financial centers emerge and develop over long periods of time, they are not too easily
shaken. Most of the described trends therefore will continue after the recovery from the
crisis.
By consequence, traditional financial centers from the US and EU continue to represent the
lions share of the global market. Although, in absolute terms, in many market segments
overall levels of market activity have diminished, financial centers from the US and Europe
provide around three-quarters of global financial services.
Let me be more precise:
- More than two thirds of global banking assets remain concentrated in financial
centers in the US and Europe.
- The US and Europe capture more than three quarters of the global revenue pool in
investment banking.
- Over two-thirds of all private and public debt securities and almost four-fifth of all
interest-rates derivatives outstanding are registered in financial centers from the US
and Europe.
- Foreign exchange trading still is highly concentrated in London and Chicago, with
the UK and the US capturing together some 50 percent share in global trading.
70 percent of all foreign exchange derivatives transactions are undertaken in the US
and the EU.
Emerging financial markets, especially in Asia, have grown strongly in past years. But they,
too, have been hit hard by the crisis. After they will have recovered from the setback of the
crisis, experts expect that they will speed up again their catch-up process.
Concentration is ongoing as size still matters. Most experts predict that London, New York,
Hong Kong, and Singapore are set to remain strongholds of global finance. Their major
advantage is that they can build on existing market strength and favorable economic
conditions.
In the long-run, emerging financial centers are likely to succeed in establishing the scale and
scope in their market environment that will help them advance into the top group of global
locations. The crisis may have accelerated this trend.
The foreseeable increasing global competition will put even more pressure on financial
centers to defend or improve their respective positions. This holds in particular for those in
Europe which is far from being a homogeneous jurisdiction.
Indeed, European financial market places are at risk to fall behind in the global race for
markets shares. The main European financial centers in Paris, Zurich, Madrid, Milan,
Frankfurt, Amsterdam, Luxembourg, and even London, have clearly lost ground compared to
other advanced and emerging locations.1
Changing environment trough new rules
The financial crisis triggered a fundamental reassessment of the financial industry. Until four
years ago, it was widely understood that financial markets were inherently self-correcting and
therefore best left to their own devices. This prevailing paradigm has been sacrificed.
After more than two decades of deregulation in the majority of the industrialized countries,
finance has entered a new era: various initiatives have been undertaken to reform and
strengthen the global framework for financial stability and reduce the probability of such a
devastating global crisis occurring again.
Major steps have been taken in the area of regulation, most notably in the "Basel III" capital
accord. The Basel III rules stand on two pillars:
- First, they focus on strengthening micro-prudential regulations, aiming to bolster the
resilience of individual banks during periods of stress. In particular, Basel III calls for
more and better capital of financial institutions and also introduces leverage ratios
and stresses the role of liquidity risk.
- Second, they also include macro-prudential regulations, aiming to mitigate systemic
risks across the banking system.
Better and more capital buffers are supposed to make the banking sector more resilient in
the case of another crisis. The increased capital requirement may come at high cost, though.
If banks hold too little capital, they are left crisis-prone and in the potential need of bail-outs.
Too much capital, however, could lead to huge swathes of the banking business becoming
unprofitable. This might cause higher borrowing cost which could affect economic growth
negatively. By consequence, riskier assets but more profitable activities might be driven into
the shadow-banking sector.
But the regulation of the shadow banking system is still an unsolved issue. These entities are
no banks in the legal sense, although they take - and generate - similar risks. If there is a
strict silo-regulation of the formal banking sector, the actual risky business does not
disappear, but moves on in the non-regulated sector.
An important issue is the problems of banks that have become too big or too interconnected
to fail. The idea that a "Systemically Important Financial institution", SIFI, will be saved in a
crisis because of its systemic importance is not compatible with the core principles of a
market economy. Those who fail in the market have to bear the ultimate consequence of
leaving the market. But if the maxim is "too big to fail", then the state and the taxpayers are
vulnerable to blackmail.
The financial crisis has exacerbated the problem in so far as some of the surviving banks
have become even bigger or more interconnected. Moreover, the government guarantees
which were appropriate in the crisis now encourage banks to grow, to connect and to take
even bigger risks.
To repair this clearly flawed incentive structure, the G20 endorsed the Financial Stability
Board's (FSB) policy framework to address the moral hazard risks and externalities posed by
SIFIs. The key policy objectives of the FSB SIFI framework are to
(i) increase their loss absorption capacity to reduce the likelihood of their failure,
(ii) to facilitate the orderly restructuring or unwinding of a failing SIFI to reduce the
impact of its failure on the financial system ("living will");
(iii) to intensify supervisory oversight for SIFIs;
(iv) to strengthen core financial market infrastructures to reduce contagion risk from
failure.2
Challenges imposed by liquidity rules
Though it is highly welcome that the new rules tackle liquidity risks, the new requirements for
liquidity management could themselves become a source of instability. One reason is that
the regulators' definition of liquidity is highly concentrated on government bonds. As the
current environment shows, some market segments of government bonds can eventually dry
up.
Another reason is the respective definitions of the Net Stable Funding Ratio (NSFR) and the
Liquidity Coverage Ratio (LCR).
- The LCR is the main component of Basel III's liquidity regime. It is also known as
the "Bear Stearns rule". It requires banks to maintain a stock of "high-quality liquid
assets" that is sufficient to cover net cash outflows for a 30-day period under
financial stress.
- The NSFR seeks to counter maturity mismatches in the balance sheet of financial
institutions. It calculates the proportion of long-term assets, which need to be funded
by longer term stable funding.
While the LCR stresses the liquidity situation up to 30 days, the NSFR focuses on the
situation beyond one year. Assets which are liquid for more than 30 days and less than one
year are not taken into account, not even on a weighted basis. However, the Basel
Committee on Banking Supervision (BCBS) has recognized this shortcoming and is
investigating the issue.
In addition, there is the risk that the reformed banking regulation has damaging impact on the
European model. The treatment of covered bonds, mutual funds, deposits etc. in the liquidity
ratios affect the business model oft many continental European banks. One can also
question whether the main victims of the new rules will not be the European universal
banking model which was certainly not at the origin of the crisis but constituted an anchor of
stability.
Finally, the lack of a resolution framework for cross-border financial institutions remains on
the agenda. In spite of the insight, that the reform of regulation and supervision cannot be
successful at the national level alone, it is still unclear how the costs would be distributed if a
cross-border institution would get into difficulty and should need to be saved.
Shortcomings in macro prudential supervision ...
As the importance of systemic financial stability has become apparent, questions on
macroprudential policies have become highly topical. Unfortunately good answers are
outnumbered by open questions.
There are few purely macroprudential policy tools, and in many cases policy makers need to
rely on micro prudential instruments. The financial sector is constantly changing, and the
level of risk does not remain the same. Systemic risk is difficult to measure and define. The
credit to GDP ratio for example is not a particularly good indicator of risks. Financial cycles
often last longer than business cycles. The probability of different shocks may be difficult to
estimate. Their impact, however, is even more difficult to assess e.g. because of
nonlinearity. The application of the classical Tinbergen rule ("one tool - one objective") is not
possible.
In short: the understanding of how to use which instrument in which situation remains at a
very early stage.
Three layers of shortages can be identified:
1. The analytical framework is short of data;
2. The instrumental framework is short of experience
3. The institutional framework is short of resources
We therefore need to recognize the limits of our understanding; these difficult questions must
be approached with a certain degree of humility.
... in spite of progress in the institutional set-up
Although the toolkits are still in their infancy, institutional progress has been made in macro
prudential supervision. In the EU, the European Systemic Risk Board (ESRB) was
established in January 2011. Its mission is to contribute to prevent or mitigate systemic risk
to the financial stability in the Union. The ESRB comprises the ECB, the national central
banks of the EU, the three new European authorities on banking, insurance and securities,
the European Commission, and the Economic and Financial Committee (representing
national treasuries). Its role will be to conduct macroprudential surveillance across the EU, to
issue risk warnings and recommendations, so as to contribute to the prevention and
mitigation of systemic risks. Recommendations can be issued to any national or
supranational authority.3
Macro prudential policy is viewed as having a wide range of tools from monetary, fiscal and
competition policies. But these instruments are under the responsibility of others. In the light
of the above-mentioned shortcomings, however, there is the risk that macro prudential
becomes policy making with other peoples instruments. The potential fight for competencies
among different institutional bodies might undermine the effectiveness of the macro
prudential approach.
Concluding remarks: Challenges remain, opportunities emerge
The financial crisis has traumatized the global financial system. The huge losses of many
major financial institutions and negative feedback loops from the real economy in the
aftermath of the financial crisis have triggered changing market structures. In addition, global
competition between financial centers has intensified.
In response to the crisis, the world has moved into a new stage of international regulation
and supervision of financial markets. The new rules - many of which have not been
implemented yet - start to bite already, due to the tightening of capital requirements and a
more homogeneous regulatory framework which pose challenges in particular to smaller
financial centers.
But this changing environment implies also opportunities to improve their relative positions.
In order to do so the provision of convincing conditions is of the essence. Local factors gain
weight, e.g. a well-educated workforce in an open and flexible labour market and excellent
infrastructure. The respective governments should comply with robust public finance in line
with a stability-oriented monetary policy.
Smart regulation - at national, regional and global level - and a stable legal and institutional
framework are a prerequisite for success. Global standards are needed to ensure a level
playing field. At the same time, it is crucial that international financial centers of systemic
importance have a voice in the international standard setting, so these can benefit from their
wealth of experience and competence in supervision based on the proximity and high
interaction with the supervised entities.