Andreas Dombret: Cui bono? Complex regulation and its consequences
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, at the 20th Banking Symposium of the European Center for Financial Services
at the University of Duisburg-Essen, Duisburg, 7 September 2016.
* * *
1. Introduction
Professor Rolfes,
Bernd,
Ladies and gentlemen
For me, Duisburg brings back memories of the infamous Inspector Schimanski from the TV
crime series Tatort. Perhaps it's because, as a banking supervisor, I'm as unpopular as the
police are among suspects.
However, unlike Schimanski, banking supervisors don't start throwing punches if a meeting
with an institution breaks down.
Thankfully, banking regulation is not exactly rife with physical violence. Nevertheless, this
symposium claims that "complexity kills".
And so we already have a perpetrator: lawmakers and supervisors. The murder weapon?
Complex, detailed banking regulation. The victims: banks and their customers. Case closed,
no investigation necessary. Splendid. Let's just call it a day.
But would an experienced inspector like Schimanski accept this at face value? I think this
alltoo convenient solution would leave a bad taste in his mouth and he would soon realise that
something was missing altogether: a motive.
This is why I am today reopening the case of complex banking regulation and its
consequences. Let's examine the evidence together. Who benefits, and who suffers?
2. Banking regulation today: optimised or muddled?
Banking regulation has become ever more intricate and complex in recent years. This
presents a challenge above all to small institutions with limited human resources.
I must confess that I, too, am sometimes dissatisfied at how intricate the regulatory
framework has become over the past few years.
But what exactly is behind this increase in complexity? It's the many rules and regulations
which are becoming ever more detailed and technically specialised, as well as the
multilayered nature of regulation as a whole.
Today, people still look back wistfully at the clear and simple Principle I, which set out capital
requirements for Germany in a concise and straightforward manner. In 2004, Basel II
ushered in an era of technical standards that not only ran into hundreds of pages but also
included numerous calculation formulas and tables. And I daren't mention the annexes or
background papers.
The reforms following the financial crisis intensified this trend further still. Basel III and the
Capital Requirements Directive, or CRR, are even more detailed, heavier on formulas, and
more complex.
Why is there this trend towards ever more complex rules? Five reasons stand out in
particular.
First: Regulation has needed to keep pace - and still needs to keep pace -with ever more
complex banking business.
Second: We are increasingly dealing with what is known as risk regulation. Here, historical
data and statistical procedures are used to calculate the probability of dangerous events
occurring - the rules and regulations then stipulate how banks must prepare for such
scenarios.
Third: Global harmonisation brought about by the Basel standards. These standards were
created mainly for large international banks, but are being applied to all institutions in
Germany and the European Union.
Fourth: Complexity is also caused by European regulation, which imposes an additional set
of rules that need to be followed. Furthermore, the relationship between European and
national rules is often unclear.
And last, but not least, complicated rules are also an outcome of compromises.
Compromises are a necessary element of regulation - especially where a large number of
countries with a wide variety of banking landscapes are involved. Moreover, the changes
proposed by banks and saving banks often haven't exactly made the rules any simpler.
This has made compliance with the rules an increasingly costly, time-consuming and
unwieldy undertaking. Such a complicated set of rules is all but bound to lead to a
considerable increase in the costs of compliance.
If such rules had been imposed on Inspector Schimanski and his ilk, Tatort would have been
a much less exciting show. I personally wouldn't be thrilled to spend 90 minutes watching the
inspector poring over implementing regulations. That's only something for masochists, and
Götz George, the actor who played Inspector Schimanski, certainly wasn't one of those.
3. Disadvantages: high compliance costs
As I mentioned at the outset, the suspect's motive to cause harm to banks and their
customers via complicated rules isn't very plausible. And the supposed sequence of events
isn't exactly water tight either.
But one thing we do have to admit is that the complexity of banking regulation has made
compliance very expensive for institutions - in two respects.
First, the regulatory requirements generate work for the institution's executives and
employees. This includes one-off costs, such as the costs of procuring new software. But it's
also about the overhead costs, ie the operational or HR costs. And it's about the time that
needs to be devoted to these matters - which is time no longer available to deal with clients,
to conduct credit analysis or to develop investment strategies.
This means that the problem is not so much the minimum capital or liquidity requirements but
instead the high operational burden imposed by implementation and compliance.
Second, as a result of the complex regulations, it is becoming ever more difficult for new
institutions to enter the market. This could significantly impact the competitive dynamics and
innovativeness of the bank and savings bank sector.
That's all I want to say for now on the effects of complex rules on institutions. But this
complexity affects supervisors, too, of course. One interesting take on the matter comes from
a couple of experts at the Bank of England.1 They believe that complexity fails to provide
absolute security, because gaps can always emerge elsewhere. In addition, regulation ties
up human resources because of the dense blanket of rules that need to be enforced. In
England it is recognised that there is therefore a danger of supervisors following a ticked-box
approach rather than carrying out a critical examination.
I think this reasoning touches on a rather sore point - it is, of course, true that complexity ties
up vast amounts of our regulatory resources. Sometimes a simple rule would perhaps be just
as effective, but less costly.
However, overall I come to a different conclusion. Namely, that complex regulation with
multiple safety nets - such as the risk-weighted approaches and the debt ratio - are a good
alternative to simple rules.
At this juncture, Schimanski would probably conclude that while the supervisor's attack was
perhaps a little heavy-handed, it wasn't deadly. And, what's more, the supervisor's
selfinterest in having complex rules is very limited, so this scarcely cuts the mustard as a motive
for murder. Inspector Schimanski would therefore have to carry out further investigations. To
this end, let's take a look at the advantages of complex banking regulation.
4. Advantages: providing stability and innovation
There is no question that the cost of the new regulation is considerable. However, this must
be weighed against the benefits to society of preventing financial crises. In this context, I
believe the cost of regulation to be justified overall.
It is therefore important, despite all of the well-reasoned criticism, to be realistic. All too often,
the debate is used to wrap broad-brush criticism of regulation in politically correct packaging.
But this broad-brush criticism clearly goes too far. Regulatory tightening in the wake of the
financial crisis was the right move as, with hindsight, capital requirements were too low prior
to the crisis. At the same time, there were quite substantial regulation gaps - and we all now
know where that led us. We must take care not to throw the baby out with the bath water in
the face of reasonable criticism.
Moreover - and I think it very important to emphasise this - it is not just society and the
economy which benefit from the new rules. Institutions, too, gain from complexity to a certain
extent.
They do so in two ways. First, regulators recognise the institutions' internal models and
therefore enable them to use internal procedures for regulatory purposes as well. This is not
self-evident. Second, this system leads to low capital requirements by historical standards.
This, too, is undoubtedly an advantage that we should not ignore.
5. A second-best solution that we can live with
Ladies and gentlemen, the case can be closed: bank supervisors are not murderers, and
complexity is not a murder weapon.
Nonetheless, complexity can only ever be a second-best solution. If we could go back to the
drawing board and create the banking world afresh with the experience we have gained over
the last few decades, we would probably choose simpler rules. However, that is not currently
a realistic option. What is more, this approach would have its weaknesses, too: for example,
less complicated requirements would probably entail higher capital requirements.
That's why we must now accept the complex set of rules as the new status quo and work
with them. For us regulators, this means subjecting the reformed rules to a systematic
review. For institutions, it means they must review and realign their business models.
These are the challenges that I would now like to address.
6. Implications for supervision: reviewing the rules with regard to proportionality
Let's start with supervision. There is no doubt that sweeping reforms were necessary in the
wake of the financial crisis.
However, now that such far-reaching reforms have been implemented, we need to honestly
ask ourselves the following questions. Do they still make sense as a package? Are the
individual components of reform working together as a whole? Precisely this process of
reflection has been ongoing for several months now, and the Bundesbank is playing an
active role in these discussions. Politicians and authorities have started to examine more
closely the impact of and interaction between these individual components.
Assessing the proportionality of the rules with respect to smaller institutions is a focal point of
this review. This issue is particularly close to my heart, which is why I would like to outline
what I believe greater proportionality in banking regulation could look like.
To do this, let's return briefly to our point of departure: complexity. What burdens are
complex rules imposing on smaller institutions?
The compliance burden is high for all institutions - regardless of their size. However, small
institutions, owing to their smaller staff sizes, are less able to spread the costs of compliance
across their employees and have to either hire additional staff or enlist external aid. This
leads to relatively higher burdens.
How might we change this? Any expansion of proportionality must begin at the European
level. That is why I endorse the proposal recently put forward by Wolfgang Schäuble to
review the relevant EU regulations with a view to achieving greater proportionality. This
mainly applies to the CRR and CRD IV,2 but also other legal regulations. That review will take
place sometime in the next two years. So you see, it's worth talking about good ideas.
These are two particular ways to give relief to smaller institutions. The first is a details-driven
approach that involves introducing special exceptions or adjustments for individual rules.
Another, more radical approach would be to rewrite the rules from scratch, thereby
establishing new legal bases that introduce relief for smaller institutions regarding some or all
of the rules.
It's worth noting here that the details-driven and the basic approaches are not in any way
mutually exclusive. However - lest I wear out my welcome - I will confine my remarks to the
basic approaches in three areas.
One option would be to establish a set of EU-level rules which make greater allowances for
proportionality while legislation and standards are still on the drawing board. Additional
proportionality clauses could, for instance, be built into the CRR and CRD IV. This would give
the EBA and the European Commission a legal footing that makes it easier for them to
incorporate simplifications into guidelines and technical standards.3 Of course, this can only
be achieved if clearly defined objectives are put in place.
Another option worth considering is the creation of an improved review process as part of the
legislative procedure - a mandatory due diligence process,4 if you will. This is already
enshrined in law in a number of countries, including the USA and UK. So why can't we do it
here in Europe, too?
In this scenario, checks would have to be carried out whenever regulations are introduced or
revised in order to assess whether the principle of proportionality has been given due
consideration. Such checks could be performed before adopting a new regulation or after a
trial period. The process requirements could be drawn up in the form of a joint directive
passed by all of Europe's supervisory authorities.5
The second area in which improvements need to be made for small banks is in the field of
reporting and disclosure. Ladies and gentlemen, I am aware that these days, you are being
asked to report an awful lot of information, and it's right and appropriate to question just why
that is. We shouldn't forget, though, that supervisors aren't the only recipients of these data -
monetary policy and financial stability decision-makers use this information as well.
So, what's the best plan of action with regard to banking supervision going forward? I would
propose a systematic approach that checks what information supervisors and other
recipients really need and compares the findings with the data which institutions are currently
required to report. This might impact on the Implementing Technical Standard on
Supervisory Reporting, for example. If it turns out that a disproportionately large amount of
information is being collected, then we need to focus on ways to reduce this burden.
Another starting point would be to abolish disclosure requirements that have been rendered
obsolete by the co-existence of European and German rules. I think unnecessary
duplications in the collection of data should be eliminated by amending the German rules.
Viewed from this angle, I see Germany's Liquidity Regulation as a candidate for the chopping
LCR
block. And it will, in fact, be eliminated at the start of 2018, once the has been fully
implemented.
Yet another point I think is worth considering is to slim down smaller banks' reporting
requirements to a minimal data package. Then, only compliance with the minimum standards
would be monitored.
Disclosure is another field where banks could be given a break. Here, we should investigate
just how often disclosure reports need to be published in order to supervise smaller regional
institutions. In addition, we need to make sure that the disclosure reforms do not introduce
any intra-year disclosure duties.
My third suggestion for achieving greater proportionality is probably the most far-reaching of
all. What I have in mind is the creation of separate regulatory frameworks for smaller
institutions, on the one hand, and large multinational banks, on the other. Even though the
response to this proposal has been tepid so far, I nonetheless think it is worth considering as
a fundamental approach - one that would systematically address the excess burden placed
on smaller institutions' operational capacities.
A two-tiered system could be put into practice through a graduated set of Basel standards for
institutions that are neither multinationals nor large in size. A broadly similar set-up has been
up and running in the United States ever since the Basel II regime was implemented. Any
institution whose balance sheet exceeds a certain threshold there is subject to the Basel
rules. However, it would only be possible to do the same here in Germany by creating rules
at the European level.
In this scenario, only banking multinationals would be subject to the fully loaded Basel III
requirements in the EU. This would be appropriate from a risk perspective: global banking
institutions would be regulated according to a harmonised set of global rules, while smaller
institutions and those operating within a certain region would be governed by graduated rules
which do justice to their different business models and risk profiles by setting less complex
requirements.
Of course, there are some who claim that transitioning to that kind of system is a flight of
fancy. What these doubting Thomases mainly ask is where exactly the line should be drawn.
I'll be the first to admit that this is a challenge, but it's anything but impossible. One way of
tackling this problem would be to use a smart combination of selection criteria - for instance,
combining a balance sheet threshold with a prudential decision based on the institutions' risk
profiles.
But there are still many crucial details and potential pitfalls that need to be addressed before
we can even begin devoting serious thought to an option of this kind. This is something I
think we should consider with an open mind. A systematic approach, assuming it's feasible,
is usually superior to an approach based on workarounds and emergency repairs.
The proposals in the three areas I have just spoken about - first, incorporating proportionality
clauses into EU legislation; second, easing reporting and disclosure standards; and third,
creating a two-tiered system - are just some of the options that are available. Before any
relief of this kind can occur, fundamental conditions need to be met.
I think it's particularly important that the focus remains on reducing the burden on operational
activities - an easing of minimum capital and liquidity requirements is not on the table. In
contrast to what is commonly argued, lower capital requirements do not automatically lead to
elevated growth, nor do they only result in increased lending.
Accordingly, the idea is not to sew a patchwork of wish lists for easing minimum capital or
liquidity requirements into existing regulations.
And what's more, relief must never endanger financial stability. Medium-sized, highly
systemically interconnected institutions - those referred to as "too interconnected to fail" -
and those institutions with risky business models should not be provided any relief. The
recent financial crisis, during which many insolvent institutions had to be bailed out, is still
fresh in all of our minds. We also need to be careful not to create any loopholes that end up
being used by so many institutions that smaller banks run into difficulties.
7. Consequences for banks: adapting business models to fit the new reality
Ladies and gentlemen, rules must be developed, reviewed, adopted and implemented.
Following the regulatory reforms' implementation, banks and savings banks will now have to
adapt to the new reality over the coming years.
I realise that these costly and challenging processes can be frustrating, especially for those
working at banks that played little or no part in the pre-crisis excesses.
But what we are talking about here are transitional processes which involve high one-off
costs and greater compliance expenses in the long term. In light of the important role of
credit institutions in the economy, they are absolutely justified.
Many of the problems stem not from regulation but from the fact that some institutions are
still clinging to their old business models despite finding themselves in a new world. But the
old world of unrestricted financial markets has gone - for good.
Like many other European banks, some German institutions are still searching for business
models that are competitive, viable, and yet sustainable. This is clear, amongst other things,
from the fact that German credit institutions have the worst cost/income ratio in the EU, and
also lag behind in terms of other profitability ratios.
I'm not going to pretend, however, that finding the solution to this problem is a piece of cake
- profitability cannot and must not focus on the short term. After all, this was one of the
causes of the most recent financial crisis. Sustainable business models must be
well-conceived and must also enable banks to weather difficult phases. If credit institutions
change their strategic focus as a result of the new rules, as we have actually already seen in
a few cases, this is not necessarily a negative side-effect of regulation. It may actually be
proof that the new rules are working - that is, that they are encouraging banks to adopt
sustainable business models.
8. Conclusion
Ladies and gentlemen, to conclude, I have some good news and some bad news. Let's start
with the bad: banking regulation has admittedly become a very complicated matter. And we
all just have to accept this new status quo. And now for the good: we actually have the
potential to improve on this status quo.
We supervisors can achieve this by looking at any negative implications that arise and
identifying where small institutions are being unreasonably disadvantaged.
Institutions, on the other hand, can achieve this by accepting the fact that their business
models - in many instances - were not sustainable in the past and will never become so in
the future barring fundamental changes.
I am confident that we can manage both. Let's keep exchanging ideas on this matter - and
unlike Schimanski, without resorting to fisticuffs.
On that note, I'd like to congratulate this conference on its 20-year anniversary and now look
forward to some lively debates.