"Rethinking financial stability;
Evaluating regulatory prime concerns a decade on from
the financial crisis"
Speech by Klaas Knot, at the Global Risk Regulation Summit, Risk Minds International
Amsterdam, 3 December 2018
At the Risk Minds International Conference, 3 December, Klaas Knot reflects on the developments
since the onset of the financial crisis in 2008. The implementation of the financial reform agenda is
advancing and the European banking sector is in safer waters. Looking forward Knot recognizes three
elements of focus: completing implementation & evaluating reforms; improving the business model
sustainability and market confidence in European banks; and being alert to the buildup of leverage
outside the banking sector. Knot concludes that the financial industry is continuously evolving, and
financial regulation will have to follow suit.
Good morning, and also on behalf of the Dutch Central Bank welcome to Amsterdam!
December is the time of year to reflect and the time of year to look ahead. 2018 was a special year, as
it marks the tenth anniversary of the onset of the global financial crisis. Many times I have heard: "ten
years since the start of the crisis". But so far I have never heard anyone frame it in a more positive
way: "It is the tenth year without a new global financial crisis materializing!" But maybe that is only
natural, as central bankers and supervisors would never celebrate a crisis that did not happen.
Looking back to the situation ten years ago, we were in the midst of immense financial chaos. Many
factors contributed to the crisis, I will not go into them, but years of deregulation and resulting gaps in
regulation were definitely part of the story.
What I will do today, is to try to shed light on the prime regulatory concerns we have right now,
divided into three main areas: First, I would like to reflect on the financial reform agenda that has
been carried out. My message there will be that we have made good progress but we still have work to
do.We need to consolidate, implement and evaluate.
Second, I will argue that the European banking sector has to move from safety to soundness, with the
key take away being that we should promote further integration and improve efficiency.
And third, I will outline my view on financial stability going forward. Financial stability being a concept
that evolves over time and should incorporate new developments and risks.
1. The financial reform agenda
So first let us look at the reforms carried out in the aftermath of the global financial crisis, which
prompted a fundamental rethink of financial stability. In the landmark April 2009 summit in London,
G20 leaders pledged to do whatever was necessary to rebuild trust1. Subsequently, supervisors and
regulators worldwide, under the leadership of the Financial Stability Board worked to repair the
financial system and strengthen financial regulation. This included bringing systemically significant
institutions such as hedge funds under supervision. They also pledged to increase the requirements for
regulated financial institutions.
Within a relatively short time frame, the foundations for reform were laid. These concerned
Too-BigTo-Fail (TBTF), the OTC markets, CCPs and the insurance sector. And most importantly with respect to
the banks at the core of the financial system: the Basel III agreements. The implementation of this
financial reform agenda is advancing2. Initially the focus was mostly on the banks, and this has led to
at least four positive developments.
First of all, the Basel III reforms increased both the quantity and the quality of capital that banks must
hold.
1
G20 London Summit - Leaders' Statement - 2 april 2009
2
FSB (2018): http://www.fsb.org/wp-content/uploads/P281118-1.pdf
Before the crisis banks could get away with as little as 2% Common Equity Tier 1 capital. As the figure3
shows, the Basel III reforms changed the composition of the capital requirement, by increasing the
share of CET1. In addition CET1 has been strictly defined, increasing the quality of capital. Plus we put
more emphasis on stress testing and pillar 2, and introduced macro-prudential buffers. For the first
time we also introduced global liquidity requirements.
Before the crisis banks became overly reliant on short term funding. The introduction of the Liquidity
Coverage Ratio, which is one of the global liquidity requirements, reduced this increased reliance on
short term funding again. The graphs illustrate this development over time for Dutch banks.
The left-hand graph looks at all funding that needs to be repaid within the next 30 days excluding
open-maturity items, such as retail deposits.4 The graph on the right side confirms this trend. Debt
securities can be considered long-term wholesale funding. The decline in the share of repos and
reverse repos compared to other sources of wholesale funding illustrates the increased tendency
towards more long-term funding.
3
Figure from Citi Research, retrieved via Valuewalk.com (2013), "Basel III Will Create New $1 Trillion Hybrid Debt Market",
accessed in November 2018.
4
The graph looks at the duration of funding. The line 'Short term funding small definition' is the funding to be repaid within
the next 30 days excluding open-maturity items, e.g. retail deposits. Sample consists of Dutch banks only.
Secondly, a greater focus was introduced on cross-border activities and consequently cross-border
supervision. In Europe we even went a step further and introduced joint supervision via the Single
Supervisory Mechanism. This strongly increased EU cooperation and harmonization, and improved the
quality of supervision of all EU banks.
The third improvement was the creation of a resolution regime.
The resolution framework is implemented in EU legislation and the Single Resolution Fund is being built
up. It is approaching the halfway mark and within the next five years we should be able to reach the
target level5.
And, finally, supervision is also becoming more forward-looking. This includes, for instance, looking at
the kind of corporate culture and conduct that has proven to be able to result in financial troubles
further down the road. In the Netherlands we were among the frontrunners here.
This is not an easy issue to address, but it is gaining traction internationally, as demonstrated by the
Irish Tracker Mortgage Examination6 and the Australian parliamentary Review of the four major
banks7. This approach is now also an element of the SSM toolkit.
The list of improvements is impressive, and worthwhile to consolidate. Acknowledging nonetheless that
the implementation of the reform agenda is not yet complete, I want to draw your attention to two
challenges.
The first challenge is confronting regulatory fatigue, and not forgetting the lessons of the crisis.
Although the crisis broke out only ten years ago, its memories begin to fade and in some corners of
the industry a renewed push for deregulation can be heard. Also we ourselves on the public side have
been working on developing and implementing the reform agenda for close to ten years now. While
tremendous progress has been made, the pace of implementation is not equally convincing
everywhere.
5
The exact target level of the SRF depends on banks' covered deposit volume.
6
Irish Central Bank (2018) Mortgage Tracker Examination
7
Australian Standing Committee on Economics Review of Australia's Four Major Banks,
For example, on the reform agenda for banks, the Basel Committee noted in October 2018 that several
member jurisdictions are behind schedule in implementing the leverage ratio, NSFR and large
exposure framework. This also hits close to home, as the EU is still working on the implementation of
these last three standards.
Good news is that the finalization of the European capital requirements legislation (CRR2) is drawing to
a close. This gives Europe much needed time to focus on the final part of the reform agenda for banks:
implementation of the most recent refinements of Basel III, which should be implemented by 2022. As
I also recently argued at the PetersonInstitute8: the current accommodative monetary policy
environment makes it even more important to fully implement standards and strengthen prudential
buffers.
The second challenge is withstanding the call for dilution. Across the globe I observe a tendency to
dilute standards. This tendency presents itself on different fronts. Examples include relaxation of credit
origination standards, application of preferential risk-weights, exemptions to the leverage ratio
requirement, and tweaks in the definition of systemically important financial institutions.
The list of examples is by no means exhaustive. And for all these modifications a certain public policy
rationale can be given: stimulating socially desirable lending, fostering financial integration, or
whatever. They however come at the expense of reduced loss absorbency in the global banking
system.
When designing and implementing such a major reform agenda it is inevitable that new distortions
enter the system. It is therefore imperative that targeted policy evaluations are also undertaken. Such
evaluations should not only focus on whether existing distortions have been sufficiently mitigated, but
also whether unintended side-effects have come to the fore. Needless to say, such evaluations should
be evidence- rather than sentiment-based.
2. From safety to soundness for banks: the status of the European banking sector
So while implementation is proceeding, we could say that we're not there yet. But it has already left its
mark on the banking sector, which is in the midst of an adjustment process. Zooming in at the
European banking sector, we see that in many respects the situation is better than ten years ago.
8
Knot, K. (2018), "Speech Klaas Knot Easy Money - Uneasy Finance", given at Peterson Institute for International
Economics, Washington, published on the DNB website
Capital was strengthened, leverage ratios improved, and at least some consolidation took place. We
are in safer waters, as the results of the EU-wide stress tests about a month ago have illustrated. I
understand that you will hear more about this later today. And we need these safer waters, as the
banking sector does have plenty of challenges ahead of it.
For starters, price-to-book values of European banks continue to be low, at 0.7 on average in the euro
area last year, compared to 1.3 in the US.9
Some will argue that this is the result of capital requirements being too stringent. Obviously, I do not
agree. The US experience demonstrates that strong requirements and sound business models and
valuation can and must go together. But the European banking sector still suffers from structural
problems which cause low valuations and low profitability.
One important legacy issue is the high level of non-performing loans. The level is declining, but
aggregated data mask the fact that there are substantial differences between countries and between
individual banks. Moreover, Europe is still overbanked and the banking sector is fragmented.
The efficiency of the European banking sector needs improving. Consolidation can help, especially
where there are many small-sized banks. In a well-integrated European market it can also be expected
9
BIS (2018), "BIS Quarterly Review - March 2018", p.84.
that more pan-European players will emerge. The conditions for this to happen have already improved,
in particular with the creation of the SSM. We do see banks expanding their activities in other EU
countries.
Cross-border mergers would be another possibility. Whether there is a good economic business case
for a pan-European merger is up to the market players themselves. We should however acknowledge
that theoretical economic benefits of mergers may not always be attainable. History has shown that
there tends to be excessive optimism in takeover deals.
In the Netherlands we have had some unfortunate experience with ABN-AMRO in 2007 and 2008 - this
kind of crisis does not bear repeating! Also, more complex institutions are more difficult to manage,
not to mention the difficult task of integrating IT systems.
From my perspective, financial stability considerations need to be taken into account as well. A
crossborder merger may increase contagion risk, as financial sectors become more interconnected. After
having addressed Too-Big-To-Fail problems at the national level, we would not want the problem to
resurface at the European level. Banks could well become more difficult to resolve, as mergers
typically make them larger and more complex.
Of course the system has been strengthened to meet such concerns. But it has yet to be proven that
this has eliminated Too-Big-To-Fail problems. Financial stability and resolvability must therefore play a
prominent role in assessing any merger, including cross-border ones. Resolution plans will have to be
credible, deposits must be safeguarded, and minimum requirements for own funds and eligible
liabilities have to be met, so there is enough loss absorbing capacity.
I think it was Mervyn King or Charles Goodhart who once said that banks are global in life but national
in death. In Europe, we have tried to address this contradiction by establishing both the Single
Supervisory Mechanism and Single Resolution Mechanism.To arrive at truly European burden sharing,
we need a fiscal backstop to the Single Resolution Mechanism, and a European Deposit Insurance
Scheme to complete the banking union. Removal of the remaining obstacles involves more ambitious
efforts to handle the problems of non-performing loans and addressing the sovereign-bank nexus.
Once we succeed in delivering both safety and soundness, the lower risk of failure will lead the cost of
equity to go down. After all, risk and return are two sides of the same coin. Before the crisis,
underpricing of risk led to excessive risk-taking.
With better, safer and sounder banks, risks will be more correctly priced, and structurally lower rates
of return on equity can be welcomed from a financial stability perspective.10
3. Financial stability going forward
In the first part of my speech I concluded that substantial progress has been made in implementing
the agreed post-crisis reforms. Subsequently, I noted that the European banking sector is still on its
way from safety to soundness. But we also have to look beyond banking. Risks are migrating, and new
risks are emerging.
The financial system is evolving and becoming more diverse. Financial stability should incorporate such
developments and, where appropriate, regulation should also catch up. The diversity of the financial
system presents challenges from a regulatory and financial stability perspective. Tightening micro- and
macroprudential policies on the banking system has inevitably lead to an increase in non-bank lending
- the so-called 'waterbed effect'11.
10
DNB (2016), "The return on equity of large Dutch banks", Occasional Study nr. 5.
11
For evidence, see Cizel et al (2016), "Effective macroprudnetial policy: cross-sector substitution effects of price and
quantity measures," IMF working paper.
In particular in the euro area we observed a relative increase in finance by non-banks. At modest
degrees of leverage, non-bank lending can be a useful complement to bank lending and reduce the
concentration in funding sources. More equity based financing would also increase loss absorbing
capacity.
Problems however arise if there is too much liquidity transformation and/or too much leverage. In this
situation non-banks can become major source of instability. The leveraged loans and high yield bond
markets are particularly vulnerable in this respect.
High yield debt levels are well above pre-crisis levels in the US, and roughly at pre-crisis levels in
Europe.12 The good news is that the direct exposure of European banks seems relatively limited. The
bad news is that non-bank financial intermediaries provide a high and increasing share of financing in
the high-yield debt market13.
Should conditions deteriorate, such non-bank financial intermediaries are directly exposed to
considerable potential losses. Increases in credit risk premia would add to that. And perhaps even
more important, there could be system-wide spillovers beyond the high-yield debt markets.
In the past decade we focused most of our attention on strengthening bank regulation. This was much
needed, and on this front much has also been achieved. Now we observe emerging risks within non
12
FSB (2017), "Global Shadow Banking Monitoring Report 2016", Annex 7 p.87.
13
Calculations based on Bloomberg data.
bank entities. Regulation of non-bank entities may help to ensure that liquidity and credit risks in all
parts of the financial system are well-managed.
But if we conclude that from a financial stability perspective excessive debt and leverage of
nonfinancial counterparts are actually the main drivers of risk, we could also look for instruments that aim
to address these directly, such as borrower-based regulation.
The Dutch consumer mortgage market is a case in point here, where we have set limits to both the
loan-to-value and loan-to-income ratios that apply to all lenders, banks and non-banks alike. Such an
approach could be explored more broadly.
5. Conclusion
Ladies and Gentlemen, I want to conclude. After the global financial crisis banking regulation has been
significantly strengthened. Efforts should now focus on consolidation, implementation, and evaluation
of the reform agenda. The banking sector is in safer waters now. But European banks need to do more
to make their business models sustainable and regain market confidence. At the same time we have to
be alert to the buildup of leverage outside the banking sector.
The financial industry is continuously evolving, and financial regulation will have to follow suit.