Luc Coene: The Belgian banking sector in 2020
Speech by Mr Luc Coene, Governor of the National Bank of Belgium, at the colloquium "The
Belgian Banking Sector in 2020" in celebration of the 75th anniversary of the Belgian
Financial Forum publications "Revue bancaire et financière/Bank- en Financiewezen" and
"Droit bancaire et financier/Bank- en Financieel Recht", Brussels, 22 November 2011.
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The many lessons learned from the crisis that began in 2007-2008 have given rise to an
ambitious, internationally coordinated, and broad-based set of regulatory reforms. The new
regulatory framework not only strengthens requirements and supervision at the
microprudential level, but it also incorporates new macroprudential requirements. Changes to
the regulatory architecture have also led to the creation of new regulatory authorities, at both
the European and Belgian levels. All of these developments will have significant impacts on
the Belgian banking sector over the next decade.
1. Microprudential supervision - Basel III
Key elements, which are designed to increase banks' resiliency to shocks, include:
 An increase in minimum regulatory capital requirements: the range of risks for
which regulatory capital must be held has also expanded.
 Higher quality of capital: an increase in the amount of capital that must be held in
the form of common equity, which offers the greatest capacity for loss absorption.
 A leverage ratio, which is a non-risk-weighted capital requirement that should serve
as a backstop to protect against situations where risk-weighted capital requirements
are too low (through underestimation of risks or regulatory arbitrage)
 Liquidity ratios: the liquidity coverage ratio will ensure that banks can withstand a
liquidity shock of 30 days in duration; the net stable funding ratio will ensure that
banks have a sufficient amount of longer-term stable funding.
2. Macroprudential supervision
One of the striking outcomes of the crisis has been a change in the focus of prudential
regulation, from a narrow concern with the resiliency of individual institutions to a broader
preoccupation with the entire financial system. This concern has translated into the inclusion
in the Basel III of new macroprudential capital requirements. It has also led to the
establishment of a macroprudential authority in the new European regulatory framework.
New macroprudential capital requirements:
 Countercyclical capital buffers (CCBs) have been introduced into the Basel III
framework, to address the time dimension of systemic risk. The level of
countercyclical capital buffers, which will vary between 0 and 2.5% of risk-weighted
assets, will be determined at national level for all credit exposures to counterparts in
that country. When credit growth is judged excessive, national authorities will require
banks to build buffers, which can then be drawn down in the ensuing downturn. The
countercyclical buffer policy is reciprocal, meaning that all banks, even foreign ones,
with exposures in a country must hold the buffer that has been set by that country's
authorities.
 SIFIs. Systemic risk also has a cross-sectional dimension, as illustrated in the crisis
by the multiple instances where governments felt compelled to intervene with public
money to rescue large financial institutions whose failure could have transmitted
distress to the entire financial system. On the one hand, failure of systemically
important financial institutions (or SIFIs) would generate large costs that the
institutions themselves do not internalize. On the other hand, belief that these
institutions are too big to fail creates a moral hazard problem, weakening market
discipline and providing the institutions with an incentive to take excessive risk. Both
of these observations point to the need to find ways to allow such institutions to fail
without injections of public money.
 At the global level, the Basel Committee is working together with the Financial
Stability Board to develop a comprehensive approach to address the systemic risk
created by global SIFIs. A methodology has been developed to 2.5%,
dependingidentify global SIFIs, which will face capital surcharges of 1 upon their
degree of systemic importance. These institutions will be subject to enhanced
supervision, as well as to the requirement to formulate recovery and resolution plans
(or living wills).
 At the Belgian level, the NBB has developed a methodology for identifying
institutions whose failure could have a significant impact on the domestic financial
system i.e., domestic SIFIs. The methodology, in line with the international practice,
focuses on the institution's size, its interconnectedness with other domestic financial
institutions, and the ease of substitutability of the critical functions performed by the
institution to gauge its degree of systemic importance.
 Domestic SIFIs will be required to submit plans for all strategic decisions to the
NBB, which has the power to veto these decisions if they are judged to have a
negative impact on the institution's risk profile or on the financial system. D-SIFIs will
also have to comply with special reporting requirements and will need to develop
recovery and resolution plans.
 The recovery plan - which is developed by the bank - outlines the different options
that can be taken in response to a major shock to its liquidity or solvency. The
resolution plan, developed by authorities, outlines options for cases where the
recovery plan of an institution has not succeeded.
3. Resolution frameworks
 The focus on recovery and resolution plans highlights another critical area of
regulatory reform: the improvement of crisis management and bank resolution
frameworks. The crisis has revealed many obstacles to the resolution of
crossborder financial institutions, and here is now a clearly acknowledged need to
improve resolution regimes.
 Importantly, the effectiveness of crisis resolution framework also affects the behavior
of financial institutions and their stakeholders, even in non-crisis times. If the crisis
resolution mechanism is weak, leading to a high probability of government bailout of
SIFIs that encounter distress, then stakeholders of these institutions will have little
incentive to exert discipline on management, who may engage in excessive risk
taking.
 In Europe, a legislative proposal soon to be published by the Commission should
help to lay the foundations for a new crisis management framework. Key elements
of the framework will involve the formulation of recovery and resolution plans (at
least for large, cross-border institutions), enhanced resolution powers for authorities,
and provisions linked to bail-in debt, which protects taxpayers by converting certain
types of debt to equity at the point of non-viability of an institution.
 Authorities in several G20 countries are currently working with their credit institutions
to develop recovery and resolution plans (RRPs). These efforts are being
coordinated by the Financial Stability Board. Along similar lines, the European
Council conclusions of May 10, 2010, relating to crisis prevention, management and
resolution contain a requirement that Cross-Border Stability Groups (CBSG)
coordinate the drafting of RRPs.
4. The new institutional architecture
 In response to the crisis, a new supervisory architecture has been established in
Europe. This framework includes three new European supervisory authorities
(ESAs) - for banking, insurance and securities markets - and the European
Systemic Risk Board (ESRB), which is responsible for macroprudential oversight
and based at the ECB.
Each of the new supervisory authorities is responsible for creating a single rulebook,
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designed to establish harmonized regulatory technical standards and ensure a level
playing field across the Union. The ESAs must also, in cooperation with the ESRB,
initiate and coordinate Union-wide stress tests to assess the resilience of financial
institutions to adverse market developments.
The ESRB monitors and assess systemic risk with the objective of lowering the
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probability of a build-up of systemic risk or mitigating the impact of any
materialization of systemic risk. The ESRB's principal tasks include identifying and
assessing systemic risks, issuing early warnings as risks emerge, and formulating
policy recommendations in response to the observed risks. Warnings and
recommendations can be addressed to the European Union as a whole, to one or
more Member States, to one or more of the ESAs, or to one or more national
supervisory authorities.
 The move in Belgium to the twin peaks model is in line with these developments.
This adaptation of the domestic institutional framework allows for a regular flow of
information between microprudential and macroprudential supervisors and for the
coordination of micro and macro-prudential policies. It also permits application of the
"four-eyes principle", which incorporates a transversal approach to risk analysis,
across risks, institutions, and time.
5. Impacts of these developments on the Belgian banking sector
As indicated by the previous speaker, the financial sector will face a very competitive
environment in the search of stable financing. This will result in a number of consequences:
 More costly credit. It is difficult to deny that the stricter capital requirements,
combined with the new liquidity rules and new taxes, will increase the cost of credit.
We do not yet know the extent to which this higher cost will impact aggregate
lending or the real economy. However, the experience of the past three years has
clearly demonstrated that banking crises are extremely costly and have significant
negative, long-term impacts on the economy. The deleveraging process will
reinforce this development. This is likely to affect more SME's than larger
corporations, that can still access the financial markets. This last development may
lead to some disintermediation.
 Fewer cross-border institutions or activity, or less centralized liquidity
management. The failures of resolution frameworks revealed by the crisis and the
difficulty of establishing an effective resolution framework for cross-border
institutions suggest that cross-border activity will be reduced in the future.
Contributing to this development may be the new liquidity requirements, which could
result in less centralized liquidity management by cross-border groups.
At the same time, while some degree of explicit or implicit ring-fencing is an
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understandable outcome of the crisis, we must be aware of the fact that Belgium is a
country with excess savings. We would not be doing Belgian banks a favor by
forcing them to employ all of Belgian savings within Belgium. We will need to ensure
that the new regulatory framework allows for an appropriate balance between
limiting the risks associated with cross-border activities and allowing savings to flow
to their most profitable uses.
 Industrial organization and SIFIs. Another dimension through which the future
structure of the banking system may be affected is related to the treatment of SIFIs.
The identification of SIFIs involves gauging, among other things, size, market
shares, and the degree of interconnectedness between banks. Limiting their size
and interconnectedness, which SIFIs should have the incentive to do, will potentially
lower concentration in the banking system and reduce the potential contagion that
could result from a shock. Risk management for systemically important banks will
also likely differ from the past, as SIFIs will be required to formulate recovery plans
and regularly update them. Developing a recovery plan requires envisaging a series
of scenarios involving severe shocks and the bank's possible responses to those the
potential in consultation with authorities shocks, as well as assessing
effectiveness of these responses. The recovery plan process must be ongoing and
integrated into the bank's risk management procedures. This process should require
banks to undertake more advanced planning for distress situations than in the past
and should encourage a fundamental reflection regarding the rationale underlying
the bank's activities, complexity, and organizational structure.
 Greater focus on traditional banking. Several elements of the regulatory reforms
(e.g., liquidity requirements and increases in capital requirements for the trading
book) provide the incentive for banks to move more toward the "traditional" model of
banking. While a requirement such as the ring-fencing of retail banking from
investment banking proposed in the UK probably goes too far, a toughening of
capital requirements for the trading book and greater alignment of capital
requirements for exposures in the trading and banking book should give banks less
incentive to take excessive risk through proprietary trading, thereby relying more on
traditional banking activity. In smaller countries like Belgium ring fencing retail banks
would be rather counterproductive. the main victims of such a reform could be the
SME's. They need more sophisticated instruments than those retails banks can offer
and they would be too small for investment banks. We have in Belgium a strong
model of universal banking. We should preserve that.
 Less discretion by banks in the determination of risk-weighted assets. Recent
events, including the European stress tests and the sovereign debt crisis, have
highlighted significant differences across banks and across jurisdictions in the
calculation of risk weights and capital requirements for certain assets. This raises
the question as to whether such outcomes are consistent with what was intended by
the designers of the Basel framework. In coming months work will be initiated by
both the Basel Committee and EBA to monitor the implementation of the new
regulatory framework and to ensure that risk-weighted assets are appropriately and
consistently calculated for exposures in both the banking and the trading book. This
will likely result in more harmonization, at least among European banks, of IRB
models for determining PDs and LGDs. Significant differences across banks in
riskweighted assets must arise as a result of true differences in risk and not from the
underestimation of certain risks by some banks.
6. Challenges
 While it is possible to make some predictions about the changes in the Belgian
banking sector in the coming years, several open questions remain, linked in part to
the challenges associated with implementation of the regulatory reforms.
 One issue that we are all now acutely aware of as a result of the crisis is the fact
that sovereign debt can no longer be considered to be a risk-free asset. It now
becomes crucial for regulators to ensure that the credit risk of sovereign debt
exposures is adequately recognized by banks. A reflection needs to be undertaken
concerning the role of sovereign debt in regulation. Questions that will need to be
addressed include the allowance of a zero risk weight for certain sovereign
exposures (standardized approach allows zero risk weight for AAA and AA-rated
sovereigns; IRB approach has no floor on sovereign PDs), the reliance of liquidity
requirements on sovereign debt holdings, and exemptions of sovereign debt from
large exposure rules. How these issues are resolved will obviously have an impact
on the future composition of many banks' balance sheets. E.g. we see now that the
liquidity cover ratio (LCR) as it is designed, discourages interbank lending.
 Other open questions relate to potential unintended consequences of the regulatory
framework. To what extent will the tougher requirements on regulated institutions
cause risks and activities to flow into the shadow banking sector and what will be the
implications for banks and for systemic risk? Work is currently ongoing at the
international level, under the leadership of the FSB, to strengthen the oversight and
regulation of the shadow banking sector, and European authorities are also working
on this issue. Yet, authorities will still need to remain extremely vigilant over the
coming years in tracking the ultimate distribution of risks.
 Finally, many reforms are being introduced simultaneously. We do not yet
understand fully the extent to which different reforms are complements or
substitutes and, hence, what their cumulative impacts will be. The interactions
between the various regulations must be carefully monitored, in order to understand
the impact of the reforms on the financial landscape and to ensure that the goal of
increasing the resilience of banks and the financial system are achieved at least
cost.