Fernando Restoy: Presentation of the book "Financial regulation: the
solution or the problem?"
Closing address by Mr Fernando Restoy, Deputy Governor of the Bank of Spain, at the
presentation of the book "Financial regulation: the solution or the problem?", Fundación de
Estudios Financieros, Madrid, 5 March 2015.
* * *
Good morning.
Many thanks for your introduction and for the opportunity to participate in the presentation of
this report on financial regulation by a group of veritable authorities on the matter. I have had
professional dealings with all of them to some extent in recent years and, in particular, with
the report's coordinator, José Pérez, who contributed to my joining the Banco de España -
when he was Director General of the Research Department - some years ago and who
therefore bears some responsibility for me being here before you today.
The book's title is admittedly a provocative one: "Financial regulation: the solution or the
problem?" It is comforting to see that the work's conclusion is not that regulation is the
problem and, therefore, that deregulation is the solution. On the contrary, I believe that the
authors, on the whole, appreciate the effort made to strengthen prudential regulation and, in
particular, to gear it to the aim of achieving more and better capital.
At the same time, I understand and largely share the concern to avoid excesses. Regulation,
like the vast majority of public policies, is no free lunch. It is there to redress market failings
that harm the collective well-being. Yet it also introduces distortions into resource allocation
that may prove costly. Accordingly, ahead of any regulatory proposal it is more than
advisable to assess the scope of these distortions.
The book, in various chapters, correctly identifies potential adverse effects of what is
categorically referred to as a "regulatory tsunami" or even, as one author puts it, a "regulatory
orgy". The text broaches the possibility that the pace and scope of regulatory change might
be affecting the liquidity of certain securities markets and also risk-taking by relatively
unsupervised sectors, and may be reducing banks' loan-granting capacity or lessening
competition, among other developments. The authors rightly suggest that the
reasonableness of the changes, their parameterisation and their implementation schedule
must be properly evaluated taking into account not only their direct contribution to financial
stability but also possible side-effects.
One idea intimated in the analysis is that, given the risks over-regulation entails, an
alternative approach might be to economise on regulatory changes and to increase
supervisory intensity instead. That is to say, there should be an attempt to contain the
avalanche of new regulatory requirements applicable across the board, replacing some of
them with intrusive supervisory measures, adapted to each bank's specific situation. This is
admittedly a very attractive idea which I would like to explore in the rest of my speech.
Supervisory challenges
Until recently, core supervisory actions in many jurisdictions had focused, perhaps
excessively, on the surveillance of banks' solvency through the monitoring of capital ratios as
defined under current regulations.
It is nevertheless true that the implementation of Basel Pillar 2 on the basis of the regular
supervisory review exercises has somewhat changed the situation. Pillar 2 allows specific
requirements to be made of each bank on the basis of its risk profile so as to cover aspects
not contained in Pillar 1 (minimum regulatory capital ratios). In that way the supervisor can
regulate solvency requirements by adjusting them to each bank's situation, thereby
extending the supervisor's discretion and reinforcing its role, while reducing commensurately
the relative significance of the general solvency requirements set in the regulations.
Likewise, the inclusion of stress tests as a supervisory tool extends the supervisor's capacity
to impose capital requirements or other constraints on banks when this is necessary to
withstand adverse scenarios, even if such scenarios are rather unlikely. Once again, this tool
broadens the weight of supervisory action.
That said, in order to optimise the scope of supervision, supplementary instruments - that
are not always available in accordance with the prudential regulations in force - are needed.
For instance, not in all jurisdictions must the supervisor expressly authorise the eligibility of
certain capital instruments, the acquisition of qualifying holdings in other financial institutions
or dividend pay-outs charged to reserves.
Above all, effective supervision should occasionally be based on discretionary actions rather
than mere application of the instruments expressly provided for under the regulations. In
particular, the supervisor should have the real capacity to influence bank managers'
decisions through moral suasion and to formulate non-legally binding recommendations, in
the sure knowledge that they will in practice be very widely followed. Supervisory actions
would otherwise be excessively hampered by a regulatory framework which, despite having
been honed in recent years, can hardly envisage all situations of supervisory significance or
include the full range of instruments needed to tackle such situations with the speed required
in each instance.
Finally, it is difficult for supervision to be effective if it does not include a thoroughgoing
review of banks' financial statements. Allow me to elaborate on this point.
Evidently, an essential aim of supervision is to oversee banks' solvency through the
monitoring of capital ratios. Insofar as these ratios are calculated on the basis of accounting
information, it is essential to ensure that such information properly reflects the value of the
bank's assets and liabilities. It is true that auditors and securities supervisors also perform
this task. However, the specific nature and complexity of bank business, the evident
relationship between published financial information and financial stability, and the
occasional lack of specificity of prevailing accounting principles all make it advisable that the
prudential supervisor should contribute to encouraging supervised banks to follow the best
practices, in full conformity with current regulations and the distribution of competencies
among institutions thereunder.
Consequently, the effectiveness of the supervisory framework, which has doubtless been
broadly strengthened by the changes to prudential regulation, depends on three aspects:
firstly, the legal availability of a broad set of instruments through which requirements or
restrictions may be imposed on banks; secondly, the ability to effectively influence
management decisions and policy through formally non-binding actions, and finally the ability
to ensure the accounts give a fair view of the bank's financial situation.
True, these elements have largely been present in the supervisory framework in place in
Spain in recent years. The Banco de España has had a relatively extensive range of powers
and has, in the exercise of its supervision, frequently used moral suasion and the issuance of
recommendations, which banks have always followed. Further, it has been empowered to
issue accounting rules affecting individual statements, which banks and audit firms have
used as a frame of reference to properly complete with the consolidated statements that,
generally, must adhere throughout the European Union to International Financial Reporting
Standards (IFRSs).
This supervisory approach is not identical to that followed in other jurisdictions. Within the
Single Supervisory Mechanism (SSM), most authorities, including the ECB, have somewhat
less extensive powers than the Banco de España. Moreover, in various European
jurisdictions, the supervisory strategy adheres to a greater extent than in Spain to the strict
use of the supervisory instruments formally recognised in the rules, with less dependence on
recommendations or informal guidelines.
For example, a recommendation, like the one made by the Banco de España in 2013 that the
cash dividends paid that year should not exceed 25% of consolidated profit, would be
relatively unusual in other countries. As you know, the recommendation made by the SSM
Supervisory Board on this matter in January was only restrictive for those banks whose
solvency ratios failed to comply with the minimum levels in line with regulatory requirements.
The more formalistic approach to supervision to be found in other jurisdictions provides
greater clarity regarding the scope of supervision. It also facilitates identification of the
respective responsibilities of bank managers and supervisors. However, rigidly subjecting to
strict rules and standards of conduct naturally reduces the supervisor's ability to identify and
correct in good time potentially destabilising developments for the bank.
In the field of accounting, the experience of the asset quality review recently conducted by
the SSM shows that there are appreciable discrepancies between the specific accounting
criteria used in the different jurisdictions, although IFRS principles must be applied in all of
them.
In Spain's case, as I have already mentioned, the criteria followed are those established by
the circular of the Banco de España on public and confidential financial reporting rules and
formats (known as the accounting circular). In other countries the criteria applied have been
established over time and, generally, with less involvement of the supervisor.
The harmonisation of these criteria would be highly desirable, especially in relation to the
classification of exposures (an area in which the European Banking Authority has made
notable progress in recent months) and, in particular, provisioning policy. It should be noted
that, although the supervisor may adjust the capital requirements, imposing higher levels of
capital does not sufficiently make up for the lack of adequate provisions. That is because the
level of provisions always has direct and transparent implications for the profit or loss of the
bank, while an increase in the minimum capital requirements via Pillar 2 is not usually
transparent (as the Pillar 2 requirements are not public) and, in most cases, does not have
any practical effect, insofar as the bank has a capital buffer that enables it to cover the new
requirements. Accordingly, the supervisor should be concerned to promote the application of
rigorous and uniform provisioning criteria involving the appropriate recognition on the
balance sheet of the value of each exposure.
Clearly, the formal publication of binding accounting criteria by the SSM may be contested,
insofar as accounting does not form part of its competencies according to the EU regulation
under which it was set up. At the same time, subjecting all banks active in the markets to
IFRSs for consolidated accounts, certainly reduces its ability to exert an influence in this
area. In short, the Spanish experience shows both the usefulness and feasibility of an
involvement of the supervisor that is compatible with the law in force.
The need for this involvement is heightened by the entry into force in 2018 of the new
standard (IFRS 9) under which banks will switch from using the concept of incurred loss to
that of expected loss in order to calculate the credit portfolio provision. This standard is
undoubtedly an improvement on the current situation, since it enhances the measurement of
the risks of loans and receivables. At the same time, it significantly increases the complexity
of calculating provisions and, thus, increases the risk of heterogeneous application across
banks, which is something the supervisor should be aiming to mitigate. The work under way
in the Basel Committee on this matter is therefore very timely.
My comments so far imply that there are in practice significant obstacles to satisfying the
legitimate expectations that a rigorous and granular supervision will help moderate the
intensity of the regulatory changes needed to promote financial stability.
The regulatory frameworks in force and different supervisory cultures, along with the difficulty
of becoming more involved in accounting practices, often place considerable limits on the
intensity of supervision attainable.
This explains why the actions of the authorities to prevent financial crises largely rest on the
definition of clear and demanding prudential standards to underpin the work of supervisors.
In the area of the SSM, these restrictions are particularly significant at the moment since,
given the variety of supervisory practices and cultures in place, only adequate codifying of
rules and procedures can help to ensure that banks are treated equitably, even if this means
that some of the benefits, in terms of supervisory effectiveness, that an appropriate amount
of discretion involve, have to be sacrificed.
Clearly, as the new European supervisory regime matures, we must strive to develop a
specific action framework that incorporates the best practices and that is sufficiently robust to
enable its application to be adapted appropriately to each specific circumstance.
Thank you for your attention.