Andreas Dombret: Reform of the global financial system
Opening lecture by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, at the Generation Forum, Eltville, 16 June 2011.
* * *
1. Introduction
Ladies and gentlemen,
The reform of the global financial system will be in the limelight during the next two days of
lectures and debates. I was asked to kick off the discussion by presenting you, in brief, the
Bundesbank's point of view about the ongoing regulatory reform process. What has already
been achieved, and what key issues still need to be tackled?
2. Regulatory reform - what has been achieved?
The global financial crisis has been keeping us extremely busy for some 4 years now.
Looking back, there is little doubt that an inadequate regulatory framework was one of the
most important causes of this crisis. Thus, it is imperative to learn the right lessons and
minimise the likelihood of future crises by closing the regulatory loopholes and mending the
weaknesses that have come to the surface.
Significant progress has already been made in this regard. Therefore, I will restrict myself to
mentioning only two key measures.
Firstly, the new capital and liquidity standards for the banking sector, commonly known as
Basel III, were finally endorsed by the G20 at their meeting last November in Seoul. Capital
requirements will rise considerably in terms of both quantity and quality. Moreover, the
firsttime introduction of global liquidity standards will bolster banks' liquidity cushions, thereby
addressing the possibility of contagion via the money markets and excessive maturity
transformation. All in all, the new rules will significantly strengthen the resilience of financial
institutions.
Secondly, and related to Basel III, substantial progress has also been made in tackling the
problem of how to deal with systemically important financial institutions, called SIFIs for
short. As you all know, the striking feature of SIFIs is that their insolvency is regarded as
virtually intolerable - because they are particularly large, complex or interconnected. Or
because they perform specific functions that cannot be readily assumed by other market
participants.
Back at the Seoul Summit last year, the G20 accepted a comprehensive framework on how
to address the SIFI problem put forward to them by the Financial Stability Board. Work on
specifying the framework's individual recommendations is currently being pursued as a
matter of urgency. The final framework will be spelled out in detail by the next G20 Summit,
which will take place in Cannes in November of this year.
3. What remains to be done?
Notwithstanding the progress already made, there is still a long way to go in making the
international financial system watertight. In my following remarks, I would like to point out
three aspects of regulatory reform that will accompany us in the coming months.
Firstly, it is indispensable to finalise, and then implement without delay, the FSB framework
for dealing with SIFIs. Secondly, we have to introduce internationally compatible restructuring
and resolution regimes for financial institutions to allow them to exit the market in an orderly
fashion without causing a breakdown of the system. And finally, we must identify the
so-called shadow banking system and expose it to supervision.
Let me now briefly discuss these three areas in more detail.
3.1 Dealing with SIFIs
As already mentioned, the FSB is currently finalising its recommendations for dealing with
SIFIs. One difficulty here lies in accurately identifying SIFIs based on criteria such as size,
interconnectedness, substitutability and complexity. I would like to promote a rather
pragmatic approach towards solving this problem: We should start with only those institutions
that are indisputably of global systemic relevance. I expect this to be a group of some 25 to
30 banks - not more and not less. The composition of this group will surely change over
time.
As experience is gained, we might later extend the framework in an appropriate manner to
other SIFIs, including financial institutions of domestic relevance, financial market
infrastructures, insurance companies and other non-bank financial institutions.
Central to the FSB concept are systemic capital surcharges for SIFIs that go well beyond the
requirements mandatory under Basel III. Such capital add-ons do more than merely improve
the resilience of a SIFI, in other words reduce its probability of failure. They surely are also a
suitable instrument with which to put a price tag on the implicit guarantee that SIFIs are
deemed to enjoy. Formal decisions have yet to be taken as to the exact application
modalities of the SIFI surcharge, especially its size. Nevertheless, I expect that at the end of
the day the amount of additional capital required from a SIFI will be related to its systemic
importance and will in all likelihood lie somewhere between two and three percent.
What is also still being discussed is the choice of capital instruments acceptable for the
surcharge. Common equity surely appears to be the natural choice for the additional charge.
But I think other instruments with full loss absorbing capacity deserve careful consideration.
For instance, contingent capital - in other words debt that converts into equity once certain
stress triggers are hit - affords loss absorbency when needed.
We have to bear in mind that contingent capital is still largely uncharted territory. It might be
necessary to conduct further research and gather practical experience with these untried and
untested instruments, especially the market implications of contingent capital and the
associated net financial stability implications. Nevertheless, contingent capital, when properly
designed, is likely to represent a major step forward in providing additional loss absorbency.
Let's all realise that contingent capital was part of the Basel III communiqué.1 Therefore, the
Bundesbank continues to be in favour of including contingent capital in the SIFI package.
3.2 Introducing restructuring and resolution regimes
Closely related to SIFIs is my second issue, namely the need for appropriate restructuring
and resolution regimes for the financial sector. Let's all realise that we will never fully prevent
individual institutions from going bankrupt. Failure is part and parcel of a market economy.
But if financial institutions fail they must not be allowed to drag down the entire system with
them. Unfortunately, in many countries general insolvency laws have proven inadequate
during the crisis. Hence there is clearly a need for special mechanisms that allow for an
orderly restructuring and resolution of financial institutions. A strong resolution regime makes
failure a credible option and thus reduces moral hazard.
In this regard, significant progress has already been made on a national level. For instance,
in Germany the so-called Restructuring Act came into effect at the beginning of this year. Its
elements include a significant extension of supervisory powers, especially the possibility of
transferring financial assets of a distressed bank to a private bank or to a public bridge bank.
Remaining parts can then be wound up during insolvency proceedings, if necessary. To
reduce the financial burden of the public sector in future crises, the Act provides for a
restructuring fund that is to be financed through a levy from the banking sector.
Despite all its positive features the German Restructuring Act represents largely uncharted
legal territory and has certain limits once banks with significant cross border business are
involved. This is another reason why we need internationally harmonised resolution
mechanisms.
While progress on a national level has been remarkable in many countries, obstacles to
effective cross-border resolution remain. Thus, one of our main tasks in the coming months
will be to establish and ensure mutual compatibility between different national restructuring
and resolution mechanisms. Yet we should bear in mind that an orderly resolution of financial
institutions which are truly active on a global level may be possible only to a certain degree.
At the European level at least, the proposed European Commission legislation, which is due
before this summer, looks to represent a major step forward.
3.3 Let's not overlook the shadow banking system
The third regulatory challenge I want to address is the necessity to extend our reform efforts
beyond the banking system.
The stricter rules imposed on banks via Basel III and the rules for SIFIs entail the realistic
danger that activities will be shifted to less regulated areas. Therefore, it is imperative for us
to better illuminate the fringes of the financial system. In other words, we must closely
monitor and regulate what is commonly referred to as the shadow banking system.
Whether a market participant is classified as belonging to the shadow banking system should
depend not so much on its institutional type but on its activities. At the behest of the G20, the
FSB is currently exploring ways and means of monitoring and regulating the shadow banking
intermediation involving
system. It has recently defined the term shadow banking as "credit
entities and activities outside the regular banking system".2 This rather broad definition
involves non-banks such as special purpose vehicles and money market funds, but also
hedge funds.
The FSB will present a set of recommendations to the G20 in autumn of this year. What is
already obvious today is the need to significantly enhance transparency by imposing
appropriate registration requirements as well as reporting obligations on all parts of the
financial system.
Yet better monitoring will not be enough. To reduce systemic risk, better regulation of the
shadow banking system will be necessary too. This could be done either directly, by
regulating the activities and actors of the shadow banking system themselves. Or indirectly,
by regulating banks' interactions with the shadow banking system.
4 Need for international cooperation
Let me close by emphasising once more the urgent need for international cooperation. More
than 4 years after the outbreak of the crisis, we are now at a crossroads. Our cooperation in
the coming months will decide whether the new rules for the financial system will be
internationally compatible or bring about an uneven level playing field, leading to regulatory
arbitrage.
At the end of the day, it is the globally consistent implementation and transposition of the
adopted key reforms into national law that counts. While heterogeneous national structures
make it imperative to maintain a certain degree of flexibility when reforming financial
regulation, we must ensure that individual countries do not game the system to the benefit of
their own financial institutions.
Financial centres, when vying for a good position among themselves, must under no
circumstances be permitted to engage in activities at the expense of financial stability, not
least given the ever closer interconnectedness in the global financial system. Individual
countries should not seek advantages by watering down, or by reluctantly implementing
internationally agreed reforms. To avoid such beggar-thy-neighbour policies, transparency,
peer pressure and a close monitoring of progress in implementing agreed standards and
measures will be essential.
5. Conclusion
Ladies and gentlemen,
To sum up:
A number of crucial reform measures designed to secure financial stability have already
been approved or are under way. Yet important tasks still lie ahead. Above all, we need
• to find a solution for the SIFI problem;
•
to ensure that all financial institutions can be resolved without dragging down the
whole system; and
•
to identify the shadow banking system and expose it to supervision.
In doing all this, we must strike the right balance between paying sufficient attention to
peculiarities of national financial systems and ensuring an international level playing field.
Thank you for your attention!