Christian Noyer: Banking regulation and the financing of the economy
Introductory speech by Mr Christian Noyer, Governor of the Bank of France and Chairman of
the Board of Directors of the Bank for International Settlements, to the Paris-Europlace
Forum, New York, 26 April 2010.
* * *
It is a great pleasure for me to be here in New York and address the audience of this
ParisEuroplace Forum. As always, the forum is an opportunity for sharing experiences and
perspectives. As we make progress in our efforts to strengthen financial regulation, such
discussions are very valuable for confronting views and making sure that we are on the right
track.
To some extent, the ultimate aim of financial regulation has to do with financing the real
economy. Sound regulation should enable the stable provision of financial services to
economic agents as they strive to finance their activities. This is why I would like to discuss
with you a few aspects of the current reforms of financial regulation that are critical in terms
of the financing of the economy.
More precisely, in the few minutes I have, I would like to share with you some thoughts on
three important policy challenges.
How can we make our financial systems more resilient and therefore capable of financing the
economy on a long term basis?
How can we reduce the procyclicality of financial systems?
How can we address systemic risk?
Before discussing these topics, let me first set the stage and recall why the current focus on
enhancing banking regulation is right.
From an economic viewpoint, banks perform two broad functions. They first perform maturity
and liquidity transformation. Maturity and liquidity transformation is due to the nature of their
assets and liabilities: traditional bank assets are rather illiquid and longer term, whereas their
liabilities are more liquid and shorter term. Banks also perform a credit risk screening
function, as they should be well-equipped to assess such risks.
As such, banks are central to the financing of economic activity. Economic development
requires sound banking systems. Indeed, productive investment and, to some extent,
consumption, which constitute the fuel for growth, require financing in order to be carried out.
This financing may be obtained through two channels: capital markets or banks. These two
channels are complementary. But the role of banks is clearly central. This is especially true in
continental Europe, where they are responsible for more than 80% of financial
intermediation. Although US firms rely much more on financial markets, banks play a key role
here too.
Admittedly, large companies, which are regularly monitored by rating agencies, may "avoid"
borrowing through banks, but we know the limitations of extending this aspect of the
securitization process, which enables direct market financing, to the financing of small and
medium-sized enterprises or households.
Typically, two constraints weight on the supply of credit by banks. The first is a constraint on
banks' capital. Prudential rules, by linking the development of banking loans to the level of
banks' capital and by weighting the loans according to their risks, create a capital constraint
that is especially harsh in times of crisis when the weighting increases with the risks and
when due to accounting rules, which impose marking to market for certain assets, the capital
base is eroded. The second constraint is a liquidity constraint. It is linked to the ability of
financial players to access markets to refinance themselves. When banks cannot refinance
their portfolios, they are forced to shed assets and cut back on new credit. The recent crisis
has featured the combination of these two constraints.
Let me now turn to the main points I would like to discuss.
How can we make our financial systems more resilient on a long term basis?
It is clear that the level and quality of pre crisis capital in the banking system has not been
adequate relative to the types of losses that have been experienced and that may be
expected to materialize in a broader economic downturn. Larger capital and liquidity buffers
are necessary, especially for trading activities.
The recent reform package of the Basel Committee will lead to a much more robust and
resilient banking system in the future, with both a stronger capital and liquidity base. The
challenge, now, is to calibrate and phase in the new framework in a way that does not
impede the recovery and does not contradict our macroeconomic objectives. In the long run,
we want stronger balance sheets in the banking system but too high capital requirements
could have negative effects, reducing loan supply and, paradoxically, fostering risk-taking in
order to keep a high return on equity. In the immediate future, disorderly deleveraging is one
of the main downside risks to the recovery process. A macroeconomic assessment of the
reforms is underway and will help us strike the optimal balance. The broader point here is
that the proposed reforms may have significant macroeconomic consequences and these
should be factored in when designing and implementing them.
A critical issue put forward relates to the behavior of banks with respect to the capital buffers
that they retain on top of the existing minimum. If banks target buffers above the regulatory
minimum, which is an endogenous market outcome, they may need to raise even larger
amounts of equity than what can be expected by just looking at the current package. We
know from empirical studies that weaker capitalized banks typically exhibit weak loan growth
compared to other better-capitalized banks. We also know that banks may find it less costly
to adjust loan volumes and loan pricing than capital, as frictions in the market for bank capital
make the latter option more expensive.
While the crisis has clearly had global ramifications, its impact on financial systems has not
been uniform across the world. Financial structures differ greatly between countries and
there needs to be scope for different countries to tailor solutions to their circumstances and
structures, while, at the same time, doing so within a globally agreed framework. For
instance, our experience in France is that our banks' universal model has weathered the
storm relatively well. It would be a major paradox to put in place rules that would challenge
such models.
Finally, any regulatory framework needs to manage regulatory arbitrage and keep up with
innovation and other forms of structural changes. For this, a necessary but not sufficient
condition is that standards be comprehensive in coverage and consistent across
jurisdictions. I am not sure, for instance, that the leverage ratio, if it were to be implemented
as a compulsory instrument, would meet this double test. Given existing accounting
divergences, consistency will be very difficult to achieve. Furthermore, it is likely to
encourage migration of credit activities towards other - less regulated - parts of the financial
system.
Convergence between accounting standards is a precondition for a consistent implementation
of some of the prudential reforms discussed by the Basel Committee. It is also essential that
new prudential standards for banks become truly universal. We should not underestimate the
difficulties on the road to accounting and regulatory convergence.
How can we reduce the procyclicality of financial systems?
Our accounting and prudential regimes have increased procyclicality in recent years. This is
detrimental to a stable flow of credit to the economy. In a mark-to-market environment, asset
price increases quickly translate into a larger capital base of financial institutions, which, in
turn, trigger additional demand for assets and a further increase in their prices. A spiral is
launched. Actually this is a kind of "inverted demand curve" where demand increases with
prices and vice-versa, possibly creating the conditions for deep and lasting financial
instability. Addressing procyclicality caused by the regulation itself is therefore a priority.
The first line of defense against procyclicality should be the accounting framework. I strongly
support the current focus on changing the accounting rules. Reducing the scope of the
markto-market approach and moving from an incurred loss model to a forward-looking model is
essential. The ultimate objective of ongoing negotiations is to create synergies between
prudential and accounting standards.
Some of the procyclicality can also be trimmed through prudential regulation. Efforts to make
solvency ratios potentially less procyclical are welcome and should be pursued. In particular,
those efforts aimed at imposing a measure of risks "through the cycle" are useful. Other
options to reduce some of the procyclicality through prudential standards include a fixed
buffer or a countercyclical capital buffer. I see clear limitations to the former and challenges
for the latter. In any case, such mechanisms may not necessarily be cumulative and we may
have to choose.
How can we address systemic risk?
As techniques for managing and allocating risk became more sophisticated, the network of
counterparties expanded in scale and in complexity. This was clearly a systemic change that
was properly understood but not fully captured by regulators at the time.
The definition of systemic entities should rely on different criteria beyond size, such as
interconnection, complexity or substitutability, and depend on the context in which the entity
evolves. Various initiatives to deal with systemic entities are currently being discussed,
including tighter cooperation between supervisors, compulsory actions on banks' structures
and, more controversially, additional capital charges and/or taxes and levies. They certainly
require further thorough analysis. It is essential to avoid threshold effects and never forget
that risks are continuous in nature, time-varying and state-contingent.
The debate about systemic firms also echoes concerns about the activities and business
models of some institutions. The presumption is that smaller and leaner financial institutions
would pose less risk to financial and macroeconomic stability than larger and more
diversified ones. Yet, facts suggest that this cannot hold as a general lesson from the crisis.
Indeed, the banks that suffered most from the crisis were precisely those that were more
specialized, such as investment banks. By contrast, large universal banks, reliant on a large
deposit base, were able to withstand the shocks comparatively better.
To deal with systemic risks, there is a lot of merit in taking a closer look at what I would call
"market options". To reap the benefits of financial innovation and reduce its risks, we need
robust and resilient financial systems and infrastructures. In this respect, concentrating
systemic risks in central clearing counterparties for the most important markets (such as
interbank and derivatives markets) may bring us a long way towards reducing them, provided
these CCPs are properly regulated. In this respect, I think that locating these infrastructures
in the same area as that of the currency they deal in and allowing them access to central
bank money are key factors.
A last option which is currently gaining some international momentum concerns the possible
taxation of financial institutions and activities. In principle, this idea seems quite appealing.
However, the diversity of objectives that may be given to such a tax shows that the policy
debate must be clarified. In a financial crisis prevention perspective, it is aimed at changing
incentives and at forcing financial intermediaries to internalize the risks that their activities
generate for the whole system. In a crisis management perspective, it should enable
governments to recoup the costs of financial bailouts in a systemic crisis.
My main concerns regarding this issue are twofold. My first point concerns the articulation
with regulation. The added value of a tax over prudential regulation still remains to be
demonstrated for countries, such as France, that have taken advantage of an effective
regulatory and supervisory framework and in which public interventions in the financial sector
have entailed no net costs to the government. My second point concerns the mitigation of
moral hazard. We absolutely have to avoid situations in which the payment of taxes or levies
is understood as a de facto bailout policy insurance. In this respect, the allocation of the tax
to a resolution fund or to the general budget does not enable public authorities to totally
remove such a risk.
Against this background, I think that an adequate, median way would be to extend the
mandate of National Deposit Guarantee Schemes to early intervention tools and resolution
powers. Moreover, we should build on the experience gained from ex ante risk-sensitive
premiums, which seem to be very important for mitigating moral hazard.
Most of these remarks have focused on the major and vital incentive to enhance financial
regulation. Let me conclude by looking into the future. A macro-prudential policy framework
could provide further room for manoeuvre. Indeed, the crisis has illustrated the necessity to
have a wider spectrum when designing financial regulation. We should also not forget that
financial intermediaries are primarily tools to promote a stable financing for the economy.
That said, in practice, developing a well-articulated macro-prudential policy framework raises
some challenges. I trust that the benefits of addressing them are worth the impressive hard
work currently underway.
Thank you for your attention.