Thomas J Jordan: Systemic risk and regulation - managing the challenges
Speech by Mr Thomas J Jordan, Vice Chairman of the Governing Board of the Swiss
National Bank, at the 5th Annual Meeting of the Swiss Finance Institute, Zurich,
3 November 2010.
* * *
I would like to thank Dr. Claudia Strub, Till Ebner and Dr. Robert Bichsel for their valuable support in drafting this
speech.
Introduction
The handling of systemic risk in financial systems is an immense challenge. First, because it
is not always possible to pinpoint the precise sources of systemic risk due to complex
interdependences in global financial markets. Second, because before the outbreak of a
crisis it is almost impossible to identify which domino will be the first to fall and thereby bear
the ultimate responsibility for causing the financial system suddenly to falter and even
collapse. Finally, the impact of systemic risk can extend way beyond the system that is
initially affected. When the financial system is close to collapse, the costs are enormous, as
was clearly apparent in the latest financial and economic crisis.
In my presentation today, I will talk to you about where we currently stand in our examination
of the background to this latest crisis and how we can best address the diverse challenges in
relation to systemic risk in the financial system. I will begin by explaining the issue of
systemic risk in a little more detail, taking the recent crisis as my example, and making it
clear why regulatory interventions in the financial system are necessary. On the basis of
these explanations, I will then present the key criteria, which, in my opinion, should be used
as guidelines when designing regulatory measures. In other words, I will be sketching the
core components of a kind of roadmap for containing systemic risk. However, since we can
never rule out the emergence of a new crisis, we also require a well-placed safety net. This
will help to secure an adequate supply of liquidity to banks and markets, even at times of
increased stress. A final section will be dedicated to this area, with some remarks on the
importance of the central banks' function as lender of last resort.
Systemic risk and the financial crisis
Normally a number of different factors are simultaneously responsible for the accumulation of
systemic risk over time leading to a crisis - as happened in the recent crisis. A number of
well-known examples of possible risk factors and undesirable developments in the financial
system include irrational market developments (e.g. bubbles during the upswing or fire sales
during the downswing), inadequate or inappropriate regulation (e.g. weak points in Basel II),
excessive confidence in markets and models (e.g. VaR), false incentive systems (such as
implicit state guarantees for systemically important banks), and complex and intransparent
products (e.g. complex securitised loans).
In summer 2007, these factors were combined or interacted with one another to create a
situation where confidence was suddenly withdrawn from the global financial system, which
then went out of control. Even though three years have now elapsed since the start of the
crisis, it would be rash of us to claim that we have clearly identified the cause of the
accumulation of the systemic risk revealed in the crisis and are now in a position to prevent
the accumulation of such risk in future. For instance, although the bubble in the US housing
market was identified at a relatively early stage, its threat to the system was totally
underestimated. This fact clearly shows that systemic crises and their effects are difficult to
forecast. Even in summer 2007, as it became obvious that the US housing market was in a
very precarious situation, almost no-one foresaw the huge impact this would have on the
global financial system and the world economy.
Ladies and gentlemen, we are all aware that systemic crises will occur again and again. This
is because risk in the financial system pro bably always emerges at a moment when we are
not yet in a position to fully identify or understand it. However, irrespective of this fact, at this
point I would like to stress how important it is that we use all the resources at our disposal to
try and contain the effects of systemic crises or lessen the probability that such a crisis will
occur, at the very least, even if we are unable to prevent crises altogether.
First, systemic crises are enormously costly. Naturally, that alone does not justify state
intervention. However, the legitimation for active state intervention can be derived from the
fact that systemic risk gives rise to negative externalities, i.e. market failure, if it is not taken
into account in the decision-making considerations of market participants. This means that
the social costs of systemic crises are higher than the private costs. In the financial sector,
this issue is particularly delicate, because of specific characteristics that can give rise to
negative systemic externalities of the kind I have just described.1 I will return to this important
topic later in my presentation.
Second, based on historic experience, I am convinced that both the magnitude of systemic
risk and the probability that systemic crises will occur can actually be reduced through
intelligent regulation. Sure, they can also be sharply increased by incorrect regulation or lack
of regulation. Yet, improvement can be achieved even if it is not easy to identify the
accumulation of systemic risk and even if regulation will never be perfect.
Consequently, the need and the potential for mitigating the accumulation of systemic risk
through regulation raises a number of questions with regard to the specific design of such
regulation. Where do we start? How do we set priorities? Which principles should we abide
by?
The number of regulatory solutions that have been proposed are as numerous as the
possible triggers of systemic crises. Often, individual solutions focus on one specific cause.
In my opinion, there are so many possible causes of a systemic crisis that it is insufficient to
focus on just one specific cause when drawing up possible regulatory solutions. It would be
an illusion to think that the issue of systemic risk could be totally eliminated in the long-term
with such an approach.
Consequently, I believe it is important that the problem be approached in a systematic
manner, and that comprehensible criteria for a list of measures that is likely to be effective be
drawn up. Unless a roadmap is drawn up based on principles which guide us in the handling
of the challenges we encounter in regulating systemic risk, there is a danger that decisions
on the requisite measures will be made arbitrarily, that solutions lacking substance will be
implemented or that nothing at all will be done. From the viewpoint of systemic stability, the
result would be suboptimal. I will now talk about the criteria for assessing regulatory
measures.
Do the measures ensure market discipline?
The first important criterion is whether the measures that are taken can reduce the social
costs that can arise as a result of systemic risk. Ultimately, what is needed is an
internalisation of the negative externalities, so that market discipline and market order are
restored. The TBTF issue, in particular, is an illustration of the fact that the market's power to
impose sanctions is not fully functioning at present, since systemically important banks
cannot currently fail. On the contrary, they benefit from a government rescue guarantee for
the very reason that, because of their systemic importance, their failure costs would be so
high. Thus, at present, TBTF financial institutions are not obliged to bear the full extent of the
risk they assume. In the event of problems they can pass on the risk to the general public.
This is a fundamental contradiction to the basic principles of a properly functioning market
economy.
In order to contain these market imperfections the guiding principle should be - do what is
necessary, but no more than is necessary! Consequently, the measures to be taken need to
contribute to stability without obstructing key welfare-enhancing functions of the financial
system. In particular, it is important that the measures are first and foremost designed to
correct false incentives and to guide them in the right direction so that, first, unprofitable
financial institutions leave the market of their own accord and, second, potential losses are
borne by these institutions themselves, and not by the state.
Consequently, in my opinion, measures such as a ban on proprietary trading or the
introduction of a narrow banking system, that intervene too strongly in banks' business
models, are not very suitable. Such measures neither target the objective nor are they in line
with the basic principles of the market economy. With regard to the TBTF issue, this principle
has prompted the committee of experts appointed by the Swiss Government to draw up
proposals including the creation of incentives for banks to become less systemically
important overall, thereby reducing potential costs for the economy. At the same time, the
committee of experts' proposal will allow for improved resolution in the event that insolvency
appears imminent, and this will significantly alleviate the TBTF problem.
Are the measures "structural"?
A second criterion is that the measures should not just address the specific circumstances of
the most recent crisis. In other words, fighting the last war will not win the next one. At the
same time, the lessons of history show us that certain basic mechanisms repeat themselves
in every crisis. Consequently, it is very important that we recognise these general patterns
and include them in regulatory considerations in order to improve our crisis prevention. This
prevention is geared to establishing instruments whose effects are as broad-based as
possible, in other words, instruments that are independent of the specific causes that lead to
crises.
One general pattern in financial crises is that market and investor confidence plays a central
role.2 In general, when a bubble is being formed, soaring price trends are initially explained
in "rational" terms. In the recent crisis, for instance, developments in the US housing markets
were, for a long time, regarded as a logical and unproblematic consequence of state support
measures or of innovation in the form of new financial products, as well as the constant
However, when the first symptoms of a crisis become evident,
inflow of capital from Asia.3
the focus moves directly to other aspects. Which market participants are exposed? How
heavily are they exposed? How can one's own assets be safeguarded in the best possible
way? The irrational optimism of the previous period is followed by a rapid loss of confidence
and then by a flight to security. A broad-based loss of confidence of this kind can sometimes
result in serious liquidity problems, even for fundamentally well-backed banks, thereby
triggering far-reaching second-round effects.4
In my view, a regulatory setup that can handle crises originating from as many causes as
possible must pay attention to fundamental mechanisms of this kind. The following example
may explain more clearly what I mean: In Switzerland, the liquidity requirements that have
been in force since June will help to reinforce trust in the stability of individual financial
institutions and ultimately to prevent insolvencies. These provisions require big banks to
ensure that liquidity is secured for at least 30 days, even in the event of a significant
exogenous shock. Their most important aim is to make sure that, should an event of this kind
occur, a clear signal will be sent to market participants that the affected bank has time to
initiate the requisite adjustment measures and to stabilise its position, no matter what kind of
shock has occurred.
In addition there are also measures designed to counter procyclicality in the financial sector.
They will help to prevent downward spiralling or crisis situations, in general. For instance, the
large capital buffer proposed for systemically important banks by the Swiss committee of
experts for TBTF will have this kind of effect.5 The new Swiss liquidity standards are also
designed with this aim in mind. In good times the liquidity and capital buffers will be
increased or maintained, and in stress situations they can be drawn upon.
In addition, new discretionary instruments could generate countercyclical effects, thereby
guarding against possible imbalances in the financial system. For instance, one possibility
would be an obligation, which would apply to all banks, to accumulate additional capital
buffers in times of excessive credit growth. However, to date, experience with this kind of
regulation is limited. It is therefore necessary to evaluate these instruments carefully.
Do the measures contribute to the robustness of the regulatory setup?
A third important criterion is that consideration must be given to the fact that each individual
measure, on its own, is either insufficient, or displays shortcomings that are often not directly
obvious, or can be manipulated or even avoided. These latter three problems become
particularly acute as the measures become more complex. One way of countering these
weak points is to make use of simple instruments, as an alternative to, or to supplement
complex instruments.
The benefits of simple instruments are, first, that although they are often less detailed and
specific, they are more effective in a crisis. For instance, it is true that a straightforward
restriction in banks' leverage using a simple instrument, the leverage ratio, does not do
justice to the different risk classes of assets and may, in some circumstances, have
unintended effects or create false incentives, as can any other regulation.6 However,
excessive leverage, in an absolute sense, is usually a clear indication that a company is
carrying a high level of risk with regard to its solvency.
In the recent financial crisis, the leverage ratio of certain financial institutions was so high that
their entire capital would have been eroded as a result of a mere 2% loss in the value of their
assets. It could then be clearly demonstrated that the institutions with relatively low leverage
weathered the crisis much better than those with high leverage.7 Second, simple instruments
offset the shortcomings of complex rules, in particular. In this way they provide a kind of
safety net in case the complex regulatory approach emits incorrect signals. For instance, the
risk assessment models upon which the risk-weighted capital approach is based are most
certainly prone to error. For these reasons, Switzerland decided to introduce a leverage ratio
for the big banks as far back as 2008.8
Another way of making regulation more robust is by ensuring the diversification or
complementarity of measures. Once again, the leverage ratio is a good example of this,
since it has to be complied with along with the fulfilment of risk-weighted capital
requirements. It is harder to simply manipulate this kind of system through regulatory
arbitrage.
The benefit of complementary measures can also be strikingly illustrated using the example
of the Swiss proposals aimed at mitigating the TBTF problem. The recommended policy mix
represents a combination of complementary measures relating to equity, liquidity, risk
limitation and organisation. More equity and liquidity must guard against insolvency on the
part of systemically important institutions. These measures can support and supplement one
another and, if necessary, counterbalance individual weaknesses. For instance, should the
capital buffer prove insufficient and a crisis situation nevertheless arise, a rescue of
systemically important functions can be facilitated by means of preparatory organisational
measures involving improvements in the resolvability of banks.
Integration in the international environment, yet accounting for national
circumstances
The fourth criterion is that the decisions on the measures that are finally taken must
ultimately be embedded in an international framework while simultaneously taking account of
specific national circumstances.
At international level, in particular, agreements on regulatory standards are based on
negotiations in which the interests of different countries at different stages of development,
with specific financial market structures have to be reduced to a common denominator. Often
these interests diverge significantly.
A uniform definition of capital, the same risk weighting for assets around the world and the
same calculation for the leverage ratio are extremely important. Only by applying the same
definitions worldwide, can the soundness of individual banks be compared internationally. It
avoids the possibility of financial institutions engaging in arbitrage through the establishment
of complex cross-border legal structures.
These international decisions are also far-reaching in their importance because they
predetermine the options and limitations faced by national regulators. However,
implementation at national level is ultimately decisive. In particular, it is the deciding factor as
far as financial institutions in any one country are concerned. In this respect, an international
minimum standard cannot suffice when it comes to addressing specific national problems.
For instance, at the moment, the Basel III package does not address the issue of
systemically important banks, which fundamentally concerns Switzerland. Because of this
concern, proposals that go beyond Basel III were presented in the report of the committee of
experts.
Central banks as the lender of last resort for markets?
I will now move on to another point, which is directly related to the topic of this conference -
liquidity. Since markets are constantly undergoing dynamic processes of adjustment, it is
clear that another crisis can never be completely ruled out. Complete security is impossible.
Consequently, at times, the markets will be unable to provide sufficient liquidity in an efficient
manner. In such cases it is essential that central banks are able to step into the breach
temporarily as lender of last resort. In this way confidence in the financial institutions can be
restored, and the vicious cycle of liquidity bottlenecks, forced fire sales and bank runs can be
ultimately avoided.
By providing emergency liquidity assistance, central banks aim primarily to stabilise the
precarious liquidity situation faced by solvent institutions. Above and beyond this, the
increasing importance of systemic risk has made the emergency liquidity provision to entire
markets ever more imperative. Markets can also be faced with liquidity runs. This was only
too evident from the high risk premia observed in the interbank market during the recent
crisis. It is conceivable that central banks will take on the role of market maker of last resort
in such situations in order to secure key market functions. Indeed, in certain situations it is
essential.9 In an acute crisis, the costs and probability of a system collapse can be reduced
in this way.
However, the assumption of a lender of last resort or market maker of last resort function is
not without problems. First, it does not guarantee long-term stabilisation in every case.
Second, these crisis measures are no substitute for tackling the root causes or for lack of
robustness on the part of financial market participants.
In particular, the presence of a market maker of last resort is associated with a variety of
incentive problems.10 It can, for instance, encourage market participants to enter into
excessive risk exposure in the expectation that the central bank will step into the breach if
necessary. Above and beyond this, in taking on the market maker of last resort function, a
central bank assumes significant financial and reputation risks.
To summarise, the direct and indirect costs of this kind of market intervention need to be
weighed up against the overall economic costs of a system-wide implosion of liquidity. At a
time of significant stress in the system, we must probably retain a second line of defence of
this kind for use when needed, if we are to carry out our task of ensuring sustainable welfare
growth in the spirit of our mandate. However, liquidity or market assistance of this kind needs
to be examined carefully, case by case. It must be planned as a distinct supplement to the
first line of defence and clear principles laid down in connection with its provision. Last but
not least, it must only be used to "kick-start" a market that is fundamentally capable of
survival. Taking on a permanent market replacement function is something that should,
fundamentally, be avoided.11
Conclusion
Ladies and gentlemen, I now come to the conclusion of my remarks today.
The accumulation of systemic risk represents a serious threat to the stability of financial
systems. It is therefore important, on the one hand, to recognise this risk at an early stage
and, on the other, to develop measures capable of containing it. I have spoken about four
fundamental criteria for evaluating measures of this kind. In very brief terms, these measures
must, first, be conducive to maintaining market order, second, aim to tackle the structural
causes of systemic crises wherever possible, third, contribute to the robustness of the
regulatory setup and fourth, be consistent with international regulatory principles while, at the
same time, not fail to take account of national circumstances. This list of criteria must be
interpreted as a systematic and pragmatic set of procedural instructions - or, to use the term
I used before, a roadmap. By observing these criteria, we can make a significant contribution
to better managing the challenges that arise in connection with systemic risk in the financial
system.
To a large extent, ongoing international regulatory reform fulfils these criteria. For instance,
the narrower definition of capital and the adjustment of risk weighting under Basel III
removes a number of key weaknesses in the Basel II standard. The individual regulatory
efforts undertaken in Switzerland are also in line with these criteria, in particular the TBTF
package and the leverage ratio. However, the reforms have not yet been fully carried
through. For example, work to contain the TBTF problem at international level has only just
begun. It is important that the measures that are still pending also fulfil the criteria I
mentioned before. In addition, there are also many proposals on the table that do not comply
with the criteria of this roadmap. Thus, we need to act carefully to make sure that we
introduce only effective and reasonable regulation and that we do not unnecessarily over
regulate the system.
It is also important to recognise that the definition of suitable measures by experts and the
authorities represents no more than a first step. What ultimately makes the difference is that
steps are taken to ensure they are actually implemented. The democratic legitimation, in
particular, is an essential prerequisite for this. At the end of the day, it is politicians who must
bear responsibility for the regulatory measures. Supervisory authorities and central banks
play an advisory role but cannot make decisions on the introduction of the necessary laws
and ordinances. Consequently, an important function of supervisory authorities and central
banks is to provide clear justification for the considerations upon which the proposed
measures and instruments are based, so that they are comprehensible for the political
decision-makers. Here, too, the roadmap I have presented to you can be of assistance.