Barbro Wickman-Parak: New international regulations for banks - a
welcome reform
Speech by Ms Barbro Wickman-Parak, Deputy Governor of the Sveriges Riksbank, at a
meeting with Tjänstemännens Centralorganisation (TCO), Stockholm, 26 November 2010.
* * *
Over the past three to four years the world has undergone the largest financial crisis since
the Great Depression of the 1930s. The scope of the crisis and its catastrophic economic
consequences quickly led to the realisation that something had to be done to avoid this
happening again. As soon as the worst phase of the financial crisis was over, extensive work
began on correcting the inadequacies in the regulatory systems that had come to light. The
reform work is conducted in many forums at both national and international levels. And not
least at EU level. But today I shall focus on the reform work in the Basel Committee on
Banking Supervision, in which both the Riksbank and Finansinspektionen (the Financial
Supervisory Authority) participate. This Committee is the international body that has
established frameworks for bank regulation since 1974.
In line with internationalisation that has taken place in recent decades, banks in different
countries have become increasingly dependent on one another. This also applies to our
Swedish banks, which to a great extent fund themselves on the international markets. Both
Swedish banks and Sweden in general therefore benefit from banks around the world
becoming more resilient. Because after the recent crisis, no one can have missed noting how
much Sweden is affected by financial developments in other countries. So it is a major step
forward that there is now international agreement on the need for tougher bank regulation.
The reform package that has been agreed is called Basel III, and the proposed regulations
will appear both in EU directives and Swedish legislation.
In brief, the Basel Committee's proposals entail tightening the regulations in four important
respects. Firstly, the banks must hold more capital. Secondly, this capital must have better
quality. Thirdly, a minimum requirement for the banks' liquidity is being introduced, and this is
completely new. There has been no regulation on this previously. Fourthly, there are stricter
requirements regarding the banks' risk management. This is what I will talk about today.
It has not been easy to reach agreement on these issues. The process has been punctuated
by negotiations and compromises all the way to the end. The reform package has
nevertheless been produced relatively quickly, given the complexity of the issues and the
many different interests involved. Some would probably say too quickly. But we at the
Riksbank welcome the fact that the work was completed quickly. When the first spark of a
crisis appears, awareness dawns at first slowly and only to a few, then the spark becomes a
blaze and the drama begins. When the acute phase of the crisis is over, the memory fades
with the ashes and interest in crisis prevention work and regulations for crisis management
soon wanes. It is better to strike while the iron is hot.
The Basel Committee has achieved a difficult balancing act. Regulations are needed to
prevent crises, but wrongly-constructed or overly rigid regulations can have a negative effect
on the economy if they make it more expensive or difficult for households and companies to
borrow. The whole reform package is not yet complete in the sense that all of the details
have been worked out. But agreements have been reached on several major issues and so
far we at the Riksbank consider that the proposals presented attain a reasonable balance.
Part of the compromise has involved a long period of implementation for the various parts of
the regulatory framework. Some parts need not be fully introduced until 2023. It is
reasonable to have a transition period in which the banks can adjust. But at the same time,
one may worry that it is too long in some areas. It is important that all parts of the framework
are in place before new turbulence or even new crises arise in the financial system. The
longer time that passes, the greater the risk that interest in implementing the changes will
wane.
But what exactly does the Basel proposal involve? What consequences will it have? How will
our Swedish banks, households and companies be affected? But before I go into these
issues, I would like to briefly describe the background to the reform package.
Financial system close to total collapse in autumn 2008
The global financial system was close to a total collapse in autumn 2008. The large rescue
packages implemented by central banks and other authorities around the world succeeded in
preventing an even worse financial crisis than the one we experienced. One hardly dares
speculate as to what might have happened if the rescue packages had not succeeded in
restoring confidence in the banking system, because without confidence developments can
be quick and drastic. The most classic example of this is a bank run. This means that the
bank's customers become concerned for their savings and rush to the bank to withdraw them
in time. But the money isn't in the bank, it has been lent out. Which is the whole point, of
course. At the same time, the banks are unable to renew their loans in the market as they
mature, which means they cannot meet their obligations to deposit customers or creditors in
the market and they collapse like a house of cards. And without banks the financial system
cannot function. If not even the most basic functions can be upheld, people will not receive
their wages and will not be able to pay their bills. The economy will grind to a halt.
But even though we managed to save the financial system through rescue packages, the
costs of the crisis have been immense. The reason for this is that a crisis in the financial
system has far-reaching consequences for the whole economy. The financial crisis causes
large falls in production, rising unemployment and increased budget deficits as incomes fall
and expenditure rises in the wake of the recession. There is thus a big difference, from
society's point of view, between banks in distress and ordinary companies suffering
problems. This is why we need special regulations for the banks.
It is no news to us Swedes that crises are extremely expensive. We only need to look back to
the crisis in the 1990s for a reminder. But this time the crisis was on a global scale. For the
first time since the Second World War we have experienced a fall in production in the world
economy. It is clear that the world will suffer the consequences of this for a long time to
come. But we Swedes have also been hit hard this time, too. Not least because we are a
small, export-driven economy that is very vulnerable to developments abroad. Because when
the credit taps are turned off, orders that have been made are withdrawn and no new ones
are made. In 2009 total production in Sweden, GDP, fell by around 5 per cent - the largest
fall in a single year since the 1940s. Such a large fall in the production flow entails an
irrevocable dent in the long-term curve. Gone forever. If one converts it, it corresponds to
about SEK 20,000 per Swedish inhabitant. This is money we could have used for
consumption and welfare. And let us remember that this is just one of the effects. Add to this
the reduction in wealth in the form of falling values of companies, financial instruments and
other assets.
Contagion effects in a globalised financial market
The origins of the crisis lay in US subprime mortgages. Although Swedish banks had very
little exposure to this type of asset, the crisis nevertheless affected them. Like the Swedish
economy as a whole, the Swedish financial system is very dependent on other countries. For
example, only half of the banks' funding is deposits from private individuals, companies and
institutions in Sweden. The rest is borrowed on the market, and a large part of this on
international markets. Moreover, most of the funding is relatively short term. This is not
unique to Sweden. The advantage is that it reduces the banks' funding costs, which in turn
makes it cheaper for households and companies to borrow money. But there are also
disadvantages.
As the banks have made themselves more dependent on the outside world, they have of
course become more vulnerable to problems arising abroad. When the international money
markets slammed on the brakes in autumn 2008 the Swedish banks' funding was
immediately affected. Not least because they had borrowed money in the short term. So
unlike the crisis of the 1990s the crisis we have just experienced is largely an imported one.
But the Swedish banks had also become involved in activities that proved to be risky. I refer
to their lending in the Baltic countries. These exposures also affected confidence in Swedish
banks during the crisis.
As we are affected very directly by disruptions on the international financial markets, it is in
our interests to have functioning global regulation. We therefore welcome the proposals
made by the Basel Committee. Hopefully, the new regulations will contribute to preventing
new crises in the financial system, or will at least alleviate their dramatic effects.
More capital of better quality provides larger buffers
I shall begin by describing the new requirements regarding the banks' capital. Because this is
what a large part of the changes agreed by the Basel Committee concern. One can say that
this capital is the money at the bottom of the treasure chest that the financial supervisory
authorities require the banks to always hold.
The banks have long been obliged to observe special minimum levels regarding the size of
their capital. There are two main reasons for this. The first is that the capital is to reduce the
costs to the state if the bank fails. Even though Sweden escaped relatively lightly on this
occasion, we know from experience that such costs can be very extensive. For instance, the
state may be forced to take over bad assets or have to pay money to depositors under the
Swedish deposit guarantee scheme.
But the role of capital is primarily to reduce the risk of a bank failing at all. When the bank
suffers losses it should have a capital buffer to meet them and thereby be able to continue its
operations. What this means for the banks in the end, as for the rest of us, is that they must
try to earn more money than they spend and have sufficient reserves to cope with the
periods when they don't. The banks manage this by constantly assessing the risk that a
borrower will experience difficulties in meeting interest payments or paying off the loan. If this
risk increases, the bank leaves a good margin for it by adjusting its lending or allocating
reserves for potential losses. But as borrowers are affected by so many factors that are
difficult to judge - for instance, economic recessions have very different impacts on different
sectors and geographical areas - it is easy for the bank's losses to become larger than
expected. The minimum capital required by the regulations should act as a buffer against
such unexpected losses.
It is necessary for everyone to be convinced the bank will survive in order for it to survive. If
the bank is perceived as unsteady, the supply of money will be cut off. A lack of sufficient
capital buffers can easily shake confidence in the bank. And this was exactly what happened
when the crisis loomed large. People were uncertain how badly off the banks were. No one
knew how large the losses would be and whether the reserve capital would suffice. Funding
ran short. Because what financiers in the market would want to give loans to a bank that
appears unsteady? And who would want money in an account in this bank? I am sure you
will remember the pictures of the queues outside Northern Rock's branches in the United
Kingdom. To restore confidence, the state and the taxpayers in many countries had to inject
capital and go in as owners of the banks. This would not have been necessary if the banks
had held more capital when the dark storm clouds gathered in summer 2007.
The Basel Committee has taken note of this. The current capital requirements are being
raised substantially. If I may go into technical details, the new regulations require that the
banks should have a Tier 1 capital corresponding to at least 6 per cent of their assets, or
more correctly their risk-adjusted assets. The risk adjustment means that for each asset one
recalculates the value, depending on whether the value of the asset can be regarded as
certain. One sign of this might be, for instance, that the value of the asset has varied a lot.
The higher risk an asset is believed to entail, the more capital needs to be allocated. At
present, the minimum requirement for Tier 1 capital is only 4 per cent of the total
riskweighted assets.
However, this comparison is not entirely valid, for two reasons. Firstly, the new regulations
entail much stricter requirements regarding what is accepted as Tier 1 capital. In future a
much larger share of this capital must be of the highest possible quality. This "common
equity Tier 1 capital" is made up of equity capital and withheld profits (the red part of the
columns in the figure below). This capital can immediately and without complication be used
to cover losses. In addition, one must have additional capital - what is known as other Tier 1
capital - of good quality, which can also be used to meet losses in going concern (orange
colour in the figure). One must also have further capital in the form of, for instance,
subordinated loans (yellow colour in the figure). This part of the capital differs from the other
two in that it can only be used once the bank has gone bankrupt.
Secondly, one will to a greater extent assume that the asset values are overestimated. So
the risk adjustments in the value of the assets that I mentioned will be much tougher. Quite
simply, one will now assume that the values of many asset classes are more inflated than
was previously assumed.
So despite the increase in Sweden being only around 2 percentage points for Tier 1 capital, it
actually entails a much tougher minimum requirement. But above all, it means that the global
minimum level is raised substantially. Especially with regard to common equity Tier 1 capital.
But not only that. The banks should also hold buffers over and above the minimum
requirements. One such buffer is what is known as the capital conservation buffer. The
further a bank is from meeting the capital conservation buffer requirement, the more limited
its capacity to pay dividends to shareholders. The reason is that one wants to prevent the
banks from showering its owners with riches in the good times, and then being caught
unprepared when the economic climate changes. If one adds this buffer, the requirements for
common equity Tier 1 capital is 7 per cent. Moreover, national authorities will have the
opportunity to force the banks to build up extra buffers during economic upturns, so that they
can more easily weather difficulties when there are downturns.
The Swedish banks already comply with the capital requirements stipulated in the new Basel
regulations. And this is an important condition for them to be able to fund themselves on the
markets.
Liquidity regulations increase resilience when funding is difficult
But even if a bank is well-equipped in terms of capital, it can nevertheless come unstuck if it
does not have sufficient liquidity buffers. And this is what happened to many banks during
the crisis. To ensure the banks are better-equipped, the Basel Committee has agreed on
introducing requirements regarding the banks' liquidity management. These are entirely new
regulations - there have previously not been any regulations in this field at all.
Liquidity can be compared to the ability to pay one's bills as they fall due. Even if you have
large capital, you may not have good liquidity. This is particularly important for the banks.
While they receive money from depositors and borrow on the market at fairly short horizons,
their lending is usually long term - perhaps 30 years or more for a mortgage. This ability to
transform short-term saving into long-term loans is the banks' main function in society. It
enables companies to invest and households to buy their homes.
Normally, a shortage of liquidity does not present a problem. Withdrawals from bank
accounts follow normal patterns and the banks are able to monitor this. If special needs
arise, the banks can manage the situation by selling assets and thus acquire cash. Normally
the banks have also been able to manage their short-term borrowing without problems. But
during the crisis problems arose on many markets. In some cases there were quite simply no
buyers at all and market funding ceased functioning. And as the banks had become
dependent on short-term borrowing, there was little they could do when their financiers
decided it was safest to demand their money back. Money the banks could not get hold of.
In these situations there is not much a bank can do. The usual remedy is liquidity assistance
from the central bank. But most central bank make tough demands regarding collateral for
lending money to banks with liquidity shortages. Collateral which the banks in many cases
were lacking during the crisis, or at any rate to the extent needed to compensate for the
enormous decline in funding on the international capital markets experienced by many banks
- in Sweden and abroad.
So central banks were forced to change the regulations so that the banks could pledge
collateral with a less reliable value. But this solution is not sustainable in the long run, as it
exposes the central bank - and ultimately taxpayers - to unacceptable risks. In practice, it
means that the central bank is forced to act as dumping ground for bad assets as soon as
there are problems in the financial markets. Of course, we want to avoid such situations in
the future, and this is why the Basel Committee has produced a number of regulations aimed
at making the banks less sensitive to liquidity problems.
So what do the regulations entail? In future, a certain part of the borrowing must be longer
term. Moreover, it must come from more stable sources of funding. In concrete terms, the
regulations mean that one multiplies the amount the bank borrows from each type of funding
source by a stability factor - in roughly the same way as for risk adjustment of the value of
assets when calculating capital requirements. This gives a stability-adjusted funding profile
for each institution that should better match the maturities for the banks' lending.
One will also require that a certain percentage of the banks' assets are liquid, in the sense
that they can be converted into cash relatively easily. This reduces the banks' vulnerability to
sudden outflows of funds deposited or maturities of loans that cannot be rolled. Put simply,
they require that the bank holds a liquidity buffer. The size of the buffer is calculated to
ensure that the bank can manage a 30-day period with very large withdrawals of deposits
and substantial loan maturities.
These two regulations - on liquidity buffers and more stable sources of funding - entail less
risk that the banks will be taken by surprise as they were during the financial crisis. But
above all the regulations will lessen the contagion effects on the markets. Stable liquidity
management reduces the risk of turbulence in individual markets or banks quickly spreading
and creating financial problems for other banks.
Stricter risk management
The third part of the Basel Committee's reform package concerns what is perhaps the most
important mainstay of the banks - the way they manage their risks. If risk management is
inadequate, having plenty of capital or apparently good liquidity management will not help.
Risk management mainly concerns credit risks and market risks. Credit risk means that a
borrower is unable to repay his or her loan. Market risk is the risk that the bank's assets will
vary in value in a way that was not anticipated, and this makes it difficult for the bank to get
hold of capital without making a loss. For example, fluctuations in interest rates and
exchange rates can affect the value of the assets. In addition to these risks, there are what
are known as operational risks. This can involve, for instance, a technical system failing to
function, or a human error that puts the bank at great risk. Some of you may remember how
the British bank Barings collapsed in 1995 as a result of speculation and unchecked risks
taken by a single employee. Risk management is about protecting oneself against such
undesirable and unexpected outcomes. In short, one wants to take calculated risks.
According to earlier agreements within the Basel Committee, the banks have the possibility
to develop models themselves to calculate the size of their risks and this is an opportunity
most of the major banks have used. Over time, their risk calculation models have become
increasingly sophisticated.
But during the crisis it turned out that not even the most advanced models managed to
capture the real risks. Sometimes it was not the model that was inadequate; there was a lack
of available data for assessing the risk. In many cases there was quite simply not enough
historical data, as the financial instruments were such fresh inventions. You may have heard
of various types of complicated derivative, such as CDOs, CDSs and so on. In other cases,
there was a change in the relationships between prices and other factors that had been
previously observed. The calculated probabilities quite simply did not reflect the reality.
It is easy to make a comparison with Swedish humorist Tage Danielsson's classical sketch
about the probability of a nuclear accident: as Harrisburg had just happened, there was
absolutely no risk that history would repeat itself. Or to look at it another way, as the
complicated financial instruments had previously escaped sudden price falls, one need not
expect any sudden price fall in the future. Slightly exaggerated. Underestimating risks and
taking excessive risks are two sides of the same coin. And this was just what happened, right
up until the US house price bubble burst and the crisis was upon us.
It is thus clear that there is a need to ensure that risk management is tightened and that the
deficiencies in the banks' balance sheets are corrected. The Basel Committee therefore
requires that the banks assume that many financial instruments - including the derivatives I
just mentioned - are much riskier than the banks previously assumed. So under the new
regulations the banks must leave a good margin for substantial losses possibly arising when
they buy and sell risky instruments.
Moreover, the Basel Committee is introducing a new risk measure - a leverage ratio. Behind
this term lies a fairly simple measure of risk that is not based on any advanced risk
calculation models. The bank's capital is examined in relation to all of its assets, even
offbalance sheet items. And to meet the requirements, the capital must not fall below a certain
ratio. One does not take into account historical risk relationships and other aspects usually
used in the banks' risk calculations. The leverage ratio thus limits risk taking regardless of
whether the banks' models show that their risk is low. Alternatively, the banks are forced to
allocate much larger capital reserves than they do now. Otherwise, the leverage ratio will
hamper growth in their lending. In this way, gross solvency functions as an additional
protective layer against the type of incorrect assumptions in the banks' models and
measurements that were revealed during the crisis.
Because the leverage ratio is a relatively uncomplicated measure, it is also more difficult to
manipulate or misunderstand. This reduces the probability of the banks' boards of directors,
financial supervisory authorities, shareholders and others being deceived or else
misinterpreting information. In connection with this, I can mention that the Basel Committee
recently agreed on a number of principles that aim to clarify the role and responsibilities of
the board of directors and to reinforce the independence and competence of the risk
management function.
Security and costs - a balancing act
A valid question here is how all this will affect the banks and the Swedish economy. Various
representatives of the bank sector have complained about the new liquidity regulations, for
instance. They claim these involve too much cost. But these are the rules of the game. The
fact is that we at the Riksbank have spent considerable time estimating the effects of the
regulations to be introduced. Next week we will publish some our estimates of the effects in
our Financial Stability Report. And our calculations show - even if they, like all estimates are
somewhat uncertain - that the negative effects will be fairly limited. Above all, the costs for
the banks are expected to be slightly higher. It is expensive to create new systems and
establish new routines to manage risks and money flows. Holding more capital means that
one ties up money that could otherwise have been lent out and generated interest income.
And the same applies to holding more liquid assets; there is a cost in the form of lower
interest income than one would have had if the funds were instead lent out.
The banks will probably pass on a small part of these costs to their customers in the form of
slightly higher lending rates. But here we are talking about changes of some few tenths of a
percentage point for the average customer - perhaps slightly more for households and less
for companies. One can probably also expect a dampening effect on the banks' profits, and it
is fairly natural that the required rate of return for bank shares will decline as the banks
become more secure. The banks may also experience increased costs for long-term funding.
But this should be compensated to some extent by the banks becoming more secure and
thus a fall in risk premiums on loans to banks. Although our calculations show that the costs
of the new regulations are limited, it is unavoidably the case that stricter regulation entails
various forms of cost. It is in the nature of the regulation.
The important thing is that these costs are seen in relation to the gains in the form of a more
stable bank system. And there is no doubt that the gains are substantial, after what the world
has gone through since the financial crisis began. Here I refer to the severe economic
downturn I mentioned at the start.
But it is nevertheless important not to tighten the screws too much. This would mean that the
banks only wanted to lend money to the most secure customers and investments. A lot of
good investments would be missed. A lot of people would be unable to buy homes.
Longterm economic growth would be slowed down and our total welfare would decline. We must
quite simply ensure we do not put a spanner in the works so the banks reduce their lending
too much. When I first worked at the Riksbank, in the 1970s and 1980s, the credit market
was severely regulated and this is not a situation we should wish to return to.
Nor should we ignore the fact that banks have an ability to circumvent regulations and make
use of loopholes in the law. And the tougher the regulations, the greater the reason for the
banks to try to circumvent them. If they succeed, no one has won. Instead, there is a risk we
will be lulled into a deceptive security, despite the risks merely being moved or hidden in
other forms. I might also add that regardless of which regulations are introduced, one still
needs effective oversight and supervision of the financial system as a whole and of individual
institutions.
If we take all of these aspects into account, I believe the Basel Committee's proposals are a
successful balancing act. They entail a substantial upgrading of the bank system in terms of
resilience. And the costs to the banks and society are small.
Long phase-in period
The Swedish banks are well-capitalised and the costs of the new capital requirements are
therefore small or non-existent. But we must remember that the situation is more difficult for
many banks around the world. If we force the banks to observe the new teachings
immediately, their ability to offer loans to companies and households may be impaired. This
could jeopardise the economic recovery. Because although the world economy appears to
be slowly recovering, the situation is still fragile. To avoid this, the Basel Committee has
agreed on a long phase-in period. Some of the new regulations will begin to apply in 2013.
Most of them will be phased in gradually. It will take a further ten years or so before all of the
regulations apply in full.
Although one must give the banks time to adjust, and allow the legislation process to run its
course, one may nevertheless consider the phase-in period to be longer than necessary. A
lot can happen in ten years or more. Over the past ten years, for instance, the financial
market and the world economy have been subjected to a number of shocks: the bursting of
the dotcom bubble, the subprime crisis and not least the debt crisis currently being
experienced by some countries. There is nothing to say that we will not experience similar
- and just as earth-shaking - events in the coming ten years. Postponing the
implementation of the new regulations may be doing ourselves - and others - a disservice.
But at the same time, I should mention that a number of countries have signalled that they
will set tougher requirements than the minimum stated. Some countries are also talking
about introducing the regulations sooner.
One step in the right direction - more are needed!
Now that the requirements regarding capital and liquidity are increasing, the allocation of risk
between the bank's owners and society as a whole is changed. The banks should
themselves bear the consequences of high risk taking to a greater degree. One might
therefore expect that the banks will actually take smaller risks in future. This, together with
the strengthening of the banks' resilience, reduces the risk of the banks experiencing
problems. But it does not make them immune to trouble.
Because although the capital buffers are much larger in the new system, they can be wiped
out in an instant if the losses are big enough. Despite the liquidity requirement, banks may
suffer a confidence crisis resulting in overwhelming bank runs and other funding difficulties.
And risk management can never be entirely watertight. In short, we cannot rest on our
laurels. Because even if we strengthen the banks, there is always a risk of banks failing. And
the fact is that we currently lack the tools to deal with this properly.
We therefore support continuing reform work by the Basel Committee in this field. For
instance, they are trying to ensure that financial supervisory authorities have the right tools to
be able to manage what are known as systemically important banks. These are banks that
are so important that the functioning of the entire financial system would be threatened if they
failed. This could be due to their size, for instance. Or because they are involved in a large
number of transactions with other banks or financial market participants. It is almost
impossible to predict the effects on the financial system, and thus the costs to society, if such
a bank were to fail. For this simple reason, we dare not take the chance. And both the
systemically important banks and their customers realise this. They rely on the state to inject
capital or provide some other form of assistance if they should get into trouble. In this way,
the systemically important banks benefit from the implied state guarantees. For instance,
through attracting more customers or being able to pay lower interest rates to their financiers.
However, when the survival of smaller banks is threatened, they are left to their fate. The
Basel Committee is now discussing the possibility of systemically important banks having an
additional increase to the capital requirement I mentioned earlier. This additional requirement
would further increase these institutions' resilience, as problems in these banks to a greater
degree affect other parts of the financial system. Switzerland has decided to introduce such
requirements anyhow.
But here in Sweden, too, we need to continue the work on strengthening the financial
system. We must, for instance, ensure that we have an effective regulatory framework for
winding up banks in distress so that their operation