Ignazio Visco: The aftermath of the crisis - regulation, supervision and
the role of central banks
Lecture by Mr Ignazio Visco, Governor of the Bank of Italy, at Harvard Kennedy School,
Cambridge (USA), 16 October 2013.
* * *
Previous versions of this text were used for lectures at the Imperial College in London and at the Accademia dei
Lincei in Rome in March 2013. I wish to thank for useful discussions and help Fabrizio Balassone, Paolo Del
Giovane, Alessio De Vincenzo and Giuseppe Grande.
Introduction
The financial crisis has brought to the fore a number of issues. It has been severe and
widespread, and has affected many economies in different and long-lasting ways.
Maintaining financial stability has once again become a major concern of policy makers;
central banks are being heavily involved in this endeavour. A clear need has emerged for a
substantial overhaul in financial regulation and supervision, also considering that the financial
system of tomorrow will most likely be rather different from the one that has developed over
the last two decades. Scepticism has grown about the role of finance in the economic
system, and especially its apparent separation from, if not conflict with, the real economy.
We should take stock of what has gone wrong, and in so doing reflect on the way forward, as
it is already taking shape, as well as on how to better link our theories to real world
developments.
In the decade before the crisis both the size of the financial system and its role and
pervasiveness in the economy increased dramatically. The process has only slowed down
with the crisis. In the euro area, the overall amount of financial resources collected by the
private sector (bank credit, bonds issued domestically and stock market capitalization) rose
from 140 per cent of GDP in 1996 to 210 in 2007, to further increase to 240 in 2012. Broadly
similar patterns are found for the United States, where the ratio rose from 230 per cent in
1996 to 360 in 2007 and then declined to 310 in 2012, and for the UK, where the ratio
increased from 280 to 440 per cent and then remained stable. The total outstanding notional
amount of over-the-counter (OTC) and exchange-traded derivatives has risen from less than
100 trillion US dollars at the end of 1998 to around 500 trillion at the end of 2006, 700 at the
end of 2007 and still 700 trillion in December 2012.
Financial deepening, by allowing greater diversification of risk and making finance accessible
to larger numbers of countries and firms, can be instrumental to broadening economic
development. But there is a risk that finance turns into an end in itself, with consequences
that can be more damaging as the system becomes more interconnected and the potential
for externalities increases.
At the same time, the interaction between monetary policy and financial stability becomes
more relevant as heightened financial complexity amplifies the widespread non-linearities in
the dynamics of financial and economic variables and the consequences of interconnections
between the financial and the real side of the economy. In these conditions, the risk of
systemic crises increases.
The correct conduct of financial business requires competence and good faith on the part of
intermediaries, as well as appropriate regulatory, supervisory and policy regimes. The fact
that fragilities in the financial system were not properly and timely identified, and that their
potential consequences for macroeconomic and price stability were largely underestimated
reflects inadequacies in regulation and supervision, as well as in the analytical framework for
monetary policy.
The financial crisis has provided two main lessons for policy-makers: first, complexity is not a
justification for a light-touch approach to regulation and supervision, quite the contrary;
second, financial stability is a precondition for price stability. Two implications, then, have
followed suit: on the one hand, a deep and far-reaching reform in financial regulation and
supervision was needed (including tighter international cooperation), on the other hand,
central banks had to rethink their role and the tools of their trade, specifically concerning the
relationship between monetary and macroprudential policies.
"Good" finance as a force for good
Finance has long been viewed as a morally dubious activity. My appeal to authority on this
matter is a reference to a lecture delivered by Amartya Sen more than twenty years ago as
the first Paolo Baffi Lecture on Money and Finance at the Banca d'Italia. Sen wondered:
"How is it possible that an activity that is so useful has been viewed as being morally so
dubious?".1 He recalled a series of historical episodes: Jesus driving the money lenders out
of the temple, Solon cancelling debts and prohibiting many types of lending in ancient
Greece, Aristotle describing interest as an unnatural and unjustified breeding of money from
money.
Superimposed on this "structural" mistrust, one can detect cyclical patterns in the public's
attitude towards finance, affected by the conditions of financial systems and shifts in the
political mood about state intervention in the economy. Until the 1970s it was taken for
granted that market failures required the presence and response of a regulator to avoid
suboptimal results. Then came the great inflation of the 1970s, combined with high
unemployment, and the emphasis shifted to government failures. Governments, central
banks and other regulators were blamed for failing to prevent these developments. This
eventually led to an ideological swing: a push to reduce the extent of state intervention. The
failures of the "regulated economy," the pace of technological advance and the rapid
expansion of international trade after the end of the Cold War fuelled a protracted process of
financial deregulation that was halted only by the financial crisis that broke out in 2007. The
latter triggered a move toward re-regulation - or better regulation - that is still under way.
The pendulum keeps swinging and will certainly continue to do so.
The global financial crisis, with its huge costs for the whole society, has caused a further
deep erosion of the trust in financial institutions. Witness to this are the widespread protests
against the financial industry, from the Occupy Wall Street movement to the "Indignados" in
Spain and their counterparts in other European countries. Anger has been fuelled not only by
the discovery of wrongdoings and perverse incentives, but also by a perceived lack of action
against those responsible, in a context of exceptionally high remunerations. The integrity of
financial intermediaries' codes of conduct has been called into question under many
dimensions: honesty, the ability to manage financial risks and the commitment to take care of
the interests of their clients.
In the first place, public attention was caught by cases of investment fraud, in which Ponzi
schemes or other types of malpractice and malfeasance led many people to lose their
savings. Feelings were exacerbated by the generous severance packages paid to top
managers after distressed financial institutions were rescued with taxpayer money. Dubious
practices were found in key junctures of the financial systems, such as credit ratings and
interbank reference rates, not to mention the allegations of financial institutions' involvement
in activities related to money laundering and other fraudulent practices.
Most importantly, the crisis has shown that market participants were not capable of
mastering the inherent complexity of the system that they themselves had contributed to
develop over the course of the last two decades. Favoured by the breakthroughs in
information technology and telecommunications, the securitization of banks' assets
expanded considerably, together with the supply of so-called structured financial instruments
(ABSs, CDOs, etc.). The traditional model of credit intermediation gave way, especially but
not only in the United States, to a system in which loans granted were rapidly transformed
into other financial products having these loans as collateral and sold on the market: the
socalled originate-to-distribute model (OTD). To the inherent difficulty of evaluating the quality
of loans, these developments added the problem of fully understanding the role of structured
finance products.
Structured finance products and the OTD intermediation model can facilitate risk
management. The granting of mortgages to households is favoured by the possibility of
managing the related interest-rate risk; the internationalization of firms depends crucially on
the possibility of hedging foreign exchange risk; and the provision of retirement saving
products at low cost over very long time horizons benefits from the ability to mitigate the
impact of fluctuations in security prices. With the OTD model, credit risk is not concentrated
in the banks' books, but is potentially dispersed among a multitude of investors. By making
bank loans tradable, it reduces their illiquidity premium thus decreasing their cost.
However, we now understand that structured finance and OTD intermediation, coupled with
lack of transparency, favoured excessive risk taking and opportunistic behaviour.
Transactions often took place through scarcely regulated financial intermediaries
characterized by high leverage and risk exposure, whose valuation (in which a crucial role
was played by rating agencies, without any particular control by regulatory authorities or
information providers) was carried out by means of statistical models and often on the basis
of incomplete and insufficient data. In many instances complexity was instrumental to
opportunistic behaviour fuelled by a distorted system of incentives especially with reference
to executive compensation. The high leverage and complexity typical of structured financial
instruments allowed them to be used to take high-risk, speculative positions.
Unnecessarily complex and opaque assets were used to prevent a correct assessment of
creditworthiness or mask the economic impact of previous transactions, exploiting the ample
scope for interpretation allowed by accounting standards. Banks' misuse of these
instruments may also be linked to the drying-up of the sources of income from traditional
credit business. This may have triggered actions designed to conceal from the market and
from supervisors the real object of derivatives transactions.
The bottom line is that financial innovation can allow more efficient allocation of credit risk,
but it also entails a number of dangers, some of them intrinsic to its mechanism, others more
generally related to the greater interdependence of the financial system. The process of
financial consolidation and the OTD model have produced intermediaries that are closely
intertwined with the capital markets. This has had some important consequences for financial
stability: a more connected world improves risk diversification and can make markets more
resilient, but when contagion is actually set off, an interlinked financial system heightens the
risk that it may spread more widely.
But the negative perception of banking and finance should not lead to a blind backlash. As
Amartya Sen argued, "finance plays an important part in the prosperity and well-being of
nations".2 It is crucial for sharing and allocating risk, especially for poorer societies and
people, insofar as risk aversion decreases with wealth. It is crucial for transferring resources
over time and removing the liquidity constraints that hamper the economy and the
exploitation of ideas. It is very important in promoting economic growth, especially by
fostering innovation.
Indeed, we have countless historical examples of good financial innovations. Think, for
example, of the "letters of exchange" introduced by Italian merchants in the Middle Ages:
they were probably the first fiduciary money, and trade benefited enormously from this
financial instrument. More recently, consider the development of "micro-finance" in the
1970s: an innovation that has enhanced financial inclusion, helping poor borrowers to
smooth their income and cope with illness or other temporary shocks. And, in the last
decades of the past century, recall the role of the "venture capital" industry in the promotion
of successful innovative corporations such as Apple, Google or Intel.
Some countries are now increasingly investing in efforts to improve the financial literacy of
the public, and this too is important. On the one hand, it helps to build the demand side of a
more inclusive finance. On the other, financially literate citizens are better able to understand
the efforts of regulators and policy makers to improve supervision and regulation, and less
likely to subscribe to the simplistic view that "finance is evil". But we should realise that - as
the case of Bernard Madoff and others in the US and elsewhere clearly show - this is no
panacea (Madoff's customers were surely much better educated than average). Therefore,
for purposes of consumer protection in the financial services industry, regulation and good
supervision are the necessary complements to education and inclusion.
Complexity was used, somewhat perversely, as an argument in favour of a sort of benign
neglect on the part of regulators. The big financial players argued successfully that
innovation was too complex and too opaque for the regulators to get their heads around.
Indeed, they said, to safeguard the international financial system from systemic risk, the main
priority was promoting an "industry-led" effort to improve internal risk management and
related systems. This, in a nutshell, was the view espoused by the Group of Thirty report
following the outbreak of the Asian crisis.3 But this thesis was often accompanied by the
argument to the effect that "you, regulators and supervisors, will always be behind financial
innovation; it would be better to allow us, the big financial international players, to
selfregulate; we are grown-ups, we can take care of ourselves". And, after all, "if someone
makes mistakes some will gain what others lose; why can't we be left alone to play this
zerosum game of ours?"
The regulators did not, in fact, have either the ability, or the right incentives to acquire the
necessary information to deal with complexity, for two reasons. First, the big financial players
are global, and national regulators had powers too narrow to be able to confront them. The
difficulties in coordinating the regulators' actions, in the face of a natural tendency to
preserve each one's particular sphere of influence, was a powerful drag on the ability to rise
to the challenge posed by a finance gone global. Second, the phenomenon of regulatory
capture was a definite reality. Powerful political and economic influences were at play, and in
some cases prevailed.
Accepting the idea that benign neglect was the right course of action was, however, a critical
mistake. The global financial crisis has highlighted the limits of the idea that self-regulation
and market discipline are sufficient to ensure stable financial systems. Regulation and
supervision have to keep pace with developments in the industry. National authorities need
to be aware of the risk that their powers become narrow compared to the sphere of influence
of the global players; the coordination of supervision across borders and across sectors is a
key condition for the stability of the global financial system. More importantly, regulators and
supervisors have to pay attention to keeping industry lobbies at due distance.
To a significant extent, the recent crisis also owes to insufficient market discipline (including
the role played by credit rating agencies), which failed to reign in (or even counter) in a timely
way imprudent behaviour, excessive leverage, or over-borrowing on the part of financial
intermediaries (and sovereigns as well). At the same time, monetary policy overlooked the
risks for price stability coming from the financial sector. The idea that it is optimal to "mop-up"
after a bubble has burst rather than implementing "leaning against the wind" policies, which
seemed to have passed the test of the dot-com bubble, led to a long period of excessive
monetary accommodation.
It has now indeed become clear that financial stability is a precondition for price stability and
that the "mop-up" approach is not always the best strategy. Notwithstanding huge monetary
and fiscal interventions, six years after the burst of the credit-fuelled housing bubble most
advanced economies are not yet back on stable growth trajectories. A key lesson of the last
decade, also supported by an increasing number of theoretical and empirical analyses, is
that too low for too long interest rates can stimulate risk taking and sow the seeds for the
next crisis if left unchecked by regulators and markets alike.
All this called for a major effort, at a national but especially at an international level, to adjust
and strengthen the regulatory and supervisory financial framework. It has also suggested
that central banks should rethink their role and their instruments. This I will attempt to review
and assess in what follows. I will also briefly discuss the importance of advances in our
analytical understanding of the workings of financial markets and of its deviations from the
stationarity assumption.
In search of a better regulatory and supervisory regime
Over the last few years the crisis has heightened appreciation of the benefits of a more
stringent regulatory regime. At an international level, under the political impulse of the G-20,
the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision
(BCBS) have introduced substantial regulatory changes to reduce the frequency of financial
crises and increase the resilience of economic systems. Much has been achieved.
The quantity and quality of capital that banks need to hold has been significantly enhanced to
ensure that they operate on a safe and sound basis. Minimum capital requirements have
been raised. The improvement in the quality of capital aims to ensure that banks are better
able to absorb losses on both a going concern and a gone concern basis. The risk coverage
has been increased, in particular for trading activities, securitisations and exposures related
to off-balance sheet vehicles and arising from derivatives. An internationally harmonised
minimum leverage ratio is going to be introduced, to serve as a backstop to the risk-based
capital measure and to contain the build-up of excessive leverage in the system.
The BCBS has also introduced international standards for bank liquidity and funding,
designed to promote the resilience of banks to liquidity shocks. A minimum requirement for
the ratio between high quality liquid assets and net liquidity outflows that banks would face
over a one-month horizon in stress conditions (Liquidity Coverage Ratio - LCR) will soon be
adopted. The minimum LCR will increase gradually in the coming years, so as to ensure that
the new liquidity standard will not hinder the ability of the global banking system to finance
the recovery.
At the behest of the G-20, the FSB has promoted initiatives to strengthen the regulation of
the OTC derivatives market. The aim is to reinforce market infrastructures, in order to
minimise contagion and spill-over effects among players that have become more and more
interconnected. These initiatives will increase transparency through requirements to trade on
organised platforms and to report transactions to trade repositories. They will also reduce
and allow more systematic control of cross-exposures between financial firms in this market,
by ensuring that central counterparties are placed between the two participants in
standardised transactions and by setting minimum capital and margining requirements.
But further progress is needed in important areas. Work should focus on internal risk control
arrangements and disincentives to excessive risk-taking, on the rapid implementation of the
set of policies developed to address systemic risks from shadow banking, on reducing
market participants' mechanistic reliance on credit rating agencies, on increasing
transparency, including by completing international convergence of accounting standards.
Board members and senior managers should possess a thorough understanding of the
financial firms' overall operational structure and risks.
It is also fundamental that supervisors regularly assess banks' corporate governance policies
and practices. Compensation policies need to be revised, in order to better align
remuneration with risk-adjusted long-term performance and avoid excessive risk-taking and
short-termism. In particular, when designing compensation policies, banks should take into
account a number of issues: the variable portion of the compensation of risk takers must be
paid on the basis of individual, business-unit and firm-wide measures that adequately assess
risk-adjusted performance; bonuses must reward the achievement of stable earnings, not
simply the fruit of extraordinary operations; executives' severance packages too must be
clearly and effectively bound to the results attained, and reflect a more general evaluation of
the manager's performance; compensation must be deferred long enough to validate the true
quality of management.
The debate that has started with the so-called Volcker rule on the organizational structure of
banks and the need to separate traditional credit business from activity in the financial field
has been reinvigorated at a European level by the reports of the Vickers Commission in the
United Kingdom and the Liikanen Group for the whole European Union. Both the Volcker rule
and these reports call for a much needed discussion around business size and complexity in
the financial sector; the experience of the crisis has indeed shown that we should not be shy
to thoroughly re-assess relative merits and costs of both (size and complexity). These reports
trace out possible lines of intervention. Protecting retail deposits and taxpayers' money from
the risks implicit in trading activities (what used to be called "speculation") - the rationale
behind these proposals - is crucial. The experience of the crisis has shown that, even if no
specific business model has performed particularly well or poorly, the banks' organizational
structure has an impact on the propensity of managers to engage in excessively risky
activities.
At all events, in today's globalized world it is crucial to make sure that countries cooperate
and agree on the appropriate stringency of financial regulation. Countries should not
compete by relaxing rules in order to attract financial business, as this generates negative
externalities for other countries. This is a most delicate issue, and while a perfectly level
playing field may not be achievable, we have to be conscious of the consequences of a
"beggar-thy-neighbour" approach to regulation. The transition to a uniform system of rules
and oversight of the financial sector must be hastened. In the euro area the plan for a
banking union is ambitious; it goes in the right direction.
Some progress has been made on the convergence towards a single set of global
accounting standards; but much remains to be done. The International Accounting Standards
Board and the US Financial Accounting Standards Board expect to make progress on the
two key outstanding issues of impairment of loans, where their deliberations should be
completed in the next months, and insurance contracts, where both Boards are holding
public consultations. Of these two outstanding issues, the need for convergence on a new
forward-looking expected loss approach to provisioning is of most immediate concern for
end-users and from a financial stability perspective.
One element that is essential for guaranteeing systemic stability is the method of measuring
risk-weighted assets (RWA), the denominator of capital adequacy ratios. RWA measures
have recently attracted increasing attention from market analysts, banks and supervisory
authorities. It has been argued - and this seems to be actually the case - that the
methodologies for computing RWAs may not be comparable across institutions and,
especially, across jurisdictions, and that they should more properly reflect risk in order to
avoid ultimately jeopardising financial stability. These problems highlight the relevance of
supervisory practices in determining banks' capital requirements (for example, in validating
internal banks' models for calculating risk weights). Here, rigorous micro-prudential
supervision is essential. We really need to work out a single rulebook, to move with
determination towards taking joint responsibility and using peer reviews as much as possible
in our supervisory activity. Overcoming differences in accounting and supervisory practices is
proving a major challenge on the way to the banking union in the euro area.
As for the initiatives to strengthen the regulation of the OTC derivatives market, these
complex reforms are taking somewhat longer than originally planned. It is therefore
necessary to pick up the pace, overcoming the difficulties of implementation and the
industry's resistance. Authorities must make all efforts to remove the uncertainties arising
when transactions involve a cross-border dimension, which is a recurrent condition in a
global market. This is necessary to pre-empt regulatory arbitrage and, ultimately, to achieve
the G20 objectives. Work is also in progress on other relevant issues at an international level
(capital requirements for exposures to central counterparties, margining standards for
noncentrally cleared transactions, as well as on authorities' access to trade repository data) and
at a regional and national level.
It will be crucial to ensure that stricter regulation and supervision of banks will not push
banklike activities and risks towards non - or less - regulated institutions (the so-called "shadow
banking" sector). Let us not forget that the financial crisis originated in the US securitization
market, largely populated by unregulated or scantily regulated operators. While we have to
address bank-like risks to financial stability emerging from outside the regular banking
system, the approach should be proportionate, focussed on those activities that are material
to the system, using as a starting point those that were a source of risk during the crisis. The
FSB has released a final set of recommendations in August 2013.4 One should bear in mind,
however, that the new recommendations will be able to address the specific risks that arose
during the crisis, and we all recognise the ability of the shadow banking sector to innovate.
Although new regulations on systemically important financial institutions have recently been
approved, the "too-big-to-fail" issue is still a major concern, and it merits strict monitoring.
Systemically important financial institutions (SIFIs) are being identified in different sectors,
and three types of measures will be applied to sharply reduce the threat that their failure
poses to the wider system. First, legal and operational regimes will be changed to enable all
financial institutions, including those operating across borders, to be resolved safely and
without taxpayer loss if they fail. Second, requirements that SIFIs have higher loss
absorption capacity will be introduced. Third, supervisory oversight (including sharing of risk
data) will be stepped up to reflect the additional complexity of these institutions and the
systemic risks they pose.
Negative externalities associated with banks' behaviour (especially for large, interconnected
financial firms) must be taken into account. A broad consensus has emerged on the idea that
"macroprudential" policies directed towards preserving financial stability should limit systemic
risk by addressing both the cross-sectional dimension of the financial system, with the aim of
strengthening its resilience to adverse real or financial shocks, and its temporal dimension, to
contain the accumulation of risk over the business or financial cycle.
Finally, even after the completion of the regulatory overhaul, it would be foolish to pretend
that defaults can always be avoided. They may be the result of imprudent behaviour or of
fraudulent operations. We need to be prepared for their occurrence, as the costs of public
support tend to be very high. In Europe, according to the latest data gathered by the
European Commission, the outstanding amount of public recapitalizations as of December
2012 came to 0.3 per cent of GDP in France, 1.8 in Germany, 5.5 in Spain, 4.2 in the UK,
4.3 in Belgium, 5.1 per cent in the Netherlands, and 40 per cent in Ireland. For Spain and
Ireland these amounts are at their highest since 2008, in the other countries they are lower
than the peaks reached in 2009. For the Spanish banks, a programme of recapitalization
using European funds of up to €100 billion was authorized in July 2012, of which €41 billion
(3.9 per cent of GDP) has already been disbursed. In Italy, taking also into consideration the
additional public support provided to Banca Monte dei Paschi di Siena, public
recapitalizations currently amount to 0.2 per cent of GDP. These figures indicate that the
ongoing work on resolution regimes is very important in this regard, and rapid progress
should definitely be made. This is particularly relevant in the euro area, where the new single
supervisory mechanism (the SSM) is being implemented.
Observations on the analytical implications of economic and financial instability
Economic systems constantly evolve and transform. Changes in institutional arrangements,
technological innovation and revisions in economic policy paradigms continuously reshape
the framework in which economic agents (consumers and businesses) make their decisions.
This in turn leads to changes in economic agents' behavioural patterns. When there is
marked discontinuity with the past, such changes may be far-reaching and the past fails to
provide enough guidance for the present (never mind the future). We should always
remember that the financial system is part of a richer social, economic and political
environment. The real world is subject to shocks that at times may have dramatic
consequences, such as those that we have experienced in the last twenty years or so, with
the end of the cold war, globalization and the sudden emergence of new major economic
actors, the ICT revolution, and substantial (not completely anticipated) demographic
changes.
However, a stationarity assumption of sorts underpins our theoretical and statistical models,
in the case of economic forecasting and (macro) policy making as well as in the case of
financial analysis and risk management. In general, the basic tenet is that future outcomes
will be drawn from the same population that generated past outcomes, so that the time
average of future outcomes cannot be persistently different from averages calculated from
past observations, and future events can be predicted with a certain degree of statistical
accuracy. In non-ergodic environments, on the contrary, at least some economic processes
are such that expectations based on past probability distribution functions can differ
persistently from the time averages that will be generated as the future unfolds.5 In case of
acute uncertainty, no analysis of past data can provide reliable signals regarding future
prospects.
The challenges posed by the non-ergodic nature of economic systems may be met by
recognizing that our models are by necessity "local" approximations of very complex
economic and financial developments. One needs to be modest, using theory and empirical
models as starting points for, not straightjackets in, our decision making. And perhaps not
enough attention has been paid by the financial community to the need for establishing
institutional and behavioural norms to reign on patterns of instability and developing proper
learning devices to deal with major shocks and regime changes.
These challenges are compounded by another general characteristic of the quantitative
analysis of economic phenomena: the difficulty of running parallel worlds, i.e. producing data
through experiments designed and controlled by the researcher. Even when economic forces
do follow repetitive patterns, it may not be easy to spot empirical regularities, because
contingencies - especially the exceptional ones - cannot be re-created at will, in the
laboratory, for cognitive purposes. Our experience will always be limited, partial and episodic.
These a