Andreas Dombret: Restoring confidence in the financial system
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, at the Generation Forum "Communication across generations - regaining trust
in banking", Euro Finance Week, Frankfurt am Main, 21 November 2012.
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1. Introduction
Ladies and gentlemen
The financial system is more resistant today than it was a few years ago. The G20 have
launched a wide range of reforms - from financial institutions to financial markets to financial
instruments. Banks have substantially improved their resilience by increasing both their
capital and liquidity. Work is under way to strengthen oversight and regulation of the shadow
banking system. Derivative markets are being transformed to reduce systemic risks.
Yet the financial system is still not as safe as it should be. More steps are necessary. In my
short remarks, I will point out three of these steps: first, ending too big to fail; second, paying
greater attention to the consistency of regulation; and finally, reviving individual responsibility.
2. Ending too big to fail
Let me turn to the first of my theses.
Financial sector reform has focused on protecting the public from having to pay for the
mistakes of financial institutions - and quite rightly so. Too often, we have answered the
failure of financial institutions by bailing them out, using taxpayers' money.
Unfortunately, despite some progress, too big to fail is still with us. There is still the risk that
financial institutions that are particular large, complex, interconnected or globally active are in
a position to jeopardise the entire financial system.
2.1 Separating banking functions?
So what can be done to overcome too big to fail? Some believe that introducing a system of
separated banking functions - in other words, divorcing deposit-taking and lending from
proprietary trading and investment banking - is the way forward. YetI am questioning if such
a system can truly fulfil all the hopes invested in it. Let me explain.
The main argument in favour of separating banking functions is to avoid contagion.
Separating deposit-taking and lending from capital market transactions is said to prevent a
crisis from spilling from one of the areas of business into the other. This would allow "good"
banks to fulfil the important task of supplying the real economy with credit while being
shielded from risks inherent in investment banking.
Banks, however, that engage in risky transactions unrelated to the real economy, would be
excluded from deposit insurance schemes. If things went wrong, they would not be rescued
at taxpayers' expense. Thus, the separation could protect depositors and, at the same time,
would reduce moral hazard as it would become more difficult to finance risky areas of
business through insured deposits.
In addition, the separation of business areas could simplify group structures, thereby
counteracting incentive and information problems which increase disproportionately with the
size of banks. This would make banks more transparent and easier to manage, benefiting
supervisory boards and management as well as supervisory authorities.
However, separating banking functions will not prevent future banking crises. Remember
that, during the financial crisis, governments had to save many specialised banks in order to
prevent systemic disruptions. The Lehman bankruptcy caused precisely such contagion, but
not because customer deposits were at risk. Rather, it had many connections to other
financial institutions including, above all, many counterparties in derivative transactions.
Essentially the same applied to AIG which was not even a bank at all, but an insurer.
Even if there were a clean organisational separation, the interconnectedness of the financial
sector and the resulting systemic importance of individual institutions would not be entirely
eliminated. Economic linkages would remain. Financial institutions are linked not only
through direct business relationships, but also indirectly through payment and securities
settlement systems.
It is also difficult to decide how and where to draw the line between "good" and "not so good".
The boundaries between customer business, hedging transactions, market making and
proprietary trading are very much fluid. And problems in drawing clear boundaries generally
result in loopholes and incentives for regulatory arbitrage. We should not neglect the danger
of transactions and risks being shifted from the banking sector to areas which are less
closely monitored and regulated, such as, for example, the transfer of proprietary trading to
hedge funds.
All in all, I do not see a clear case for separating banking functions. In other words, I do not
believe this to be the first-best solution.
2.2 Introducing credible resolution regimes
Given these difficulties, what else can be done to end too big to fail? For me, rather than
intervening in financial institutions' business structures, the preferable regulatory solution is
the credible threat of an orderly market exit. And the decisive factor here, as always when it
comes to money and finances, is credibility. Only the credible threat that even systemically
important financial institutions may exit the market, and that this can be executed in an
orderly fashion, will restore trust in the rules of the game.
Unfortunately, the crisis has revealed a significant lack of suitable instruments for effectively
dealing with failing financial institutions. Existing insolvency laws have proven inadequate in
many countries, especially when it comes to firms that operate on a global level. Thus, new
resolution tools, and credible tools at that, are needed.
Some progress has already been achieved in this regard. A year ago, the G20 Leaders
endorsed a new international standard: the Key Attributes of Effective Resolution Regimes
for Financial Institutions. These Key Attributes set out for the first time essential features of
national resolution regimes on a global level. For instance, in future every G20 country is to
entrust restructuring and resolution functions to appointed authorities. So-called Crisis
Management Groups are already in place for nearly every global systemically important
financial institution. Recovery and resolution planning will become mandatory for both
financial institutions and authorities. In addition, firm-specific, cross-border cooperation
agreements are to be put in place, setting out roles and responsibilities of home and host
authorities.
The Key Attributes represent quite a step forward. Implementing them will gradually align
national resolution regimes, thus ensuring smooth interaction between the different
frameworks. I am hopeful that this will significantly curtail financial institutions' ability to
blackmail the taxpayer. It is now up to governments to transpose the Key Attributes into
national law and legislation. In Europe, the draft directive for the restructuring and resolution
of credit institutions and securities firms, which was published in June by the EU
Commission, is an important step in the right direction. It is necessary to continue on this
path.
3. Paying greater attention to consistency
When setting the rules for the financial system, one main challenge is that regulation has
been geared towards a sector-specific approach. This is reflected, for example, in the way
regulatory standards and principles applying to the banking, insurance and securities sectors
have developed largely independently of one another. However, this entails the danger of
losing sight of the financial system as a whole.
We need to be aware of this risk and focus our attention more on the systemic aspects of
regulation. One of the most important reasons for this is the prevention of regulatory
arbitrage. This applies not just to the relocation of business activities from one jurisdiction to
another, but also to shifts between different sectors of the financial system. For instance, as
already mentioned, tightening banking regulations may well push activities towards the
shadow banking system.
Besides regulatory arbitrage, we must also pay attention to the cumulative effects of, and the
interplay between, individual regulatory initiatives. Where there is a lack of consistency there
is a danger that different measures may create conflicting incentives or may even cause
countervailing effects. This then may diminish, or even completely prevent, the desired
effects of new rules. Take, for example, the interplay between the Capital Requirements
Directive/Capital Requirements Regulation, which serve to implement the Basel III rules in
Europe, and Solvency II: the former seeks, among other things, to place bank funding on a
more stable, long-term basis. However, Solvency II may, under certain circumstances,
benefit short-dated bonds, impacting insurers' asset allocation and thus banks' funding costs.
4. Implementing Basel III
Ensuring consistency clearly calls for intensive cross-border cooperation. This holds
especially true as the reform process is shifting from policy development to implementation.
Countries must live up to their commitments and ensure the timely and globally consistent
implementation of agreed policies. This applies, above all, to Basel III, which is without doubt
the central achievement of our reform efforts. Although it has become apparent that some
countries are having difficulties sticking to the timetable, I urge all authorities involved to
implement the framework as internationally agreed.
Recently, there has been a somewhat disconcerting discussion about the perceived
shortcomings of Basel III. Some argue that it is not enough. Others argue that it is too
complex. Yet, neither of these criticisms is convincing. First, one clear lesson from the crisis
is that banks' risk absorbing capacity was way too low. Therefore, Basel III substantially
raises capital requirements, reducing the probability of bank failures and the associated risks
to financial stability and to taxpayers.
Second, while risk measurement will never be perfect, simplicity can sometimes come at a
cost, too. Operating exclusively on a simple non-risk-based ratio may counteract one of the
Basel framework's overarching principles: more risk-taking means higher capital
requirements. Having said this, I fully agree to the leverage ratio's overall intention which is
to deliver a simple, transparent and credible ratio, complementing the risk-based capital
requirements - and not replacing them. It should just serve as a backstop.
There is no alternative to implementing Basel III on a global scale. In particular, I call on my
colleagues in the US not to unexpectedly question the whole framework in the 11th hour -
after taking part in its negotiation during the entire process. Nobody would understand why
the largest financial market in the world suddenly were to go its own way on capital rules.
Every country must absolutely avoid seeking advantages by watering down, or by reluctantly
implementing agreed reforms. Such a policy would only lead to new tensions in the financial
markets during a time of anyhow increased stress. We simply cannot afford going down this
route.
5. Reviving individual responsibility
The crisis has opened our eyes to an undue reliance on the market that has sometimes
prevailed. Confidence in the financial system will only return if we improve the rules of the
game. Yet, regulation can and will never catch everything. It can only put in place a
consistent and reliable framework in which financial transactions take place, and try to
prevent market forces from getting out of control. This does not mean simply banning
undesired activities and stopping market processes. Statism and dirigism are, by no means,
the right path to take.
Market participants themselves must do their part to strengthen financial stability. This
implies, above all, returning to a founding principle of social market economy: individual
responsibility. Those who take risks must not only reap the benefits but also face the
consequences. The possibility of loss and default is a constitutive element of any functioning
market economy - and financial markets cannot, and must not, be an exception to this. That
is why it is so important that all financial institutions are able to exit the market in case of
insolvency without impairing financial stability. And without using taxpayers' money.
Reviving individual responsibility requires a change in behaviour and a change in culture
within the financial sector. The manipulation of LIBOR is just one shocking example for this.
Bad attitude cannot be fixed by a few new rules. Nevertheless, a lot has already been set in
motion. Banks are now seeing themselves more as servants to the real economy. Many
move away from unrestrained pre-crisis profit targets. They are reconsidering their business
models as well, focusing on retail and corporate banking.
Remuneration practices in the financial sector are also slowly, but surely changing for the
better. There is no disputing that mismanaged remuneration systems helped cause the crisis.
Asymmetries in terms of risk and reward led to short-termism and excessive risk-taking.
Remuneration needs to be aligned to prudent risk-taking and be based on sustainable
creation of value, rather than on short-term earnings. Don't get me wrong: good work needs
to be rewarded with good money. Yet to be good, work has to be sustainable and
responsible.
6. Conclusion
Let me sum up:
First, ending too big to fail is not everything. But without ending too big to fail, all comes to
nothing. Rather than intervening in financial institutions' business structures, I prefer credible
resolution systems.
Second, while setting the rules of the game, we must take on a more systemic perspective,
paying attention to regulatory arbitrage and the interplay between individual reforms.
Countries need to implement agreed policies consistently and on schedule, including in
particular Basel III.
Finally, we have to return to individual responsibility: those who take risks may well reap the
benefits but must also face the consequences.
Thank you very much for your attention.