Andreas Dombret: Financial market regulation - standing still means
falling behind
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, at the 2014 Alternative Investor Conference of the Federal Association for
Alternative Investments (Bundesverband Alternative Investments), Frankfurt am Main,
14 May 2014.
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1 Introduction
Ladies and gentlemen
Thank you very much for inviting me to speak at this year's Alternative Investor Conference -
I am delighted to be here today.
My responsibilities at the Bundesbank have actually changed slightly since I accepted your
invitation. As you may know, the Bundesbank appointed a new Deputy President, Professor
Claudia Buch, yesterday, and the distribution of responsibilities within the Executive Board
has now changed. After being the board member in charge of financial stability for four years,
I was assigned responsibility for banking and financial supervision yesterday.
Ultimately, though, these two areas have the same overarching aim - they simply approach it
from different angles. Their objective is to maintain a stable financial system. And the
business of achieving this aim has not got any easier over the past few years.
Our world - and, not least, our economy - is becoming more and more interconnected. And
a global economy can't function without a global financial system. This makes the financial
system more important, yet it is ultimately still a means to an end - it is a service provider for
the real economy.
In this role, the financial system - or, more precisely, its stability - is a public good. As
economists like to put it, there are external factors at play. If the financial system is thrown off
balance, this also has a negative impact on those outside it - businesses in the real
economy or taxpayers, to name two examples.
That is why it is necessary to regulate the financial system in order to safeguard its stability.
The need for regulation is beyond dispute: the question is not whether, but how we should
regulate. Of course, there are a number of different ways to approach the issue, but one
thing is clear: regulation isn't stationary. The financial system is in constant flux, and
regulation has to keep pace with it.
Regulatory reform is usually triggered by a crisis - and the recent crisis is no exception. It set
in motion a fundamental review and reform of financial market regulation. Work on this
reform began at a global level in 2008, and it is still underway. Many important measures
have been agreed, and some have already been implemented. Yet certain areas still need a
lot more work. I would like to discuss two of these issues here today: the "too big to fail"
problem and the shadow banking sector.
2 Still "too big to fail"?
The "too big to fail" problem was a key factor in the recent crisis, and it still isn't completely
solved. But first let's take a look at the essence of this problem.
Participants in the financial system are highly interconnected. If a bank runs into trouble, this
will also affect its counterparties. And if the bank in question is particularly large or has an
especially high number of counterparties, its woes can destabilise the entire financial system.
We saw how devastating this scenario can be in 2008, when Lehman Brothers became
insolvent.
In such cases, the state may have no option but to bail out the distressed bank in order to
prevent an escalation of the crisis. Such bail-outs are, of course, extremely costly; in 2010,
Ireland was obliged to spend more than 30% of its annual GDP on bail-outs for stricken Irish
banks. And these costs are ultimately borne by none other than the taxpayer.
But this policy not only comes at a cost to the taxpayer; at a deeper level, it also changes the
structure of the financial system. Large and interconnected banks enjoy an implicit state
guarantee. If they run into difficulties, they can always count on the state bailing them out -
they are "too big", "too interconnected" or simply "too important" to fail.
This encourages large and interconnected banks to enter into high-risk transactions. If these
transactions are successful, the bank will reap the benefits; if they make a loss, the taxpayer
may ultimately have to foot the bill. Large and interconnected banks therefore intrinsically
pose a risk to financial stability. At the same time, this is precisely why they engage in such
risk-taking in the first place - which all makes for a dangerous feedback loop.
So how can regulation help? One option would be to prevent large banks from becoming
distressed in the first place. Notably, the new Basel III capital requirements are an important
step in this process. But can they rule out bank failures altogether? And should we even try
to do so?
My answer to both of those questions is a resounding "no". Of course we can't rule out bank
failures entirely, and nor should we try. The possibility of a market exit is fundamental to any
market economy. Failed business models must make way for better ones, in the process that
Schumpeter famously described as "creative destruction".
What we need are mechanisms that allow even big banks to fail without destabilising the
entire financial system. Only then will banks face the real threat of a market exit; only then
will we eliminate their implicit state guarantee; and only then will banks have an incentive to
be risk-aware in their actions.
Without these kinds of mechanisms, we cannot solve the "too big to fail" problem. And there
is still a good deal left to be done, as the markets themselves acknowledge. Recent studies
by the IMF and the OECD show that the markets still assume that, if push came to shove,
the state would not let big banks go under. And it's true that there are two problems relating
to credible resolution mechanisms which have yet to be resolved.
First, resolution mechanisms are inherently complex - especially those for big banks, which
tend to operate globally. They often have dozens of branches spread across numerous
countries. To be able to resolve a bank of this kind, we need international cooperation that is
built on solid legal foundations. We have now taken some initial steps towards this goal -
through the Financial Stability Board principles at an international level and the agreement to
create a Single Resolution Mechanism at a European level. Even so, there is still a long road
ahead of us.
Second, each bank resolution throws up the same question: who should bear the costs?
When a bank is resolved, there have to be sufficient resources available to absorb losses.
These resources - known as "gone concern loss absorbing capacity", or "GLAC" - should be
sufficient to allow the failed bank to be resolved. In other words, GLAC should help to
recapitalise viable components of the failed bank, or a bridge bank. The aim is to preserve
the bank's critical functions while avoiding a government bailout or turmoil on the financial
markets.
GLAC should become to the "gone concern" scenario what the Basel III regime is to the
"going concern" scenario. And for both we need internationally binding minimum standards
which are mutually compatible. The Basel III capital standards have already been approved,
whereas a minimum standard for GLAC is currently under development.
3 Parallel banking - there is no light without shadow
Ladies and gentlemen, we haven't yet crossed the finishing line in our quest to solve the "too
big to fail" problem. But that is not the only area which needs a lot more work. If we want to
safeguard financial stability in future, regulators will need to set their sights beyond the
banking system - to the shadow banking system.
But I have my reservations about the term "shadow banking system". The word "shadow"
usually conjures up images of unsavoury, shady activities. And that is in no way a fair
description of the shadow banking system.
Still, there's no denying that we have too little data on the shadow banking system, which
means that we don't have quite as clear a picture of it as we do of other parts of the financial
system.
In addition, the shadow banking system is in constant flux: innovations shift its boundaries;
activities and participants come and go. To regulate the shadow banking system, we need a
definition that does justice to these changes.
The Financial Stability Board has therefore opted to define the shadow banking system fairly
broadly as "the system of credit intermediation that involves entities and activities outside the
regular banking system". Put simply, this definition covers bank-like entities and bank-like
activities which are not subject to banking regulation.
Examples of shadow banking entities include money market funds, hedge funds, asset
management companies and financial vehicle corporations. Fittingly, their business is often
described as "non-bank banking" or "parallel banking". Examples of shadow banking
activities include securitisations, securities lending and repos.
Despite the blurred and constantly shifting boundaries, we can attempt to estimate the size of
the shadow banking system. The Financial Stability Board, for instance, puts the figure for
assets under management in the shadow banking system at US$71 trillion. That would make
the shadow banking system about half as big as the regular banking system. However, this
global aggregate does not capture major regional differences. For example, in the United
States the shadow banking system is about 175% the size of the regular banking system,
whilst the ratio in Germany is only around 25%.
As well as the size of the shadow banking system, its rate of growth also varies between
regions. In 2012, the system saw its sharpest expansion in emerging market economies, with
China recording the fastest growth worldwide. By contrast, the German shadow banking
system grew comparatively slowly. Overall, the global shadow banking system has grown
rapidly in recent years: between 2002 and 2012, its assets under management expanded by
US$45 trillion.
This growth could continue into the future. For instance, more stringent regulation of banks
may cause activities to migrate to an increasing extent into shadow banking - what is
referred to as regulatory arbitrage.
However, it would be wrong to attribute the growth of the shadow banking system to
regulatory arbitrage alone. Growth is also being driven by demand for the specialised
products and services offered by the system. Institutional investors in particular make use of
shadow banking products - such as repo trades - as an alternative to traditional bank
deposits.
In consequence, the effects of shadow banking on financial stability are not entirely clear. On
the one hand, the system undeniably fulfils an economic role: it offers alternative sources of
funding to enterprises in the real economy as well as to banks, thereby adding to
diversification and specialisation. In general, that enhances both the efficiency and the
resilience of the financial system.
On the other hand, the shadow banking system also harbours risks. If activities are shifted
into shadow banking as a result of regulatory arbitrage, then the concomitant risks are shifted
too - and thus sometimes moved out of reach of the regulatory access that is actually
needed.
However, the shadow banking system may be a source of risks other than those deriving
from regulatory arbitrage. Shadow banking participants undertake maturity and liquidity
transformation, they engage in the transfer of credit risk, and they operate with leverage. This
means they carry out a range of bank-like functions which are associated with bank-like
risks. At the same time, however, there are two key differences compared to the regular
banking system. First, shadow banking participants and activities are not subject to banking
regulation. Second, shadow banking participants have no access to central bank liquidity, nor
do they benefit from public backstops such as deposit insurance schemes.
The consequence of this structure is a latent risk of runs on shadow banking participants. A
run may lead to liquidity bottlenecks which can only be cleared by rapid deleveraging. That in
turn may contribute to a collapse in prices on the financial markets, and thus exacerbate the
problems in procyclical fashion. At the same time, the structure of many of the transactions
conducted in the shadow banking system means that the participants are closely
interconnected. Thus, contagion effects within the system are highly likely.
These systemic risks within the shadow banking system may then spill over into the regular
banking system. The latter is linked to the shadow banking system through a number of
channels. Partly this is because banks are directly involved in shadow banking. At the same
time, many banks are connected indirectly to the system through liquidity facilities, claims on
shadow banking participants and common exposures in individual markets.
Thus, the shadow banking system may well be a source of systemic risk. Accordingly, it is
very high up the G20 reform agenda. In November 2010, the G20 asked the Financial
Stability Board and other international standard setters to develop approaches to ensuring
better supervision and regulation of the shadow banking system.
In this connection, let me be absolutely clear: the purpose of regulation is not to proscribe
shadow banking activities or to drive participants out of the market when such activities and
participants engender no systemic risk. The sole aim of regulation is to put a brake on
systemic risk.
There are essentially two approaches: a direct one and an indirect one. Indirect regulation is
aimed at the regular banking system and tries to keep a check on its links to the shadow
banking system. Direct regulation, on the other hand, takes direct aim at shadow banking
participants and activities.
In terms of indirect regulation, some progress has been made in the reforms to the Basel
framework. For instance, capital requirements for various connections to the shadow banking
system were increased - including for risks arising from securitisation and from liquidity
facilities for securitisation vehicles. In addition, banking supervisory liquidity ratios may help
to stem systemic risk - where macroprudential considerations are factored into defining
them.
Money market funds constitute one example of direct regulation of participants. US money
market funds in particular bear a strong resemblance to banks. For investors, there is very
little difference between these funds and a bank account - including access to cash at ATMs.
The main problem comes with money market funds which operate with constant share
values, such that investor deposits have a constant value. With funds like this, losses are not
distributed evenly across all investors. Instead, a "first come first served" rule applies. Those
who withdraw their deposits first get back the full amount, while those who act too late have
to accept corresponding losses. This rule makes such money market funds susceptible to
runs.
Therefore, a shift to money market funds which operate with variable share values is an
important step in making the sector more stable - in these funds, losses are shared evenly
by shareholders. Regulatory proposals in this regard have now been published in both the
United States and Europe. However, these are focused on alternative measures such as
capital cushions, liquidity charges and delayed withdrawal for funds with a variable valuation.
These initiatives are to be welcomed, but an obligatory shift to variable share valuation would
be better.
An example of direct regulation of activities is that applying to securities financing
transactions. In these transactions, a German bank, for instance, provides a UK-based
hedge fund with short-term financing against collateral in the form of securities. In a liquid
market, this type of transaction can contribute to a procyclical build-up of leverage. Since the
securities furnished as collateral are generally used several times over, this creates long
chains of transactions involving many different participants - participants in both the shadow
banking system and the regular banking system. This adds to the degree of
interconnectedness within the financial system, increasing the risk of contagion effects. To
counter this risk, the European Commission put forward a proposal for a regulation at the
end of January. Under the proposed rules, securities would only be reusable if the provider of
collateral agreed to it. These moves to put a brake on systemic risk in the securities financing
markets are without doubt a step in the right direction.
4 Conclusion
Ladies and gentlemen
The financial system needs appropriate regulation so that it can function as a reliable
provider of services to the real economy. The crisis laid bare a number of gaps in the
regulatory framework applying to the financial system, gaps which we now need to close.
We have already come a long way in this, but we have not yet reached the goal. We cannot
allow ourselves to come to a standstill, either with regard to the too-big-to-fail problem, or
with respect to the shadow banking system and other issues still requiring more work.
Standing still would in fact mean falling behind, because the financial system is constantly
changing. Thus, regulation is aiming at a target which is forever receding. And that is a good
reason to make progress somewhat more swiftly - regardless of whether we are talking
about regulation from the point of view of banking supervision or in terms of financial stability.
Thank you very much.