Vítor Constâncio: Regulation and supervision of financial services in
Europe - reforms and results
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the
13th Euro Finance Week, Frankfurt am Main, 16 November 2010.
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I am pleased to take part in this conference, today, dedicated to risk management and to
open this first session on regulatory and supervisory reform in Europe.
The concept of systemic risk underlies the changes in the regulatory framework and
supervisory architecture in the EU and, to a large extent, around the globe. The financial
crisis has shown how the materialisation of systemic risks can have devastating effects for
the financial sector and the broader economy. This has underscored the need to strengthen
macro-prudential oversight of financial systems and to strengthen micro-prudential
supervision of individual institutions. The need for enhancements in risk management
systems of financial market participants at large has also been highlighted. Therefore, the
need for a better understanding of the concept and measurement of systemic risk, on both
the private and regulatory sector sides, and how to limit it or mitigate its damaging effects, is
at the core of the new regulatory and supervisory framework we will discuss today.
In my remarks, I will touch upon these issues, with a focus on macro-prudential oversight and
policy and on the soon-to-be-established European Systemic Risk Board, which will be
responsible for this function at the EU level. I will start by reflecting on the new
macroprudential oversight framework for the EU. I will move on to the ECB's role in
macroprudential analysis at the EU-wide level, with a view to providing analytical support in the
ESRB's decision-making process. I will then discuss the information basis for risk
identification and risk assessment, and focus on the interaction with the European
Supervisory Authorities, or ESAs, and with the financial industry in this process. Finally, I will
recall the regulatory and micro-prudential dimension, as well as the contribution of the
financial industry in the move towards a more stable financial system.
1. The new EU framework for macro-prudential oversight
The financial crisis has revealed a substantial policy gap between financial stability oversight
and targeted policy responses to mitigate risks considered to be potentially systemic. This
deficit calls for the strengthening of the macro-prudential approach to regulation and
supervision at the national and international level.
The role of central banks in this process has emerged as critical, mostly on account of their
responsibility in safeguarding financial stability, their analytical capability in the analysis of
risk from a system-wide perspective and their proximity to financial markets and market
participants. Testimony to this is the institutional response around the globe. In the United
Kingdom, the Bank of England has seen its responsibilities in both the macro and
microprudential fields enhanced. In the United States, the Federal Reserve System became the
principal macro-prudential supervisor with competencies in prudential policy design and
implementation, emerging with a more prominent role. The European Systemic Risk Board,
chaired by the President of the European Central Bank, will become operational in
January 2011 and will be responsible for macro-prudential oversight in the EU. The ECB will
provide analytical support to inform ESRB deliberations and also its Secretariat.
More broadly, in a number of EU countries and elsewhere around the world, even if changes
to the institutional set-up have not been launched, a redefinition of macro-prudential
strategies is underway. A common element of these strategies is the closer cooperation
between micro and macro-prudential supervision - irrespective of whether this is conducted
by the same or different authorities - with a view to better assess interdependencies across
individual institutions and between the financial sectors and the real economy.
This feature is also critical for the EU-wide macro-prudential framework, where close
interaction between the ESRB and the three new ESAs for the securities markets, banking
and insurance sectors is of the utmost importance. This interaction has to be continuous,
starting with the formation of a comprehensive and detailed information base for the
screening of risks and comprising the discussion of risk assessments from macro and
microprudential perspectives and the design of policy responses, should the identified risks be
considered of a systemic nature.
2. The ECB's analytical support to the ESRB
Let me now turn to the ongoing preparatory work at the ECB on the analytical front to inform
discussions within the ESRB and to support its deliberations.
The focus of the analysis is clearly on the systemic dimension of risk factors and their
interconnectedness. Treating aggregated risk as endogenous clearly differs from the risk
analysis approach carried out from a micro-prudential perspective or by financial institutions
individually, where aggregate risk, stemming from other financial institutions' actions and the
overall environment, is perceived as exogenous.
To support the risk identification process at an EU-wide level, the risk surveillance that we
plan to undertake - in the same fashion as done, for instance, at the ECB in the context of
the preparation of our Financial Stability Review - needs to have a wide reach, monitoring
markets, financial institutions and the economy at large, so as to ensure that no risk is
overlooked. Several analytical tools and models are being developed for this type of analysis,
including early warning models and financial stability indicators that use the information
content of available financial and macroeconomic data to identify, early on, where
imbalances may be building up. Important variables to monitor in this context are, for
example, measures of bank leverage, balance-sheet growth, maturity mismatches, property
price changes, private sector leverage and current account deficits. Contemporaneous
financial stability indicators, capturing the state of system stability and forward-looking
indicators revealing the market perception of the probability of an adverse systemic event in
the period ahead (e.g. calculated on the basis of credit-default swap spreads) are also
important risk surveillance tools.
The risk identification process would support the design of risk scenarios and the discussion
of possible triggers that could lead to their crystallisation, supported by current and projected
macroeconomic and financial variables.
Once a set of risks has been identified as potentially systemic, the second leg in the analysis
is the assessment of the severity of those risks, as well as an evaluation of the ability of the
financial system to absorb their impact. This step will form the basis for risk prioritisation and
inform the ESRB in its decision on a possible need to issue a risk warning. It is therefore
most closely associated with the policy action, and for this reason, a well-developed
analytical framework is needed that allows us to quantify both the likelihood and the severity
of a specific risk in order to support the ESRB's decisions. Clearly, there is widespread
awareness that the analytical framework, no matter its level of sophistication, cannot replace
the expert knowledge and judgment of the ESRB's members. However, a consistent
analytical framework and rigour in the analysis would provide valuable input to the Board's
discussions and back deliberations on risk warnings and policy recommendations.
Analytical tools to assess the severity of identified risks and overall resilience of the financial
system clearly include macro stress-testing models.
An EU-wide stress-testing exercise, prepared and conducted by the CEBS and national
supervisory authorities, in close cooperation with the ECB, was completed in July this year.
The exercise included adverse scenarios that reflected severe assumptions, especially in
relation to sovereign risk and growth paths. Such adverse scenarios, although not very likely
to materialise in practice, are useful components of the assessment of the resilience of the
financial system.
Besides this type of bottom-up stress-tests - which are based on the work conducted by
individual financial institutions according to the guidance by authorities on stress scenarios -
we need to also conduct top-down macro stress-tests conducted by the authorities on the
basis of all the available information. Such top-down macro stress-tests should be conducted
with the view to complement and cross-check the results of bottom-up tests and assess, in
particular, how the identified risks should be prioritised - a task which has been formally
entrusted to the ESRB.
Challenges are substantial, but progress is being made with a view to constructing robust
models to cover and replicate interlinkages within the financial sector and ascertaining how
they may be activated and play out under conditions of stress. This reflects not only the
structural features of financial institutions - namely, which institutions are heavily exposed to
each other and under which conditions such exposures can impair their viability, with ripple
effects through the system - but also the interrelationships among the risk factors at the
starting point of the analysis. In a real world situation, more than one risk factor tends to crop
up at any one time, for example, at present, weak macroeconomic conditions and financial
sector fragilities. But modelling a combination of several risk factors poses some challenges,
both in terms of data and modelling complexities. For instance, we need to use models that
allow us to identify the impact of each risk factor in isolation (e.g. to support a risk
prioritisation view), while also being able to account for the overall effects of risks in
combination.
Databases with the necessary information on individual financial institutions also need to be
developed to allow the implementation of the top-down macro stress-tests.
Furthermore, macro stress-testing models, being the workhorse of systemic risk assessment,
tend to provide an evaluation of the severity of the risks that is confined to the banking or
financial sectors. This applies even to models that allow for a certain degree of interaction
between financial institutions, and between these and the real economy. Risk assessments
should also incorporate, to the extent possible, a view on the potential magnitude of risks
which could spread via plausible propagation channels. Contagion and spillover models can
be of use in this context, for example, in the analysis to evaluate the impact of specific
failures within the financial system or in the assessment of the transmission of instability
across sectors in the economy.
These are very ambitious goals requiring substantial analytical investment in the areas of
macro-prudential analysis and research. In preparing its support to the ESRB, the ECB is
making efforts to respond to various elements in this vast list of analytical requests,
alongside other members of the ESRB and a number of national and international bodies
with competences in the macro-prudential.
3. Information base
Now, while challenges remain on the analytical side, it goes without saying that the reliability
and quality of the output of these models crucially depends on the quality of the data input.
This applies to all models, including those regularly run at your institutions which provide
inputs to daily or longer-term strategic decisions. In the same vein, of paramount importance
for the identification of risks is a comprehensive, high-quality information base.
At the global level, the G20 and the Financial Stability Board are engaged in considerable
efforts, to which the ECB is contributing, in order to reduce the data gaps identified in the
aftermath of the crisis. In this vein, an important element of the ECB's preparatory work to
support the ESRB consists of expanding and enhancing macroeconomic and financial
statistical databases for macro-prudential purposes at the level of the EU. In this respect,
close collaboration with the national authorities and the future ESAs is ongoing so as to
ensure the ability to perform risk-focused analyses with adequate detail and scope in terms
of, for example, country granularity, financial sector coverage and data frequency.
The private sector is also contributing, and could contribute more, to enhance the quality of
the information base on which macro-prudential analysis will be based by continuing to
enhance the transparency and granularity of individual reporting. This applies, in particular,
to the large, complex and interconnected institutions on which a substantial part of the
macro-prudential analysis is likely to be centred, as these institutions tend to contribute
significantly to the level of risk of the overall system. The combination of better firm-level and
macro-financial statistical information would also likely contribute to inform risk management
decisions, as well as to enhance firms' own stress testing frameworks.
But not all information needed is of a quantitative nature. A well-functioning macro-prudential
framework needs the support of market participants, also in qualitative terms, as rigorous
monitoring of systemic risks will require continuous market intelligence. Contact with market
participants will be essential for detecting important trends, such as growing financial
imbalances, convergence of business models, similarities in investment strategies and
innovations in financial instruments. Information gathered via market intelligence could, for
example, be valuable in capturing market developments and perceptions not yet apparent in
the most recent data and complement more quantitative-based surveillance work. It will also
allow combining accounting-based information on the banking and financial sectors at large
with firms' risk management views and their perception of the main risks further down the
road. As such, in setting up an effective EU-wide risk surveillance process, importance is
being given to the establishment of a structured dialogue with the financial industry focused
on financial vulnerabilities at the system-wide level. It could take place on a regular basis
both among high-level representatives and at the working level.
4. Towards a more stable financial system
This brings me to the last part of my remarks today.
The move towards a more stable financial system has been set in motion on a number of
different fronts. I mentioned the enhancement of macro-prudential analysis and policy with a
view to identify, in a timely manner, risks of a systemic nature and to respond with warnings
or targeted policy measures to address them. This was at the centre of my talk, since this is
where the ESRB will play an important role in safeguarding financial system stability at the
EU-wide level.
Another dimension that will be at the core of this conference today are the prudential
measures to increase the resilience of the banking sector over the coming years so as to
increase firms' ability to withstand shocks and to reduce the overall vulnerability of the
system. These include measures of both a micro-prudential and a macro-prudential nature,
forming a comprehensive package of capital reforms and the new global liquidity standard.
Banks loss-absorbing capacity will be reinforced by regulatory capital consisting of common
equity and including two capital buffers: the capital conservation buffer and the
countercyclical buffer, addressing macro-prudential risk in a time-varying fashion. Market
risk, counterparty credit risk and securitisation risk rules have also been revised to ensure
that risks are adequately captured. To limit model risk and the build-up of excessive leverage
on and off the balance sheet, a non-risk based measure - the leverage ratio - has been
introduced. On the liquidity framework, two key ratios have been put in place to enhance
liquidity buffers in short and longer-term horizons, with the aim of reducing funding
vulnerabilities and increase overall resilience to liquidity drains.
Here, we should bear in mind that, to a large extent, underlying the new regulatory
framework is a better understanding of the concept and measurement of systemic risk,
reflected in relatively simple and operational measures to address it. The aim is to have
better regulation as a result of the combination of micro-prudential and macro-prudential
perspectives, rather than more regulation per se.
Without pretending to be exhaustive, let me just refer to private sector initiatives which will
also contribute to the overall soundness of the financial system. These comprise initiatives in
the area of financial market infrastructure, such as the establishment of central
counterparties for over-the-counter (OTC) derivatives clearance. Sound market
infrastructures with appropriate risk management frameworks should mitigate counterparty
risk and contribute to restoring trust in the financial system in the years ahead.
The role of the financial sector in constructing a more stable financial system is also critical
with respect to disclosure. More disclosure in firms' financial reporting and better quality of
publicly available firm-level data should enable a better assessment of counterparty risk and
for contagion via direct and indirect channels. For macro-prudential analysis, enhanced
disclosure will allow a better understanding and measurement of where systemic risk might
be via the construction of more accurate indicators of aggregate leverage, correlation and
concentration of exposures to specific asset classes and of a firm's level of interconnectedness,
for example. Furthermore, for financial market players, better quality of information on a
counterparty's financial condition should also contribute to enhancing in-house stress testing
and strengthen firms' risk management systems. This could enable financial institutions to
improve their forward-looking capacity in decision-making, resulting in them taking corrective
measures with sufficient lead time and being more resilient to market tensions should they
arise.
Concluding remarks
The financial sector has an important stake in a stable financial system and therefore in a
well-functioning macro-prudential oversight and policy framework. In my remarks today, I
have referred to the main areas in which the ECB and the central banking community are
investing in order to operationalise the new macro-prudential oversight function entrusted to
the ESRB.
In this process, the industry needs to be closely involved in risk detection and overall
surveillance work, as information and insights from market participants will be essential
inputs. We also expect the industry to pay close attention to the macro-prudential views that
are communicated by the ESRB, among others, stemming from regular systemic risk
assessments. Although each institution may not, per se, be able to create disruptive market
conditions - at least in normal times - as the financial crisis has shown, the collective
positions of the financial industry can have severe implications for financial stability, possibly
with repercussions in the broad economy. In this regard, we will send messages to the
industry that we trust will be heeded.
Efforts are also underway to ensure close cooperation between central banks, supervisory
authorities and the ESAs so that risk assessments combine micro and macro-prudential
perspectives and are of high quality and rigour. This should act as an important crisis
prevention tool, also enabling the ESRB and the ESAs to respond in a timely fashion with
policy measures aimed at addressing specific risks should this be deemed necessary. We
are determined to make the new framework work in an efficient way to ensure financial
stability in the European Union.