05 March 2013

Bank of Italy/Visco: The financial sector after the crisis

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 securitisation 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 so-called originate-to-distribute model (OTD). To the inherent difficulty of evaluating the quality  of loans, these developments added the problem of fully understanding the effective role of  structured financial products.

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 ongoing  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.

Capital and liquidity regulation must be  accompanied by improvements in internal risk control arrangements and by actions aimed at  correcting incentives to excessive risk-taking. Board members and senior managers should  possess a thorough understanding of the bank’s overall operational structure and risks. It is  also fundamental that supervisors regularly assess banks’ corporate governance policies and practices. Compensation policies also 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.

It will be crucial to ensure that stricter regulation and supervision of banks will not push bank-like 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 securitisation  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, focused 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 is currently refining the set of recommendations issued in November of last year. 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. Some progress is being made in developing and testing methodology for the identification of  global systemically important insurers (G-SIIs), and in developing appropriate supervision  guidelines. An identification methodology for all non-bank financial institutions of global  systemic relevance is also under preparation. For banking institutions (G-SIFI) the  implementation of the framework recently agreed upon has much farther to go; we need to rapidly move forward.

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