19 November 2013

Bundesbank/Dombret: What is "good" regulation?

Dombret listed the three components of good governance he considers essential for the creation of a sound framework for a financial system: application of market economy principles, good institutions and macro-prudential perspective.

First, "good regulation" of financial markets pursues a clear objective, in my opinion: to create a sound framework for the financial system and thus ensure its stability. A stable financial system ought to be able at all times to fulfil its core task of allocating capital efficiently. To keep the financial system stable, it is therefore important to apply a fundamental principle of market economies – incentive and punishment mechanisms – to regulation: risk-taking and liability have to be consistent with one another. This means that those who take risks in order to make profits also have to shoulder the risks involved – irrespective of their institutional form or size.

This principle, however, was nullified during the crisis. Several banks facing the threat of bankruptcy had to be bailed out by governments with taxpayer funds. These banks were regarded as too complex, too interconnected or simply "too big" to fail. That goes against the principles of a market economy. Private funds should be used for the recovery of a distressed bank. If shareholders are not willing to take that step, the institution should be resolved – without destabilising the entire financial system in the process. The option of a credible resolution is the only way to eliminate implied government guarantees for systemically important banks.

We are on the right track with regard to dealing with the systemic importance of banks, but the finish line is still a long way off. The new international agreements on resolution regimes developed by the Financial Stability Board (FSB) are a crucial step. Applying them globally will make the orderly resolution of a big bank a more realistic option and thus also a more credible threat. Intensive work is being carried out at the European level on the implementation of these principles. Negotiations on the European Recovery and Resolution Directive are scheduled for completion by the end of this year. However, it is not only banks that can be systemically important. In July 2013, the Financial Stability Board published a list of global systemically important insurers, or G-SIIs. Much like systemically important banks, these nine institutions will be made subject to recovery and resolution planning requirements and capital surcharges. These measures, too, are designed to strengthen market economy principles.

But good regulation requires more than just well-thought-out legislation; good institutions are crucial. And this brings me to the European banking union. The single supervisory mechanism (SSM) has finally been adopted, and the European Central Bank (ECB) has begun to set up the necessary structures.

We need a centralised European resolution authority for banks which is based on sound legal foundations. The debate on this single resolution mechanism (SRM) is in full swing, and several proposals are on the table. I believe the best solution is one that promises to be effective and enforceable in a crisis event while at the same time avoiding potential conflicts of interest on the part of the resolution authority from the outset. It is clear to me, too, that the SRM for banks should be launched as soon as possible after the SSM. I am for the beginning of 2015 as the kick-off date.

The third and final aspect of "good regulation" is the macroprudential perspective. The financial crisis swept away any lingering doubts that we need to broaden our regulatory perspective beyond individual banks. This means that we need macroprudential oversight alongside microprudential supervision.

Having mentioned these important three aspects of "good regulation", I would like to touch briefly on a core problem: complexity. In my opinion, complexity is one of the central challenges in both the design and the implementation of new – and, hopefully, good – regulation. There are many levers which supervisors and/or lawmakers can pull. In some cases, pulling only one single lever the wrong way is enough to threaten the stability of the system. This can lead to unintended consequences such as regulatory gaps, duplication or arbitrage.

Full speech

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