10 March 2014

Bundesbank/Dombret: The euro, the banks and the crisis – Reshaping the world of finance

Dombret argued that the banking sector needs to be aligned with the principles of market economy to ensure financial stability in the future. He also called for adequate monitoring and regulation in the insurance and shadow banking sectors.

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Aligning the banking sector with the principles of a market economy will take us a big step towards financial stability. One issue we definitely have to address is the connection between banks and the public sector.... We need resolution mechanisms that allow us to resolve and restructure banks without placing the financial burden on public finances... But we also have to revert to regulation. We have to adapt regulatory requirements in order to protect banks from government finances running into difficulties...

If we are looking to offer banks greater protection against distressed public finances, it is government bonds we must target. From the perspective of regulation, there are two factors which play a role here.

The first factor concerns banks’ capital. Under the current regime, banks do not need to hold capital against the risks of loans to sovereigns – unlike other loans. This regime is based on the assumption that loans to governments are risk-free because states cannot default. And, if no losses can develop, it is not necessary to establish capital buffers. All those who had trouble following this line of argument saw their doubts confirmed by the sovereign debt crisis in Europe. Whether we like it or not, we obviously need to rethink the assumption that loans to governments are risk-free.

Consequently, it appears urgently necessary to change the rules. If banks were required to hold capital against the risks of their government bond portfolios, this would make them more resilient to fiscal distress. At the same time, banks would have an incentive not to buy such large volumes of government bonds.

And this brings us to the second issue: capital alone is insufficient. A crucial tool of risk management is diversification. The rule of thumb is "never put all your eggs in one basket". A cap on loans to an individual sovereign should therefore also be introduced.

And there are several other sectors we have to look out for: insurance business and the shadow banking system that provides an alternative source of funding and is therefore associated with diversification and specialisation benefits. Their funds are, in principle, very much welcomed in the context of the Comprehensive Assessment. Nevertheless, institutions in the shadow banking system perform bank-like activities and incur bank-like risks without being subject to bank regulation. And these risks can certainly be systemic because of unregulated liquidity and maturity transformation, because of the build-up of leverage, and because of pro-cyclicality.

We therefore will have to make sure that such entities and activities are adequately monitored and regulated. This objective is high on the agenda of the G20, and we have already made good progress. Nevertheless, quite some work still lies ahead.

The world of finance is a global issue, and reshaping it requires global cooperation. Against this backdrop, recent regulatory initiatives in the US such as the enhanced standards for bank holding companies and foreign banking organisations worry me. They seem to contradict the need for international cooperation. Balkanisation of regulation is a real risk and any regulatory decision should be taken with that consideration in mind – in Europe as well as in the United States.

But not only do we need cooperation between authorities of different countries. In my speech, I have mainly discussed how to reform regulation. But there is one thing we should be aware of: we cannot solve all of our problems through regulation. In order to reshape the world of finance, change has also to come from within.

Financial stability begins in the hearts and minds of those who work in finance: investment bankers, stock market brokers, hedge fund managers and everyone who invests other people’s money. What we need is a change of culture. The times of “greed is good” should be left far behind us. I am not at all against ambition, but short-termism and greed need to be stopped. We should see the financial system for what it is: a service provider for the real economy.

And again we have to look beyond the banks. Especially in Europe, companies tend to rely on bank loans as a source of funding. Here, it would be beneficial to diversify by turning more to the capital markets as an alternative source of funds. A more diversified funding mix would improve companies’ access to funding in normal times as well as in crisis times.

Full speech

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