06 April 2013

Bundesbank/Lautenschläger: Banking regulation - review from the perspective of supervision

Many believe that too little has been done, referring to regulatory smokescreens, while others believe that the flurry of regulation has already gone too far. In Lautenschläger's opinion, both extremes of the debate are wrong. It is time to take stock.

2008 was the key turning point in the recent history of banking and financial market regulation. This was the year in which the G20 heads of state and government agreed in Washington on the principles for financial market reform and, in particular, stricter regulation. This process was triggered by the outbreak of the subprime crisis in the United States and its devastating effects on the global financial sector and countries that consequently had to bail out their floundering financial institutions. The heads of state and government agreed on specific measures to strengthen the resilience of banks.

With the adoption of the Basel II.5 regulations in 2009, the Basel Committee on Banking Supervision aimed to quickly address, among other things, the weaknesses in the regulation of investment banking that had come to light during the crisis. It increased capital requirements for market risk in banks’ trading books and for securitisations. It also intensified the risk management requirements for banks. These rules came into force in Germany at the beginning of 2012.

After providing rapid emergency assistance, politicians and supervisors set about fundamentally strengthening the resilience of banks and the banking system. The result is the Basel Committee on Banking Supervision’s Basel III package, which aims to reduce the risk of once again having to use taxpayer funds to bail out banks in times of crisis. To achieve this, the quality of capital is to be substantially improved and the quantity significantly increased.In the event of losses, the new capital category “core tier I capital” is fully liable without limit. Minimum common equity, i.e. core tier I capital as a percentage of capital, will rise from 2 percentage points at present to 4.5 percentage points in future. The Basel Committee also introduced a capital conservation buffer of 2.5 percentage points for core tier I capital. Institutions will therefore have to retain minimum core tier I capital of 7 per cent in future. But that is not all. Global systemically important financial institutions have to meet an additional requirement. Depending on their systemic importance, they have to retain an extra capital buffer of core tier I capital, as the collapse of these banks could have serious consequences for the entire banking system. All in all, this places significant demands on a number of German banks. They will use the transitional period before the new rules come into full effect in 2019 to increase their capital to the required level.

However, Basel III not only calls for improvement to the quality, and a significant increase in the quantity, of capital. In addition to the risk-sensitive capital ratios, the Basel Committee has introduced a maximum non-risk-based leverage ratio of 3 per cent. This aims to prevent an excessive build-up of leverage at banks, especially in good economic times. This limit will hit many German banks harder than the increase in risk-based capital ratios.

Finally, as a lesson learned from the crisis, the Basel Committee has revised its principles for liquidity risk management and for the first time presented harmonised minimum standards for liquidity risks. In stressful times, banks have to retain sufficient liquidity for one month and refrain from performing excessive maturity transformations. At the beginning of 2013, the Basel Committee finalised large sections of the framework for the short-term stress test ratio, the liquidity coverage ratio (LCR). It is now focusing on finalising the rules for the structural ratio, known as the net stable funding ratio (NSFR).

However, the new Basel standards can only reach their full potential if they are applied in all key financial markets. Only then can we ensure that the European banking market is not affected by second and third round effects from banks in countries where, for example, it is not necessary to hold adequate capital for certain operations, such as complex securitisation transactions.

Basel III comprises mainly micro-prudential regulations, i.e. regulations that address risk at the level of individual institutions or groups of institutions. However, the financial market crisis has shown that the insights gleaned from macro-economic analysis need to be combined with micro-prudential supervision to better recognise the development of risks to financial stability and individual banks. Progress has also been made in this regard. The Financial Stability Committee was founded in Germany at the beginning of the year. It aims to promptly identify risks to financial stability and, using the two instruments available to it (warnings and recommendations), take action against them. The Bundesbank will play an important role in this micro-prudential analysis and oversight. It presents analyses to the Committee and, where appropriate, suggests the use of instruments. The Committee, chaired by the Federal Ministry of Finance, then takes this information into account in its decision.

The Bundesbank also serves as an interface to the European Systemic Risk Board (ESRB). This allows it to bring together the information chains from various tasks and harness synergy effects – for example, information flows and risk assessments from the areas of international analyses, off-site surveillance of financial institutions, the new macro-prudential mandate, monetary policy and markets. Ultimately, banking supervision in the euro area is undergoing a fundamental upheaval that presents significant opportunities as well as risks. For example, a Single Supervisory Mechanism (SSM) is currently being created under the umbrella of the European Central Bank (ECB). This is an ambitious project, but if done properly, the new banking supervisory mechanism will be more effective and efficient than national supervisory authorities. It can access a broader range of information and will therefore be able to identify risk trends earlier and more effectively. Its supervision policies will also enable it to create a level playing field, where appropriate.

Full interview

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