19 April 2013

Bundesbank/Dombret: How regulation and crisis management will change the world's financial landscape

Single supervisory mechanism is not sufficient. To shield banks from weak public finances, it must be accompanied by a sound regulatory underpinning. Such regulation should include upper limits for lending to governments and appropriate capital backing for sovereign bonds. Finally, a banking union should comprise a European resolution and recovery mechanism to ensure that bank creditors – and not taxpayers – are the first in line to bear losses from a bank’s failure.

Stricter banking regulation might set incentives to move business to less regulated entities. The regulation of the shadow banking system is therefore another pressing issue. Regular monitoring exercises help us to gain a better understanding of the kind and scale of business conducted outside the regulated banking system. But its actors and activities still remain largely unregulated. I consider it particularly important to deliver a final set of integrated recommendations on regulating the shadow banking system to the G20 in September. And it is absolutely crucial to finally solve the too-big-to-fail problem. However, we have to keep in mind that this term is not very precise. In many cases, institutions were not too big but actually too important to fail. Recent examples of nationalisations and repeated bail-outs of institutions in the Netherlands and France show that, ultimately, it is still the taxpayer who is at risk when banks are in trouble. We need to remove the implicit government subsidy for systemically important institutions and subject them to the ultimate sanction of the market. It must be possible to force banks to exit the market without destabilising the financial system. To make this threat credible, we have to restore a constitutive element of any functioning market economy: the principle of liability. The one who profits must also be the one to bear the losses. I consider the implementation of the internationally agreed framework for dealing with systemically important financial institutions as a top priority.

To avoid regulatory arbitrage, we must take into account the cross-border effects of regulation. The global financial system needs global rules. Accordingly, we need to ensure that internationally agreed measures are transposed into national laws and regulations in a timely and consistent manner. I strongly support the in-depth implementation monitoring by the Financial Stability Board and by international standard-setting bodies as essential tools for maintaining implementation pressure.

The crisis has reminded us that containing systemic risk is vital for safeguarding financial stability. To mitigate and prevent systemic risks, macro-prudential policy frameworks are being implemented in many countries, including Germany. Since the beginning of this year, the German Financial Stability Act has been in force. A Financial Stability Commission comprising representatives of the Bundesbank, the Federal Financial Supervisory Authority and the German Finance Ministry has been established. The Commission is in charge of designing consistent macro prudential policies and held its first meeting just yesterday. The institutional set-up is fairly advanced. Now, we need to deepen our understanding of the effects of macro prudential tools and operationalise their use.

Although financial sector reforms are not yet complete, it is already possible to see the impact of new regulation on the financial landscape. Some banks have fallen off the list of global systemically important banks because they have simplified their structure, downsized or de-risked their operations. This also includes a German bank. Several banks are de-emphasising high-profile but risky capital market business that benefited employees more than shareholders and society as a whole. The modified business models should ultimately result in a more resilient and diversified sector with a more sustainable risk-return profile.

Further changes to banks’ business models will be brought about by structural measures. Concerns about institutions’ business conduct built the political case for such measures, including the ring-fencing or prohibition of certain activities. Corresponding recommendations have been made by Paul Volcker, John Vickers and Erkki Liikanen in the US, the UK and the EU respectively. While the proposals differ in important details, they share the same general idea. Deposit-taking credit institutions should be shielded from the risks of speculative proprietary trading and high-risk lending. Such a separation of business lines can play a part in making the financial system more stable and resilient. But it is not a silver bullet. Ultimately, we should leave it to bank boards and management to decide what business model is best for the future. I appreciate that the German legislative proposal on introducing a ring-fence leaves some leeway in that regard.

Finally, there is evidence that the corporate culture of banks is changing. Risk management, for example, has gained a more prominent role in the organisational structure of some banks. Efforts to strengthen risk governance have been undertaken as well, but further improvements are necessary. The manipulation of benchmark interest rates by traders is a case in point. Withholding or clawing back variable parts of remuneration packages of employees who were involved in such fraudulent activities can only be a first step. In the future, I expect to see further changes in institutions towards the promotion of sounder risk cultures.

Full speech

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