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10 July 2010

Trichet: Europe’s economic challenges are recovery, reform and renewal


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Trichet highlighted that more transparency and less pro-cyclicality of the financial system will reduce market volatility. Regulation should be more effective and thorough, and misjudgement of underlying risk should be limited by more stress on long-term profitability.


Speaking about the reforms of the financial sector, Trichet said that:
1.    More transparency is needed to ensure that financial market participants return to their prime mission of assessing the quality of investment. Securitisation lessened lenders’ incentives for prudent screening and steady monitoring. Risk could be bundled, sliced and re-bundled for further sale. Risk management became difficult because information was unavailable to investors, buried in financial structures that were not transparent. Reform must ensure that sellers of securitised products disclose all information about the underlying loan structures so that both investors and rating agencies can correctly price the risks embedded in these products.
2.    Better – that is, more effective – regulation will ensure that no financial product and no financial market participant can escape the eyes of supervising authorities. Many financial players with high leverage have gone unchecked by our regulatory system. Better regulation will expose the risks inherent in the financial system and make the system more stable. Needless to say, highly leveraged institutions should be part and parcel of this process.
3.    Less pro-cyclicality of the financial system will reduce market volatility. Regulation should attempt to limit the risks that banks assume by imposing higher, countercyclical capital requirements, thus limiting leverage. Financial institutions will be asked to raise the quality and quantity of their capital base to ensure they have adequate buffers against future market disruptions.
4.    Less short termism: the promise of significant returns in the short term was often linked to a misjudgement of underlying risk. At the level of individual institutions, compensation schemes must be adjusted to avoid encouraging excessive risk-taking on the basis of relatively small amounts of capital. Instead, the incentive structure should encourage profitability over the medium to longer term. At the same time, on Wednesday, the European Parliament approved significant curbs on bank bonuses as part of wider efforts to reform the financial sector. EU finance ministers are set to endorse the law next Tuesday with the curbs taking effect from the start of next year. At the level of the financial system as a whole, we need to improve decisively the prevention of build-up of risks, including systemic risk. Macro-prudential oversight will help to prevent the building up of imbalances.
 
 


© ECB - European Central Bank


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