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The crisis has shown that market participants were not capable of mastering the inherent complexity of the system that they themselves had contributed to develop over the course of the last two decades. Favoured by the breakthroughs in information technology and telecommunications, the securitisation of banks’ assets expanded considerably, together with the supply of so-called structured financial instruments (ABSs, CDOs, etc.) The traditional model of credit intermediation gave way, especially but not only in the United States, to a system in which loans granted were rapidly transformed into other financial products having these loans as collateral and sold on the market: the so-called originate-to-distribute model (OTD). To the inherent difficulty of evaluating the quality of loans, these developments added the problem of fully understanding the effective role of structured financial products.
Financial innovation can allow more efficient allocation of credit risk, but it also entails a number of dangers, some of them intrinsic to its mechanism, others more generally related to the greater interdependence of the financial system. The ongoing process of financial consolidation and the OTD model have produced intermediaries that are closely intertwined with the capital markets. This has had some important consequences for financial stability: a more connected world improves risk diversification and can make markets more resilient, but when contagion is actually set off, an interlinked financial system heightens the risk that it may spread more widely.
Capital and liquidity regulation must be accompanied by improvements in internal risk control arrangements and by actions aimed at correcting incentives to excessive risk-taking. Board members and senior managers should possess a thorough understanding of the bank’s overall operational structure and risks. It is also fundamental that supervisors regularly assess banks’ corporate governance policies and practices. Compensation policies also need to be revised, in order to better align remuneration with risk-adjusted long-term performance and avoid excessive risk-taking and short-termism. In particular, when designing compensation policies, banks should take into account a number of issues: the variable portion of the compensation of risk takers must be paid on the basis of individual, business-unit and firm-wide measures that adequately assess risk-adjusted performance; bonuses must reward the achievement of stable earnings, not simply the fruit of extraordinary operations; executives’ severance packages too must be clearly and effectively bound to the results attained, and reflect a more general evaluation of the manager’s performance; compensation must be deferred long enough to validate the true quality of management.
It will be crucial to ensure that stricter regulation and supervision of banks will not push bank-like activities and risks towards non – or less – regulated institutions (the so-called “shadow banking” sector). Let us not forget that the financial crisis originated in the US securitisation market, largely populated by unregulated or scantily regulated operators. While we have to address bank-like risks to financial stability emerging from outside the regular banking system, the approach should be proportionate, focused on those activities that are material to the system, using as a starting point those that were a source of risk during the crisis. The FSB is currently refining the set of recommendations issued in November of last year. One should bear in mind, however, that the new recommendations will be able to address the specific risks that arose during the crisis, and we all recognise the ability of the shadow banking sector to innovate.
Although new regulations on systemically important financial institutions have recently been approved, the “too-big-to-fail” issue is still a major concern, and it merits strict monitoring. Some progress is being made in developing and testing methodology for the identification of global systemically important insurers (G-SIIs), and in developing appropriate supervision guidelines. An identification methodology for all non-bank financial institutions of global systemic relevance is also under preparation. For banking institutions (G-SIFI) the implementation of the framework recently agreed upon has much farther to go; we need to rapidly move forward.