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Regulators and supervisors have to face the challenge of finding the narrow path between giving prompt and adequate responses to current developments in the short run, and mitigating the mechanisms that may fuel the downward spiral of financial and economic contraction in the longer term, ECB President Trichet said.
Key for providing proper guidance for policy makers is a thorough understanding of the underlying developments as well as the identification of the nature and scope of shortcomings in the financial system, Trichet said. The root of the problems for many financial institutions was their inability to adequately assess the risks associated with the exposures they held, he laid out. Further problems related to the originate-and-distribute model, the lack of transparency throughout the securitisation process, and liquidity strains which made it impossible to properly value a range of financial assets and off-balance sheet exposures.
The complete elimination of cyclical variations in banks’ lending activity is unrealistic, Trichet said. Regulators should instead focus on reducing the occurrence and severity of systemic crises.
A major challenge for authorities is the proper definition of a regulatory framework that would allow banks’ capital buffers to shrink in downturns, without creating moral hazard and regulatory arbitrage, the ECB President concluded