A.
Damaging effects of banking crises
There is a wide body of evidence that the most severe economic crises
are associated with banking sector distress.
While there is variation in findings across studies, the Basel
Committee’s long-term economic impact study found that the central
estimate in the economics literature is that banking crises result in
losses in economic output equal to about 60% of pre-crisis GDP.
Why are banking crises so damaging?
Banks are highly leveraged institutions and are at the centre of the
credit intermediation process.
In addition, credit and maturity transformation functions are
vulnerable to liquidity runs and loss of confidence.
A
destabilised banking system affects the provision of credit and
liquidity to the broader economy and ultimately leads to lost economic
output.
In the most
recent phase of the crisis there has also been
significant spillover of risk between the
banking sector and sovereigns.
Governments
in a number of industrialised countries had to increase their debt in
order to stabilise their banking systems and economies.
As a result, debt-to-GDP ratios in a
number of economies increased by as much as 10-25 percentage points.
It therefore is clear that the economic benefits of raising the
resilience of the banking sector to shocks are immense.
B.
Frequency of banking crises
The costs of banking crises are extremely high but, unfortunately, the
frequency has been as well.
Since 1985, there have been over 30 banking crises in Basel
Committee-member countries.
Roughly, this corresponds to a 5% probability of a Basel Committee
member country facing a crisis in any given year – a one in 20 chance,
which is unacceptably high.
Many countries may not have been the cause of the current crisis, but
they have been affected by the global fall out.
Moreover, history has shown that banking crises have occurred in all
regions of the world, affecting all major business lines and asset
classes.
Moreover,
there tend to be a common set of features
that seem to repeat themselves in various combinations from banking
crisis to banking crisis.
These include:
1. Excess liquidity chasing yields
2. Too much credit and weak underwriting standards
3.
Underpricing of risk, and
4. Excess leverage
In the current crisis, these recurring trends were magnified by:
1. Weak bank governance practices, including in the area of
compensation
2. Poor transparency of the risks at financial institutions and in
complex products
3. Risk management and supervision focused on individual institutions
instead of also at the system level
4.
Procyclicality of financial markets propagated through a variety of
channels, and
5. Moral hazard from too-big-too-fail, interconnected financial
institutions.
C. Benefits of tighter regulation through Basel III exceed the costs
The
objective of the Basel III reforms is to
reduce the probability and severity of future crises.
This will involve some costs arising from stronger regulatory capital
and liquidity requirements and more intense and intrusive supervision.
But our analysis and that of many others has found the benefits to
society well exceed the costs to individual institutions.
The Committee’s long-term economic impact analysis found that capital
and liquidity requirements could be increased – well above current
minimum levels – while still achieving positive net economic benefits.
These findings are not surprising.
It is widely accepted that prudent fiscal and monetary policies are
the cornerstones of financial stability and sustainable economic
growth.
Indeed, maintaining conservative fiscal and inflation policies involve
a cost – they result in potentially lower short-term economic growth,
which is offset by more sustainable long-term growth.
Increasing stability of the banking and financial system involves a
similar trade-off, where the costs are more than offset by the
long-term gain.
In particular, it is difficult to imagine a country that can maintain
sustainable growth on the foundation of a weak banking system
III. Key
features of the Basel III reform package
The Basel
III framework is the cornerstone of the G20
regulatory reform agenda and the final Basel Committee rules were
issued at the end of last year.
This development is the result of an unprecedented process of
coordination across 27 countries.
Compared to Basel II, it was also achieved in record time, less than
two years.
The next step, which is just as critical as the policy development, is
implementation.
The full
potential of Basel III will only be achieved if all Committee-member
countries and regions work within the global process, and fully
implement the minimum standards.
Some countries may choose to implement higher standards
to address risks particular to their national contexts.
This has always been an option under Basel I and II, and it will
remain the case under Basel III.
Why is Basel III fundamentally different from Basel I and Basel II?
First, it
is more comprehensive in its scope and, second, it combines micro- and
macro-prudential reforms to address both institution and system level
risks.
On the
microprudential side, these reforms mean:
1. A
significant increase in risk coverage, with a focus on areas that were
most problematic during the crisis, that is trading book exposures,
counterparty credit risk, and securitisation activities;
2. A fundamental tightening of the definition of capital, with a
strong focus on common equity.
At the same time, this represents a move away from complex hybrid
instruments, which did not prove to be loss absorbing in periods of
stress.
We also introduced requirements that all capital instruments must
absorb losses at the point of non-viability, which was not the case in
the crisis;
3. The introduction of a leverage ratio to serve as a backstop to the
risk-based framework;
4. The introduction of global liquidity standards to address
short-term and long-term liquidity mismatches; and
5.
Enhancements to Pillar 2’s supervisory review process and Pillar 3’s
market discipline, particularly for trading and securitisation
activities.
In
addition, a unique feature of Basel III is the introduction of
macroprudential elements into the capital framework.
This includes:
1.
Standards that promote the build-up of capital buffers in good times
that can be drawn down in periods of stress, as well as clear capital
conservation requirements to prevent the inappropriate distribution of
capital;
2. The leverage ratio also has system-wide benefits by preventing the
excessive build-up of debt across the banking system during boom
times.
To minimise
the transition costs, the Basel III requirements will be phased in
gradually as of 1 January 2013.
I would now like to say a few words in particular about two of the
newer elements of the regulatory framework, namely the liquidity
standards and the leverage ratio. As mentioned, excess leverage and
weak liquidity profiles of banks were at the core of the crisis, and
they therefore represent a critical part of the Basel III framework
going forward.
A. The
Liquidity Framework
There is broad support for the liquidity framework introduced by the
Committee.
Banks and
other market participants already use methods similar to the
Liquidity Coverage Ratio (LCR) and the
Net Stable Funding Ratio (NSFR).
Many of the issues that have been raised pertaining to these
requirements revolve around the calibration of the ratios, rather than
the conceptual basis of the framework.
It is
important to emphasise the Committee’s goal in establishing the
liquidity framework: to require banks to withstand more severe shocks
than they had been able to in the past, thus reducing the need for
such massive public sector liquidity support in future episodes of
stress.
The success of the framework should not be measured in terms of
whether it will have zero cost.
Instead, the better measure of success is whether the framework
corrects pre-crisis extremes at acceptable costs.
Banks that
take on excessive liquidity risk should be penalised under the new
framework, while sound business models should continue to thrive.
With these objectives in mind, the Committee will use the observation
period to review the implications of the standards for individual
banks, the banking sector, and financial markets, addressing any
unintended consequences as necessary.
In this regard, the Committee’s focus is now on ensuring that the
calibration of the framework is appropriate.
Certain aspects of the calibration will be examined and this will
involve regular data collection from banks.
Any adjustments should be based on additional information and rigorous
analyses.
Moreover, relying just on banks’ experiences from the crisis is not
sufficient, as it embeds a high level of government support of banks
and markets.
Hence, the
analysis will need to include both quantitative bank experience and
additional qualitative judgement.
It is worth
emphasising that a number of effects of
the framework are indeed intended.
For
example, with regard to the pool of liquid assets, the rules are meant
to promote changes in behaviour.
Contrary to popular perception, they are not about promoting the
hoarding of government debt, but about creating incentives to reduce
risky liquidity profiles.
This can be achieved, for example, by pushing out the average term of
funding or increasing the share of stable funds.
In other cases, banks did not price
liquidity appropriately throughout the firm, and correcting risk
management deficiencies will in turn improve liquidity profiles.
In fact, the initial response we have observed in some countries that
have already implemented comparable liquidity ratios suggest that
these are the types of strategies that are being pursued.
Also contrary to what many have claimed, the new standards should help
promote greater diversification of the pool of liquid assets held by
banks.
Bank holdings of liquid assets continue to be dominated by exposures
to sovereigns, central banks and zero percent risk-weighted public
sector entities.
These assets comprised 85% of banks’ liquid assets according to the
Committee’s most recent quantitative impact study.
By
recognising high quality corporate and covered bonds – subject to a
limit – the liquidity framework will help promote a further
diversification of the liquid asset pool.
B. The
Leverage Ratio
Many banks entered the crisis with excessive leverage.
This increased the probability of bank failures.
It also exacerbated the effects of the crisis on broader financial
markets as many banks rushed to de-leverage once the crisis hit.
The objective of the leverage ratio is to serve as a back-stop to the
risk-based measure.
The Committee’s calibration work shows that bank leverage was a highly
statistically significant discriminator between banks that ultimately
failed or required government capital injections during the crisis and
those that did not.
Moreover, at the height of the crisis, the market gravitated towards
simple leverage based measures to compare banks.
The
leverage ratio also serves a
macroprudential purpose.
We have seen during this and prior crises the cyclical movement of
leverage at the system-wide level.
Leverage, which tends to build up prior to crisis periods, is
subsequently unwound when a crisis occurs.
This cyclical aspect exacerbates both the upswing phase and the
downturn.
In addition, what can appear to be very low risk assets at the
institution level can ultimately create incentives for the build-up of
risks at the broader system level.
The leverage ratio serves to limit excessive concentrations in such
asset classes.
As with the liquidity framework, the Committee has a process in place
to assess the impact of the leverage ratio on business models.
It will take actions if necessary to make sure that the design of the
leverage ratio will achieve its objectives.
As I stressed earlier, it is important that all countries and regions
continue to work within this global process.
IV. What
still needs to be done to ensure longer-term banking sector and
economic stability?
Over the past three years, much has been achieved by the global
regulatory community to respond to the crisis.
This policy work is now substantially complete.
But to ensure longer-term banking sector and economic stability,
consistent and timely global implementation of Basel III is critical.
In
addition, a key remaining area of policy development work is focused
on dealing with systemically important banks (SIBs).
Finally, we will also need to stay attuned to bank-like risks that
emerge in the shadow banking sector.
V.
Implementation of Basel III
The Committee has put in place mechanisms to help ensure more
consistent implementation of its standards.
This applies not only to Basel III but to other global standards
agreed by the Committee.
The efforts
of the Committee are reinforced through
additional institutional arrangements introduced at the level of the
Financial Stability Board (FSB) and the G20.
Going forward, the Committee’s Standards Implementation Group will
play a critical role in conducting thematic peer reviews of member
countries’ implementation of standards and sound practices.
Implementation involves not only introduction of the standards in
legal form, but also rigorous and robust review and validation by
supervisors.
We therefore are also introducing processes to ensure the integrity of
key elements of the framework.
An example of this is the review of banks’ risk weightings, which
should include the use of test portfolio exercises.
As we have painfully learned from the recent crisis, the failure to
implement Basel III in a globally consistent way will again lead to a
competitive race to the bottom and increase the risk of another crisis
down the road.
VI.
Addressing the Too-Big-To-Fail (TBTF) problem
During the crisis, the failure or impairment of certain banks sent
shocks through the financial system.
This had an adverse knock-on effect on the real economy.
Supervisors and relevant authorities had limited options to prevent or
contain problems effecting individual firms and this led to wider
financial instability.
As a consequence, public sector intervention to restore financial
stability during the crisis was necessary, as was the massive scale of
these responses.
The fallout from the crisis underscores the need to put in place
additional measures to reduce the likelihood and severity of problems
emerging at systemic banking institutions.
The
Committee, in close cooperation with the FSB is working to address the
financial system externalities created by Systemically Important Banks
(SIBs).
To achieve this broad objective, policy tools are being designed to:
1. Reduce the probability as well as the impact of an SIB failure;
2. Reduce the cost to the public sector should a decision be made to
intervene; and
3. Level the playing field by reducing too-big-to-fail competitive
advantages in funding markets.
The Committee has developed a methodology that embodies the key
components of systemic importance.
These are size, interconnectedness, substitutability, global activity
and complexity.
The methodology can serve as a basis for the differentiated treatment
of systemic institutions without needing to specify a fixed list of
such institutions.
Common equity is the key when it comes to going concern capital as it
is available to absorb losses with certainty, thus reducing the
probability of failure.
The
Committee also continues to study the role that going-concern
contingent capital could play in its framework for SIBs.
Strong resolution and recovery frameworks play a critical role in
reducing the impact of failure by facilitating the orderly wind-down
of a global bank.
In this context, the Committee is reviewing the role that bail-in debt
could play in complementing Tier 2 capital to provide additional
resources that can mitigate the systemic impact of banks at the point
of non-viability.
The
Committee’s work on systemically important banks is part of the
broader effort of the Financial Stability Board (FSB) to address the
risks posed by SIFIs.
The Committee is working closely with the FSB through this process,
and expects to consult on proposals to address the risks of globally
systemic banks around the middle of the year.
VII.
Shadow Banking
The final area where further work is needed is shadow banking.
Shadow banking was a key mechanism through which the crisis was
propagated.
SIVs, money
market mutual funds, the securitisation process, and bank liquidity
lines to off-balance-sheet exposures all served to amplify the impact
of the crisis on banks.
While it is clearly important to address issues in the shadow banking
sector, its existence should not detract from the fundamental need to
strengthen the resilience of the banking system itself.
The banking sector remains at the centre of the credit and liquidity
intermediation process.
This is true even in economies that are more reliant on capital
markets.
Moreover,
significant parts of shadow banking were created, sponsored or
financed by the banking sector and these include SIVs, ABCP conduits,
MMMFs, certain securitisation structures, and hedge funds.
Finally, much of the shadow banking sector depends on the financing
and liquidity support of the banking sector.
Basel III goes a long way to closing the gaps in exposure to shadow
banking. It does this in several ways:
1. By
addressing the capital treatment for liquidity lines to SIVs and other
types of off-balance sheet conduits;
2. By addressing counterparty credit risk;
3. By including off-balance sheet exposures in the Basel III leverage
ratio; and
4. By incorporating a range of contractual and reputational risks
arising from the shadow banking sector into the liquidity regulatory
and supervisory standards.
Thus, stronger, consolidated banking regulation and supervision will
go a significant way towards containing the risks of the shadow
banking sector.
In addition, to the extent that bank-like risks emerge in the shadow
banking sector, they should also be addressed directly.
Supervisors should take a system-wide perspective on the credit
intermediation process.
To the extent that bank-like functions are carried out in the shadow
banking sector and pose broader systemic risks, they should be subject
to appropriate regulation, supervision, and disclosure.
In particularly this is the case where activities combine credit
intermediation, maturity or liquidity transformation, and leverage.
The FSB, the Basel Committee and the Joint Forum of Banking,
Securities, and Insurance Supervisors will monitor developments
closely and promote appropriate responses as circumstances dictate.
VIII.
Other Basel Committee initiatives
The Committee is also conducting a fundamental review of the trading
book.
It is fundamental in the sense that it will help inform basic
questions such as how to address the line between the banking and the
trading book and how to improve upon the current VAR based framework
for measuring trading risks.
We will consult on this issue as the work progresses, which I expect
will be around the end of this year
Other issues on the Committee’s agenda include further work on
cross-border bank resolution issues and updating of large exposure
standards, as well as a revision of the Core Principles for Effective
Banking Supervision.
It is critical that we incorporate the lessons of the crisis into a
revised set of Core Principles, which will serve as the basis for
enhanced country level reviews through the IMF and World Bank.
IX.
Conclusion
The policy work for developing the Basel III framework has for the
most part been completed.
The reforms are significant and bring together micro and macro lessons
of the crisis.
The Committee has now moved to the next phase: implementation.
One of the regulatory lessons of the crisis is that it is critical
that all countries and regions now follow the global implementation
process.
By definition, it will be hard to predict the cause of the next
crisis.
Many risks are still looming on the horizon, and all countries need to
continue the process of building their capacity to absorb shocks –
whatever the source.
The banking sector’s shock absorbing capacity must be much stronger
than it has been in the past, and the implementation of our standards
must be more globally consistent and robust
Speech by
Jean-Claude Trichet, President of the ECB,
Madrid, 13
May 2011
