19 March 2013

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

The crisis has highlighted shortcomings in the Union’s institutional framework. Let me remind you of three serious flaws.

• First, the deficit rules of the Stability and Growth Pact were not only circumvented by some member states, but deliberately bent.
• Second, Member States’ borrowing was not effectively curbed because financial markets failed to exert a disciplining effect on public budgets.
• Third, contagion effects transmitted via Member States’ financial systems were largely underestimated. The introduction of the single currency led to a greater integration of European financial markets. The highly integrated market increased the probability of contagion effects occurring via Member States’ financial systems. Hence, it amplified the existing close link between risks stemming from a country’s public finances and the state of its banking system.

A banking union can help to strengthen financial stability by loosening the nexus between banks and sovereigns. A European banking supervisor would benefit from the ability to make cross-border comparisons, for instance. Such a body should be able to monitor the build-up of excessive risks and pinpoint them more easily and at an earlier stage. A single supervisory mechanism should also overcome the national bias of supervisors.

But a 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.

Changes will also be made through financial sector reforms. The financial crisis has highlighted weaknesses in financial sector regulation. As a response to this, the G20 Heads of State or Government set in train a comprehensive reform agenda in November 2008.

One of the most pressing issues is the implementation of Basel III. What is most worrying is that doubts about implementation have been voiced with respect to countries that are home to global financial centres and systemically important institutions. I consider it of utmost importance that all G20 countries live up to their self-commitment of leading by example. The initial implementation timelines have been modified in the EU and the US. We need to make sure that such delays do not lead to a watering down of the measures that we agreed upon internationally.

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.

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.

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.

Full speech

© Deutsche Bundesbank