21 November 2012

Bundesbank/Dombret: Restoring confidence in the financial system

Ending too big to fail

Separating banking functions?: Some believe that introducing a system of separated banking functions – in other words, divorcing deposit-taking and lending from proprietary trading and investment banking – is the way forward. Yet I am questioning if such a system can truly fulfil all the hopes invested in it...  Separating banking functions will not prevent future banking crises... Even if there were a clean organisational separation, the interconnectedness of the financial sector and the resulting systemic importance of individual institutions would not be entirely eliminated. Economic linkages would remain. Financial institutions are linked not only through direct business relationships, but also indirectly through payment and securities settlement systems... All in all, I do not see a clear case for separating banking functions. In other words, I do not believe this to be the first-best solution.

Introducing credible resolution regimes: Rather than intervening in financial institutions’ business structures, the preferable regulatory solution is the credible threat of an orderly market exit. And the decisive factor here, as always when it comes to money and finances, is credibility. Only the credible threat that even systemically important financial institutions may exit the market, and that this can be executed in an orderly fashion, will restore trust in the rules of the game... It is now up to governments to transpose the Key Attributes of Effective Resolution Regimes for Financial Institutions into national law and legislation. In Europe, the draft directive for the restructuring and resolution of credit institutions and securities firms, which was published in June by the EU Commission, is an important step in the right direction. It is necessary to continue on this path.

Paying greater attention to consistency

When setting the rules for the financial system, one main challenge is that regulation has been geared towards a sector-specific approach. This is reflected, for example, in the way regulatory standards and principles applying to the banking, insurance and securities sectors have developed largely independently of one another. However, this entails the danger of losing sight of the financial system as a whole.

We need to be aware of this risk and focus our attention more on the systemic aspects of regulation. One of the most important reasons for this is the prevention of regulatory arbitrage. This applies not just to the relocation of business activities from one jurisdiction to another, but also to shifts between different sectors of the financial system. For instance, as already mentioned, tightening banking regulations may well push activities towards the shadow banking system.

Besides regulatory arbitrage, we must also pay attention to the cumulative effects of, and the interplay between, individual regulatory initiatives. Where there is a lack of consistency there is a danger that different measures may create conflicting incentives or may even cause countervailing effects. This then may diminish, or even completely prevent, the desired effects of new rules. Take, for example, the interplay between the Capital Requirements Directive/Capital Requirements Regulation, which serve to implement the Basel III rules in Europe, and Solvency II: the former seeks, among other things, to place bank funding on a more stable, long-term basis. However, Solvency II may, under certain circumstances, benefit short-dated bonds, impacting insurers’ asset allocation and thus banks’ funding costs.

Implementing Basel III

Although it has become apparent that some countries are having difficulties sticking to the timetable, I urge all authorities involved to implement the framework as internationally agreed.

Recently, there has been a somewhat disconcerting discussion about the perceived shortcomings of Basel III. Some argue that it is not enough. Others argue that it is too complex. Yet, neither of these criticisms is convincing... There is no alternative to implementing Basel III on a global scale. In particular, I call on my colleagues in the US not to unexpectedly question the whole framework in the 11th hour – after taking part in its negotiation during the entire process. Nobody would understand why the largest financial market in the world suddenly were to go its own way on capital rules. Every country must absolutely avoid seeking advantages by watering down, or by reluctantly implementing agreed reforms. Such a policy would only lead to new tensions in the financial markets during a time of anyhow increased stress. We simply cannot afford going down this route.

Conclusion

First, ending too big to fail is not everything. But without ending too big to fail, all comes to nothing. Rather than intervening in financial institutions’ business structures, I prefer credible resolution systems.

Second, while setting the rules of the game, we must take on a more systemic perspective, paying attention to regulatory arbitrage and the interplay between individual reforms. Countries need to implement agreed policies consistently and on schedule, including in particular Basel III.

Finally, we have to return to individual responsibility: those who take risks may well reap the benefits but must also face the consequences.

Full speech

© Deutsche Bundesbank