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Financial reform: what has been achieved and what remains to be done

Speech by Jean-Claude Trichet, President of the ECB,
Madrid, 13 May 2011

Ladies and Gentlemen,


We are nearly four years on from the first tremors in the world’s financial system that started in the summer of 2007, and in a few months we will approach three years since the dramatic intensification of the crisis in the early autumn of 2008.

As you are all well aware, the euro area, the world’s second largest and most open economy, was immediately and strongly affected. And as guardians of what is generally considered the world’s second most important currency, the European Central Bank (ECB) was profoundly involved in the response to the crisis.

Our consistent aim in the crisis has been to protect as far as possible the real economy from the financial distress in the system. Over the past few years, our toolkit has featured the standard monetary policy measures of setting interest rates, as well as a range of non-standard monetary policy measures. The latter have included temporary measures such as full allotment of liquidity, expanded eligibility for collateral, longer-term refinancing operations and interventions in bond markets.

The ECB has also been involved in actions focused on the long term to try to ensure that the financial sector cannot pose such a danger to the real economy again. The financial turmoil that emerged from the US housing market and which sent shockwaves across the world economy revealed deep flaws in the way the financial system in advanced economies operates and in the way that system is supervised and regulated.

Tackling those systemic flaws through financial reform is what I would like to discuss today.

The ECB’s involvement in financial reform takes place through our role in the institutional framework of the European Union as well as the institutional framework of the global economy – the G20, the Basel Committee and other fora of international cooperation.

Last year several important decisions were taken on the pillars of the new supervisory and regulatory framework. First, the adoption of Basel III. Second, reforms of market infrastructure. And third the establishment of macro-prudential oversight institutions, including the European Systemic Risk Board (ESRB).

Key areas where work is still in progress include the treatment of systemically important financial institutions, crisis management and resolution, oversight of the shadow banking system, and – very importantly – the regulation and oversight of financial markets and their functioning.

* * *

Today I would like to lay out what I believe are the three main building blocks of the financial reconstruction that is currently in progress – to outline what has been achieved and what remains to be done.

The first building block is banking regulation. Here, the global community has made the right diagnosis and, in the Basel III framework, drawn the appropriate lessons.

The second building block is regulation of the financial markets. Here, reform must create greater transparency for the various market segments and products, ensure sufficient competition in all markets, and attenuate as far as possible the pro-cyclicality from structural features such as ratings and market phenomena such as herding.

The third building block is macro-prudential oversight. This new discipline focuses on the interactions between the various parts of the financial system and between the financial sector and the real economy. New institutions, including the ESRB, will pursue the task of identifying sources of systemic risk, issuing early warnings and recommending remedial action.

The birth date of macro-prudential oversight in Europe will probably be identified as the start of this year but it was originally conceived in 2009 through the work of the Committee presided over by Jacques de Larosière. The fact that it took little more than a year and a half from policy design to institutional establishment was made possible by thorough groundwork by the European Commission and very rapid decisions by the European Parliament and the European Council. I feel very honoured to chair this new body, the ESRB, together with Mervyn King and Andrea Enria.

Let me discuss each of these three building blocks, focusing on both progress to date and the challenges that lie ahead.

1. Banking regulation and Basel III

First, banking regulation, where the Basel III framework represents the cornerstone of the newly revised international regulatory architecture. This framework envisages higher minimum capital requirements, better risk capture, stricter definition of eligible capital elements and more transparency. It introduces entirely new concepts, such as non-risk-based leverage ratios and mandatory liquidity requirements.

Beyond the micro-prudential dimension of regulation – typically represented by institution-specific solvency requirements – Basel III also introduces macro-prudential elements, most prominently the capital buffer regime based on aggregate credit growth.

From both a macroeconomic and financial stability perspective, the implementation of Basel III should bring substantial long-term benefits. As painfully experienced in recent years, financial crises impose enormous costs on society. The main benefit of the reform will stem from the reduced frequency of future crises.

The new standards aim at improving banks’ capital base and the sector’s resilience to a crisis. Financially sounder banks will, in turn, help foster financial stability as well as mitigating systemic risk. The prevention and mitigation of downside tail risks for the economy implies a sizeable reduction in the expected output losses associated with systemic events, contributing to more sustainable growth.

Although the net benefits from Basel III are difficult to quantify precisely, the Committee’s analysis indicates that the potentially negative impact of the new framework on long-term output is considerably lower than the growth benefits associated with the reduced frequency of crises. Additional benefits include lower funding costs for banks and a decline in risk premia.

At the same time, it is acknowledged that implementation of the new framework will impose some transitional costs on the sector as banks need to meet the more stringent regulatory requirements. Banks can adjust their capital ratios through a combination of several measures, for example, by raising capital or reducing dividends for some time.

The length of the implementation period matters crucially for the transition costs. The Basel Committee has designed relatively long phase-in arrangements to mitigate adjustment costs. If the new framework had been implemented hastily, banks would have needed to reorganise their balance sheet structure quickly, which could have had adverse impacts on credit intermediation in the short term.

Implementation over the time frame 2013-19 has been agreed to provide the sector sufficient time to adjust to the new requirements. The gradual implementation should prevent disruptions in credit flows and bring enough clarity and scope for banks to absorb the necessary adjustments smoothly over time.

Looking forward, the introduction of the new standards presents the international regulatory and supervisory community with two major challenges. The first is to ensure proper implementation of Basel III at the global level. In line with the G-20 recommendations, all national authorities should honour their commitment to implement the framework without any undue postponement.

The second challenge relates to thorough assessment of the new regulatory concepts and measures. Some of the new concepts, such as liquidity standards and leverage ratios, have sparked controversy and delayed final agreement. To alleviate concerns about potential unintended consequences, an observation period has been agreed to serve as a basis for the final design and calibration.

Work in progress on systemically important financial institutions, crisis resolution and shadow banking

Let me turn to some issues of banking regulation on which it is important that work continues. The first is systemically important financial institutions, which the G20 and the Group of Governors and Heads of Supervision have stated should satisfy additional solvency requirements beyond the levels agreed in Basel III. The main goal here is to reduce the externalities related to the financial distress of such institutions, and ultimately avoid a repetition of the crisis.

The Financial Stability Board (FSB) has been working on identifying systemically important financial institutions and evaluating the desirable magnitude of additional capital with which they should comply. Its recommendations will be delivered to the G20 summit in November.

The FSB’s work is a fundamental step towards an international framework that fully reflects the greater risks posed by these large institutions. Looking forward, it is crucial that effective peer reviews of final implementation are set up, ensuring consistency across jurisdictions. Enforcing a level global playing field remains a priority for the regulatory agenda, to prevent regulatory arbitrage to parts of the financial sector with less supervision and weaker regulation.

In parallel with higher solvency requirements for systemically important financial institutions, important initiatives are underway – both in Europe and globally – to improve the capacity of authorities to resolve financial institutions, especially in a cross-border context.

An effective resolution regime should consist of a comprehensive toolkit of gradually increasing powers, complemented by credible financing arrangements that reduce the reliance on government budgets. It is essential to make significant progress in the coming years to ensure that all systemically important financial institutions can be resolved in an orderly manner and without taxpayers’ support.

The FSB is identifying the key elements of effective resolution regimes. At the same time, the reform of national (or in the case of the EU, supra-national) resolution frameworks is already underway in the major jurisdictions, including the Dodd Frank Act in the United States. Here, the European Commission has published a public consultation document on the planned EU framework, for which legislative proposals are expected in June.

Let me briefly mention shadow banking. The introduction of more stringent capital requirements for credit institutions may provide further incentives for banks to shift part of their activities outside the regulatory perimeter. Against this background, the FSB is developing recommendations to strengthen oversight of the shadow banking system in collaboration with other international standard setting bodies.

Work on the shadow banking system should aim to develop a better understanding of the interconnections between regulated banks and unregulated entities that are conducting credit intermediation, either directly or as part of a complex chain of intermediation activity, as well as the channels for possible contagion. In this context, it is crucial to understand the functioning of the repo market. It is also vital to identify entities or activities within the shadow banking system that may be sources of systemic risk.

2. Market regulation

Let me turn to the second building block, namely regulation of financial markets. One of the key lessons from the crisis is that the risks to market returns did not come mainly from shocks to the real economy. The risks came from the financial sector itself. The financial structures that we thought were in place to assess, absorb and neutralise risk were either dysfunctional or worked to magnify volatility.

Key factors in creating this risk were opaque financial structures and pro-cyclicality in financial markets. The lack of transparency in many financial instruments meant that some market players could exploit – for their own, private benefit – information that was not generally available.

Pro-cyclicality acts as a formidable accelerator of financial trends. Two important factors that drive such amplification are distorted incentives and herd behaviour. The role of distortions in economic incentives is widely understood, but herd behaviour as a driver of pro-cyclical patterns in financial markets still needs a thorough explanation.

One explanation lies in the significance of market players’ evaluation of their performance relative to the rest of the market. This is reminiscent of Keynes’ famous beauty contest analogy. To be successful in this environment, individual participants do not form their own opinions, but follow the general mood. Everybody seeks to ride the wave, hoping to step off before the mood turns.

A second complementary explanation is that global markets are in fact less atomistic than we think. Derivatives activity in the US banking system, for example, is dominated by a small group of large institutions. And, of course, the market for credit ratings is famously dominated by three signatures, which act as standard-setters for an enormous volume of transactions.

Many regulatory initiatives are underway to remedy these issues, including work on OTC derivatives, which comprise 80% of traded derivatives. The near-collapse of Bear Stearns in March 2008, the default of Lehman Brothers in September 2008 and the bail-out of AIG the same month highlighted shortcomings in the functioning of the OTC derivatives market, and underlined the need for appropriate action to increase transparency and address concerns about financial stability.

To this end, there is now a regulation underway in Europe aimed at bringing more safety and more transparency to the derivatives market. According to the draft regulation, information on OTC derivative contracts should be reported to trade repositories and be accessible to supervisory authorities. Furthermore, standard OTC derivative contracts should be cleared through central counterparties, thus reducing the risk that one party to the contract defaults. Any possible concentration risk involved in the set-up of the CCPs could be assessed at the macro-prudential level.

Of course, financial market infrastructures can only help to foster the stability of markets to the extent that they are safe and sound. To this end, the Committee on Payment and Settlement Systems and the Technical Committee of the International Organization of Securities Commission are reviewing the relevant regulatory and oversight standards. A consultative report published in March 2011 outlines principles that will provide greater consistency in the oversight of financial market infrastructures worldwide.

3. Macro-prudential supervision and the ESRB

Let me come to the final building block: macro-prudential oversight.

As my earlier remarks suggested, the financial crisis has been revealing in many respects. It has revealed the fallout from the failure of large financial institutions. It has revealed the fragility of the financial system to features and trends that cut across institutions, markets and infrastructures. And it has illustrated the amplitude of the consequences of the adverse feedback loop between the financial system and the real economy.

All these three elements are key features of systemic risk: first, contagion; second, the build-up of financial imbalances and unsustainable trends within and across the financial system; and third, the close links with the real economy and the potential for strong feedback effects.

The strengthening of macro-prudential oversight – with the establishment of institutions devoted to that task such as the ESRB, the US Financial Stability Oversight Council and the UK’s Financial Policy Committee – should enhance our ability to identify and address systemic risk. How can these new bodies reach their full potential?

The first precondition is that they have an adequate infrastructure to identify and analyse systemic risks. This demands a state-of-the-art analytical toolkit, which can provide a solid basis for systemic risk analysis and the ensuing formulation of policy responses.

In the field of systemic risk assessment, great attention is currently devoted to macro stress testing as a tool to evaluate the impact of shocks on the financial sector and the real economy. This complements micro stress tests relating to individual financial institutions. A key challenge is modelling feedback effects between the financial system and the real economy.

Another promising area relates to network analysis, which aims to identify systemic inter-linkages across firms, sectors and countries. This type of analysis, which is well established in other domains, is still at its infancy for the financial sector.

A key point in this context is that the effectiveness of the analytical toolkit is strongly dependent on the availability and quality of data. There are several data gaps, which make it difficult to assess the sources and magnitude of systemic risks and the very complex network of inter-linkages in the financial system.

The second precondition for the success of the new bodies is a coherent framework for macro-prudential oversight and policy development. In this context, it is important to note that the institutions do not have direct control over policy tools. In the case of the ESRB it may issue risk warnings and recommendations to other authorities, which should comply with them or give reasons for non-compliance.

Since existing policy tools that can be used for macro-prudential purposes fall in other policy domains (e.g. micro-financial supervision, monetary policy or fiscal policy), it is essential that effective coordination mechanisms should be developed between the responsible authorities. In particular, close cooperation between macro- and micro-supervisory authorities is essential as most of the macro-prudential tools are micro-prudential in nature. It is therefore of utmost importance that the mandate of macro-prudential authorities as well as the role of supervisory authorities in macro-prudential surveillance are clearly defined.


Let me conclude. I believe we are now about halfway through the comprehensive financial reforms that the crisis has demanded. We have achieved a blueprint of more stringent bank regulations that includes more loss-absorbing capital, better risk coverage and limitations for undue leverage. The oversight of financial institutions as well as markets and market infrastructure are being strengthened. And the organisational structure of financial supervision is being overhauled.

But much remains to be done. The key aspect is implementation of the reforms. Moreover, the issue of systemically important financial institutions requires further reflection. And oversight of the proper functioning of financial markets in a way that avoids undue volatility, excessive influence of dominant players and oligopolistic market structures, while reinforcing transparency, needs to be addressed resolutely.

Thanks, in particular, to prompt and resolute action by central banks and by governments, the international community avoided a great depression, after the intensification of the crisis in mid-September 2008. With the global recovery being confirmed, numerous voices in the financial sector are arguing that we are now back to business as usual. Achieving an ambitious programme of reforms of rules, regulations and oversight of the financial sector is considered by some as unnecessary and counterproductive. I do not at all share those views. It is an absolute obligation, for all of us, to do all what is necessary to reinforce the resilience of the financial system and ensure its sustainable contribution to growth. We must be sure that the excessive fragility that was revealed in 2008 and 2009 is eliminated. Not only because the costs of financial crises in terms of growth is always considerable but, even more, because it is extremely likely that our democracies would not be ready to provide once again the financial commitments to avoid a great depression in case of a new crisis of the same nature. Our people would not permit, for a second time, that governments mobilize 27% of GDP of tax payer risk, on both sides of the Atlantic, to avoid the collapse of the financial sector. For these reasons public authorities must pursue and implement their G20 programme with inflexible determination, and it is essential that the private sector fully implements this programme.

Thank you for your attention.


European Central Bank

Directorate General Communications

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