Balancing risk-taking and financial regulation

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<p>Romesh Vaitilingam interviews Axel Weber for Vox</p>
<p>September 2009</p>
<p>Transcription of a VoxEU audio interview [http://www.voxeu.org/index.php?q=node/4040</p>
<p><strong>Romesh Vaitilingam</strong>: Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam, and today&rsquo;s interview is with Axel Weber, who is president of the Deutsche Bundesbank. Axel and I met at the Global Economic Symposium in Germany in mid-September 2009, where he was speaking at a session on balancing risk taking and financial regulation. I began by asking him to give his perspective on that challenge.</p>
<p><strong>Axel Weber</strong>: For me, there is a need to rebalance between risk taking and regulation. Regulation typically is static, so in between regulatory reforms there is a lot of expertise in the market that tries to use the regulation and implement it; but there&rsquo;s also a lot of expertise trying to circumvent and find loopholes in the regulation. So, once in a while, with markets being very dynamic and regulation being static, regulation has to be updated. The best time to do that is when a financial crisis had occurred. Even better would be to do it before and discover the loopholes, but this financial crisis was pretty unpredictable. It came from the core of the world&rsquo;s financial centers and, therefore, what we now need to do is we need to update Basel II and the regulatory framework. We need to take into account that liquidity played a role, so liquidity standards will be something that we have to push forward.</p>
<p>And finally, we also have to, in my view, move on risk management and basically getting a better grip on the shadow banking system, which so far has not been part of regulation. It&rsquo;s no good to continue regulating tighter and tighter the banking system when you have similar business models and a huge amount of activity just outside that regulation in the shadow banking system. SPV is a word nobody knew three years ago; everybody knows now, and that&rsquo;s exactly the kind of aims we have. Hedge funds, private equity &ndash; we need to have regulation that doesn&rsquo;t provide regulatory arbitrage across market players or across constituencies.<style type="text/css">s */
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<p><strong>Romesh</strong>: You&rsquo;ve described the root of the financial crisis as being excessive risk taking. What do you think were the things that allowed that to happen and encouraged that to happen, encouraged market participants to take too many risks?</p>
<p><strong>Axel</strong>: Well, I think basically we saw the problems emerging in structured finance products. Structured finance and securitisation are very good things. We don&rsquo;t want banks to keep all risks on their balance sheet. The general idea of packaging risks, tranching them, and selling them to others that have a higher demand for risk is good. But, at the same time, we discovered that securitisation is only as good as the weakest link in that chain.</p>
<p>There were weak parts in all parts of the securitisation chain. There were problems in the disconnection between those that were getting the customers into the contracts and not putting money and capital into these contracts themselves.</p>
<p>There was a problem that not all the incentives were right in the securitisation process, apart from the issue of whether you should take first loss pieces on your balance sheet or whether you sell the entire tranche. So, there are many weaknesses we can discover in the chain of securitisation. As I said, like in a real chain, it&rsquo;s only as strong and good as its weakest link, and we discovered there were many weak links.</p>
<p><strong>Romesh</strong>: How do we go from here? You said this is the window of opportunity to make these serious reforms. Of course, the big issue seems to be about transnational regulation. That&rsquo;s the big issue, that so much financial regulation has been at the national level, and we need to think about these much more at the global level. Can you suggest how we go about doing that?</p>
<p><strong>Axel</strong>: Well, I think the transnational is only one part of what we need to aim at. We need to avoid regulatory arbitrage. So we have to make sure that capital standards - liquidity standards - are binding as much in one constituency as they are in others. At the moment we still have many areas where we have very different standards. We have IFRS accounting standards in Europe, whilst we have U.S. GAAP in the U.S. There&rsquo;s a totally different treatment of prudential filters of netting procedures. It&rsquo;s very hard to compare two balance sheets done in the two accounting standards, so we need truly global, converged accounting standards.</p>
<p>The second issue the U.S. still applies Basel I to their banking industry as a regulatory standard, whilst most of Europe and increasingly many more emerging markets have moved to Basel II. We need the same banking supervision framework across the globe.</p>
<p>Then, finally, within these banking supervision frameworks, we need a common definition of capital, what capital to hold against exposures. And that varies widely across the board. On top of that, not just the definition of capital is different; the quality of capital found in the different banking systems is quite different, from common stocks to hybrid forms of capital. We need to sort out and make clear that we move to a common definition and a clear definition of the most preferable and the highest quality capital.</p>
<p>In addition to that, we need to apply much bigger buffers in terms of capital. Even if you look at the start of the crisis, many financial institutions would have withstood the initial turmoil if they had had a bigger capital cushion above the regulatory required minimum. We need to increase capital in the banks in terms of capital buffers, but we cannot do this right now, because we are fully aware that if we ask banks to raise capital now, this could be strongly procyclical, aggravate the crisis as we stand, and probably cause problems in new engagements of banks, in particular in credit engagement. So, we need to phase this in as the recovery is assured.</p>
<p>Then we really found that liquidity was a key issue. Before, the philosophy of Basel II was that every bank which is solvent has access to liquidity. That is not the case. We now have to align much more than in the past the holding maturity structure of the assets with the funding side of those banks. For me, it&rsquo;s inconceivable that we can come out of this crisis with banks having long-term assets finding short-term and commercial paper markets overnight or at week intervals. We need to have more maturity congruent funding and some liquidity buffers in excess of the average maturity of the assets held in banks.</p>
<p>Once we&rsquo;ve done all that - each individually at our national standards - I think we&rsquo;ve gone a long, long way already to harmonise internationally and cross borders. Of course, we also need a cross-border banking supervision, and we need to work very hard, because it&rsquo;s not part of regulation yet.</p>
<p>The system itself is more than the sum of its parts. The system can never be stable if the parts are not stable. But, even if the parts are stable, it doesn&rsquo;t ensure, by and in itself, that the system is stable under all conditions. We need to add this macro-prudential dimension to Basel II. In particular, I think it is relevant if you look at the issue of procyclicality. We need some measures of capital buffers that are basically built up in the good phase of the cycle and can be run down in the bad part of the cycle. We need some counter-cyclicality in parts of the capital buffers to increase that. That has to be linked to macro-prudential issues: it cannot be linked to firm-specific characteristics. We need to work hard how to build in the macro economic developments into the regulatory standard at the micro prudential level.</p>
<p>Romesh: How do you think about it in terms of the balance, the responsibility, among organisations, among finance ministries, and central banks, and financial supervisory authorities in terms of taking care of both the micro-prudential issues that you talked about, but also these systemic issues, this term that has now become popularised, the macro prudential supervision?</p>
<p><strong>Axel</strong>: Well, the way to balance it is to have a working agenda, which we have embarked on since the G20 process has been elevated, and really now is culminating in a meeting of the heads of state on the 24th of September in Pittsburgh. We have had a number of work flows, both in the Basel Committee, in the Financial Stability Board, and among central banks that have all worked towards the last week&rsquo;s meeting in London of the ministers and governors of the G20.</p>
<p>We have put forward many standards to be adopted and put in place after the meeting of the G20 heads in Pittsburgh. So really all of these issues are coordinated among the main players in the G20: be it regulators, be it central banks, or be it ministries of finance. So, for the first time, there will be a package that is agreed by everybody around the table to put forward, and then the key issue will be implementation. It has to be done without aggravating the crisis.</p>
<p>I keep warning that a few rays of sun don&rsquo;t mean we are yet over the problems. There are still some problems in financial markets. Banks are still weak at this juncture, so we need to phase in this regulation over the next years. We have to grandfather some parts; for example, capital injections by governments into banks that were rescued have to be grandfathered under these old standards. You cannot reopen those packages, so we have to consider some additional provisions for implementation. But, implementation is key, and implementation needs some sensitivity analysis. It needs calibration. It needs some impact studies. That will be done during the earlier part of 2010.</p>
<p>As we move along, and as the economies around the world become more robust, we will have to phase this new regulation in. I don&rsquo;t think there is any disagreement on that at all anymore between the major players.</p>
<p><strong>Romesh</strong>: How do you think about these issues of financial regulation in relation to traditional macroeconomic policy, monetary policy goals? Central banks, until recently, have been very much focused on targeting inflation and responding with the interest rate. Now, we&rsquo;re talking about a much wider set of goals involving financial stability. To some extent, that&rsquo;s been there. Now, we&rsquo;re talking about it much more broadly. It makes the whole thing much more messy, doesn&rsquo;t it?</p>
<p><strong>Axel</strong>: Well, I am very cautious that adding macro-prudential or banking regulatory authorities to what central banks do cannot come at the expense, and should not come at the expense, of price stability. But, in my view, it doesn&rsquo;t introduce a trade-off. That would be the worst thing that could happen: that regulators or central bankers have to balance in their mind a trade-off between financial stability on the one hand and price stability on the other hand. But, that&rsquo;s not the case. In my view, we need financial stability so that the monetary policy transmission mechanism works. In order to achieve price stability, financial stability is a prerequisite.</p>
<p>Without it, it&rsquo;s much harder to have price stability, in particular as we understand price stability not just in limiting inflation rates at low target levels, but also in preventing deflation. A typical risk you encounter when a bubble bursts is that there is a deflationary process. To ensure medium-term price stability both on the upside and downside, we need to have financial stability. As I said before, for that it doesn&rsquo;t create a trade-off between price stability and financial stability, not just at the macro-prudential level, but also at the micro level. Because the system itself cannot be stable if the parts are not stable; that we found out with the Lehman default this year. If you have one weak part in that chain, again, the whole thing unravels or is at a high risk of unraveling.</p>
<p>I think central banks need to be involved in both. We, the Bundesbank, are involved in Germany in micro-prudential supervision. It&rsquo;s very important for gathering intelligence from the banks&rsquo; balance sheets and capital ratios. We are also involved in some macro-prudential decisions, and these macro-prudential decisions are even more important. In Europe, they will be organised at the level of the Systemic Risk Council in the ECB. That is a key forum for macro-prudential issues. Central bankers, and supervisors get together and will have a forward-looking approach to what stability risks emerge in what market segments, product segments, or banking areas.</p>
<p><strong>Romesh</strong>: Can I ask you a final question, a broad question about the value of all this activity in financial markets, because I think a lot of people outside of the system see this crisis happen, and say why is all this going on? Why is this such a big part of our economy, particularly in the UK and the United States? Then they&rsquo;re saying should finance be put in its place? Should we make finance less proud and make industry more proud, I think in the words of Winston Churchill? What&rsquo;s your view on that, on the role of finance in the economic system?</p>
<p><strong>Axel</strong>: I think finance has grown out of proportion in many of our economies relative to GDP and the contributions of industry and service sectors. It is part of the service sector, but it&rsquo;s a very high value-added sector. Now, if I look closely at the new regulation that we propose &ndash; increasing capital buffers, increasing liquidity buffers, surcharges for potentially systemic relevant banks, counter-cyclical capital provisioning &ndash; all of these issues will tie down a lot of additional capital in the banking system as safety buffers. That in itself will reduce largely the profitability of banking, and a reduced profitability of banking will bring down through that avenue some of the heated debate also in terms of bonuses and remuneration of CEOs and traders in the banking industry.</p>
<p>But, we need to go further. We also need to make sure that the infrastructures are not just owned by the supply side. Take counter-party exposures you have in central counter-party platforms that deal, for example, with derivative trades. Many of these platforms are owned by the traders&rsquo; industry. They are, in my view, much more infrastructures, public utilities, and as public utilities, they should not be owned by the supply side alone.</p>
<p>The demand side, the buying side, needs to be represented, and as a matter of fact, if it really is an infrastructure, you could well think about having a government role played in those. Again, there is a large part of what I would call oligopoly or monopoly profits in the financial industry simply because they own many of the infrastructures themselves, and the pricing in these infrastructures is supply-side driven. Unless we really focus on that issue, we will not have a full effect.</p>
<p>For me, that remains on the table as a key issue. There are differences of view across the Atlantic, and across the Channel, and the continent on those things, just as on remuneration and bank bonuses, but we need to move on these things.</p>
<p>I think the financial industry in the future will have much less economies of scale. So size will not pay as much as in the past. Actually, there may be a point where size is even penalised, so there will be diseconomies of scale from that point on. I think that will help to not necessarily shrink, but to bring down to a reasonable size, the financial sector as part of the overall economy.</p>
<p><strong>Romesh</strong>: Axel Weber, thank you very much.</p>
<p><strong>Axel</strong>: You&rsquo;re welcome.</p>

Topics:  Financial markets Global crisis

Tags:  regulation, Global Economic Symposium, G20

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