World Finance: States Must Innovate. How can regulation be efficient?

Speech by Thomas Mirow, President of the European Bank for Reconstruction and Development, at Les Rencontres Économiques d’Aix-en-Provence

The financial crisis of 2007-2009 originated in a poorly regulated financial sector. Banks turned out to be undercapitalised. Significant risks turned up in portions of the financial sector which were not regulated. Cross-border supervision and bank resolution regimes did not work well. Resolving the crisis had huge fiscal costs.

To make matters worse, many of the structured financial products that had given rise to these losses did not seem to have obvious connections to lending to businesses or individuals. Rather, they seemed to be designed mostly to give investors and financial sector players the opportunity of placing ever-more complicated bets. The crisis thus cemented a view of the financial sector as a source of socially risky activities without obvious offsetting social benefits.

As a result, the call to strengthen and broaden financial sector regulation has been nearly universal. And more importantly, it has been followed by significant action in at least three areas:

• First, extensive work has gone into redefining capital and liquidity standards for banks in fora such as the Basel Committee for Banking Supervision and the Financial Stability Board. This has led to the Basel III framework, a set of recommendations that must now make its way into national and EU legislation. The Commission is about to release its proposal for adopting the Basel package in the coming weeks.
  
• Second, in the European context, there has been significant progress on cross-border supervision. The EU has established three new supervision agencies with significant powers, and is defining a ‘common rule book’ that will guide both these agencies and national supervisors.
  
• Third, national and international supervisory institutions are being reshaped, and sometimes created, to pay much more attention to the systemic, or “macroprudential” elements of financial sector risk. At the European level, the most tangible outcome of these reforms has been the European Systemic Risk Board (ESRB), which will examine risks to the entire financial system, including from large institutions.

This is huge progress. European policy makers should be united in supporting the swift implementation of these reforms and in protecting them from being diluted. While more regulation always involves trading off the benefits of greater safety and the costs of stifling innovation and restricting access to finance, I am generally comfortable with how these trade-offs have been resolved in the proposals for which implementation is currently under way.

That said I also believe that current reform efforts leave significant problems unaddressed. This is where I hope this panel will enrich us with its views and ideas.

Impressive as it is, the current reshaping of the regulatory and cross-border supervisory landscape may not go far enough in addressing some of the key weaknesses in the financial architecture that were revealed in the crisis.  I see at least two areas where additional efforts are likely to be needed.

• For one, regulation remains disproportionately focused on the formal banking system. But there are other sources of finance, and consequently other potential causes of overleveraging and asset price bubbles: secondary markets; non-bank financial institutions, and pools of private and sovereign wealth seeking high returns. To some extent, the risks from these additional sources of finance may be “caught” by supervisors taking a macro-prudential view. But do these supervisors have the information that they need to understand what is going on in the “shadow banking system”? And even if they do, do they have the tools to address these risks?  Furthermore, if bringing the shadow banking system out of the shadows requires new institutions – for example, central clearing houses for the rapidly growing market for derivative contracts – how do we ensure that these institutions do not in themselves become a new source of systemic risk?
  
• Much work also remains to be done in the area of cross-border crisis resolution. Credible regulation and effective supervision of cross-border financial institutions is only possible if it is clear who will bear the burden if the institution becomes insolvent and needs to be recapitalised. It is my sincere hope that Europe recognises the imperative of preserving the benefits of the integrated market, and that cross-border crisis resolution arrangements are put in place to prevent it being undermined by growing mistrust and uncoordinated national regulation.

The second challenge for the ongoing financial sector reforms is to properly adapt them to the financial system – the “habitat” as it were –  in which the regulated institution operates. I am sensitive to this issue perhaps because the financial sectors in the EBRD region, while integrated with advanced Europe, have very different size and structural characteristics compared to more advanced countries. This may alter the cost-benefit calculus that is used to calibrate regulatory standards, and perhaps call for entirely new forms of regulation. I will give you some examples. Notably, they do not all go in the same direction. Some call for tougher regulatory standards or additional regulation; others for less.

1. Institutions may be “systemic” at the national level even if they are relatively small players in the European field. This argues for allowing national regulators to exceed Basel III capital adequacy standards when they deem this appropriate.

2. Foreign currency denominated lending has been a first order risk in most countries of emerging Europe, but not in advanced countries. This may call for tougher regulation, and also from forms of regulation that go beyond the realm of capital and liquidity ratios. One example is to encourage banks to differentiate loan-to-value ratios and perhaps payment-to-income ratios according to the currency of borrowing.

3. Developing countries may depend more heavily on trade finance than industrial countries. Assigning greater risk weights to trade finance may hence generate greater costs.

4. Banks in emerging Europe lack sources of long-term funding in domestic currency. Developing the confidence in the national currency that will encourage longer term deposits, and domestic capital markets that can be used to issue bonds will take time. As a result, if we want to encourage long-term lending, we will need to accept higher liquidity mismatches than may be desirable for an industrial country financial system.

Hence, adapting the Basel capital and liquidity standards – and regulatory standards more generally – to emerging markets will require flexibility. The critical question is how this flexibility can be achieved without jeopardising the central objective of the Basel process – namely, harmonisation of regulation.  After all, the purpose of this harmonisation is not only to promulgate best practices internationally, but also to create a level playing field that minimize the risks from arbitrage between countries.

Last updated 11 July 2011