When Nout Wellink became chairman of the Basel Committee on Banking Supervision in July 2006, the hard work on the Basel II Capital Accord had been done. The revised framework to align bank capital more closely with the risks taken had been issued by the committee and was in the process of being transposed into national laws around the world. Apart from overseeing some fine-tuning, it seemed that Mr Wellink’s main responsibility for the new accord would be to ensure its smooth and timely implementation.
Then the credit crunch hit. Suddenly the Basel Committee chairman’s job took on a new sense of urgency and direction. The committee announced in April 2008 that it would revise key aspects of the Basel II framework to make the banking system more resilient to financial shocks. The key proposals were to set higher capital requirements for certain complex structured credit products, liquidity facilities that support asset-backed commercial paper conduits and credit exposures in the trading book.
It also proposed three broad measures outside the scope of Pillar 1 (minimum capital requirements) of Basel II, which is typically the aspect of the framework that attracts the most attention. These other initiatives were to strengthen global practices for liquidity risk management and supervision; to initiate efforts to strengthen banks’ risk management practices and supervision, relating in particular to stress-testing and off-balance sheet management (ie: Pillar 2, the supervisory review process); and to enhance market discipline through better disclosure and valuation practices (ie: Pillar 3, market discipline).
Man of experience
Despite the unprecedented nature of the global financial crisis, Mr Wellink has taken it all in his stride. This is what one would expect of a man of his experience. He has been president of De Nederlandsche Bank (the Netherlands’ central bank) since 1997. He has been on the board of directors of the Bank for International Settlements (BIS), of which the Basel Committee is part, for just as long, and was BIS chairman from 2002 until 2006.
He is also on the governing council of the European Central Bank, a member of the Group of 10 Governors (the Committee of G10 central bank governors) and a governor of the International Monetary Fund.
Being in a position of such authority and influence, what can Mr Wellink tell us about the state of the global financial sector today? Are we over the worst, and should supervisors, governments and financial institutions now be worrying more about the problems in the rest of the economy?
“That’s a difficult question,” he admits. “I feel that we, as central bankers and supervisors, have done almost as much as we can. It is also my feeling that the situation in the financial sector might be improving gradually as a consequence of the measures taken. Having said that – and that’s why it is a difficult question to answer – the real economy is entering a recessionary phase. This is a rapid process and it is hard to forecast how deep the recession will be.”
World leaders, including finance ministers and central bank governors, have been discussing the creation of a new global financial order to replace the 1944 Bretton Woods system, which is past its ‘sell-by date’. Mr Wellink warns that a new structure cannot be set up overnight.
“One of the problems we face is that we are in the middle of a process, and it is not easy to decide what the most important elements in this process are.” He believes that, among other things, the new world financial order should concentrate on better crossborder co-operation between central banks, supervisors and international bodies.
Words into action
“All the things the Basel Committee promised in April, we will have delivered by December,” says Mr Wellink. Many of the enhancements to Basel II were already in the pipeline.
“At a meeting in December 2006, the committee concluded that although Basel II had been finalised and could be adopted by national parliaments, there were certain weak spots that needed looking at,” he recalls. They were to do with stress tests, valuations and risk management.
“We decided to address these weaknesses by updating the accord at a later stage. We could have delayed the accord, but if we had done that it would have taken longer for it to come into effect,” he adds. “So we decided to finalise the accord and continue our work on these other things, not realising that a crisis would develop so rapidly. As it turned out, all the weak spots became extremely relevant in August of the following year. We were outpaced by macro developments.”
The new capital adequacy framework came into force in Japan and Canada in 2007, in the EU in January 2008 and in the US this month. Smaller industrialised countries and many emerging markets have also introduced it. Why, then, has the Basel Committee felt it necessary to urge the “prompt implementation” of the framework when it was already law, or close to becoming law, in the G10 and other countries?
The simple answer, says Mr Wellink, is that it is one thing for the accord to be a regulatory requirement and quite another for banks to become 100% compliant.
“We are seeing Basel II being implemented but, at the same time, there are unresolved issues,” he says. “Our accord implementation group is finding solutions to these unresolved issues. The accord is being implemented, but it is work in progress when it comes to the details.”
Some commentators have argued that the financial crisis has proved that Basel II does not work. If it had, they say, banks’ capital cushions would have been voluminous enough to protect them from what happened. “That is utter nonsense,” says Mr Wellink. “I have read articles, even by learned people, saying we should blame Basel II. But it was only implemented in Europe in January 2008 and it won’t be implemented in the US until January 2009.”
In other words, although the accord came too late to be of any use in this crisis, it will be of great value in helping to prevent future misalignments of risk and capital allocation.
Basel II addresses many of the problems that have been so spectacularly highlighted by the crisis. From now on, banks will need to set aside more capital to support riskier activities. There will be some activities that banks will not embark on because of the high capital charge.
Working together
As well as working closely with supranational and national authorities around the world to deal with crisis, Mr Wellink has been keeping a close eye on what action the industry itself is proposing to take. But he is doubtful about what self-regulation can achieve.
“Not everyone trusts the financial industry – to some extent rightly so, because it is partly to blame for what has happened,” he says. “I have been pleasantly surprised by the industry’s positive attitude, especially the Institute of International Finance, but the fundamental problem with the recommendations in its final report is, how will it implement what it is suggesting?
“Banks always say to us, ‘no additional regulation please, we can do it ourselves’. I trust them when they say they want to do it themselves, but I don’t always trust them when they say they can do it themselves.”
Mr Wellink believes banks will find it especially hard to reform their bonus systems. He gets annoyed when bankers say it is not the job of regulators to determine bonuses. “I am a regulator and these bonuses are part of an incentive system,” he counters. “They can’t tell me I am not allowed to say anything about their bonuses if their risk management systems do not create the right checks and balances. So please, until they can prove that their risk management is of such high quality that the negative effects of these incentives are neutralised, I feel completely free to intervene in banks’ bonus systems.”
He says that he has learnt a lot from the crisis, in particular how important Basel II will be as a response to the problems of high risk taking and low capital provisioning that has emerged in the past 10 to 15 years.
As the interview ends, Mr Wellink makes a final point. “What I really want to stress is that banks need to hold more capital.”
Any changes that resulted in more capital would, he adds, only be carried out as part of a considered process that balanced the objective of maintaining a vibrant, competitive banking sector in good times against the need to enhance the sector’s resilience in periods of financial and economic stress.
Nevertheless, his final point is a significant one. Ever since Basel II was mooted, the committee has said the aim was to achieve a better alignment of capital with risk, not to increase the total amount of capital in the global banking system. That central tenet has now been modified. Mr Wellink, the supervisor of all banking supervisors, is not content with just better alignment, he wants more capital as well.
