Banks play a vital role in any modern economy and, indeed, in our everyday lives. We simply could not manage without them. Entrepreneurs, bankers and individuals alike: we all benefit from a stable banking and financial system. Financial stability is therefore a public good, not just nationally but also globally.
At the same time, banking can sometimes involve external effects. It does not just affect banks and their business associates; it also has an impact on third parties with no stake in the game. During the financial crisis, those third parties were the taxpayers.
Regulators and supervisors can rectify a market failure of this kind, and it is in the public interest for them to do just that. It is not a question of 'whether' but of 'how' to regulate. To clear up any misunderstandings right from the outset: it is not the job of regulators and supervisors to keep each and every bank in business. In a market economy, it has to be possible for banks without a workable business model to fail – however large, interconnected or significant they may be. The task of regulators is to create a framework in which market forces can take effect without destabilising the entire financial system.
Simple or complex?
It is vital to ensure that this framework is not overly rigid; we should not confuse stagnation with stability. Innovation has been keeping the financial system in a constant state of flux, and regulation has to keep pace with it. Tradable asset-backed securities are a case in point. Introducing timely and adequate regulation of these innovative instruments might have prevented the financial crisis from taking such a dramatic course. The regulatory framework therefore needs to be just as adaptable as the financial system itself.
It is now widely accepted that innovations rarely make the financial system simpler and, usually, they make it more complex. The key financial innovation in ancient Phoenicia in 1200 BC was the forward contract – a financial instrument that all bankers are familiar with today. Since then, financial innovations have become increasingly complex – to the point where the instruments used today are often understood by only a handful of experts.
But does regulation have to be increasingly complex? Or might a small set of simple rules suffice to ensure effective supervision and safeguard financial stability?
One current example of the debate over 'simple' versus 'complex' regulation is the discussion about how to set the leverage ratio. Advocates of a simple leverage ratio for banks want to replace the current risk-based capital rules with a ‘blanket’ capital requirement. They believe that the same percentage of capital should be held against all assets, regardless of their risk. The idea appears appealingly simple at first sight. And it would avoid the mistakes and manipulation that can arise during the complex process of calculating risk weights. But a leverage ratio would also create the wrong incentives. If banks have to hold the same percentage of capital against all assets, any institution seeking to maximise its profits will probably invest in high-risk assets, as they produce particularly high returns.
If we weigh up the pros and cons of simple versus complex regulation, we would probably be well advised, in this situation, to use risk weightings in combination with the leverage ratio – which is precisely what the new rules envisage. Consequently, the answer to the above question is that regulation must be as simple as possible and as complex as necessary.
Coherence is key
The more complex the regulation, the more important it is to adhere to another principle: coherence. I believe that regulation must be coherent on at least three levels.
First, regulation has to be coherent across borders and regions. We have a global financial system, and it therefore requires global regulation. Where regulation varies from country to country, there is a danger of regulatory arbitrage – of banks moving their business to countries with the lightest-touch regulation. The problem with this behaviour is that the risks stemming from these transactions could potentially affect the entire financial system.
This is why the G20 has made the issue of financial market regulation a priority. In co-operation with the Financial Stability Board and the Basel Committee on Banking Supervision, it is working to develop a coherent global regulatory framework. It is therefore worrisome to see that some countries outside Europe are adopting their own regulatory initiatives in breach of the principle of cross-border coherence. The danger of banking regulation one day returning to the principle of ‘every man for himself’ needs to be taken seriously.
Regulation not only needs to be coherent across borders and regions but also across different sectors. Here, too, the central issue is the danger of regulatory arbitrage. One current example is the growth of the shadow banking industry, where financial enterprises conduct business that creates bank-like risks but is either regulated insufficiently or not at all. In many cases, these risks are not even recorded. Yet, the shadow banking industry may become a source of systemic risk. We therefore need to expand the regulatory framework in this area to ensure that it is coherent.
Third, it goes without saying that the content of regulation also needs to be coherent. The capital rules are a case in point. Unlike for all other forms of credit, banks do not have to hold capital against government bonds in line with the risks that they carry, and this inconsistency has dangerous side-effects. Since the euro area sovereign debt crisis – if not before – it has become clear that government bonds are anything but risk free. In this area, too, we should work to restore, in the medium term, the coherence of regulation.
The way forward?
To sum up, there are at least three principles for ensuring good regulation. First, regulation has to be flexible and able to keep pace with developments in the financial system. Second, regulation must be as simple as possible and as complex as necessary. Third, regulation has to be coherent in terms of content as well as across borders, regions and sectors.
Abiding by these principles will not, of course, solve each and every regulatory problem. Yet they do provide us with a benchmark for assessing regulatory provisions. And I believe that is very valuable.
But how do we go about ensuring an adequate regulatory framework? The past history of regulation has been one of constant ups and downs. Periods of deregulation have usually been followed by a crisis, then by a period of re-regulation, followed by a period of deregulation. It is precisely in phases of re-regulation that banks tend to carp and moan about the expense and effort required – and the present period is no exception. But are we really over-regulating? If we look at the benefits to society of a stable banking system and the social costs of a banking crisis, I believe the costs of regulation are justifiable.
However, going forward, regulation needs to evolve in a somewhat more even manner and adapt more quickly to new challenges such as the low-interest-rate phase, high-frequency trading, allegations of Libor manipulation or the setting of foreign exchange rates and gold prices. We should not wait until the aftermath of the next crisis to come up with ways of responding to these challenges.
I do not believe, however, that regulators and supervisors are all knowing and all powerful. We can only maintain financial stability if we work together. Bankers are just as responsible as supervisors and regulators. Although the ‘bad apples’ represent a very small minority, their behaviour causes all of us to suffer: the public, when a crisis breaks out, and the bankers, when the public tar them all with the same brush.
But we should be aware that the value of the financial system is measurable against one key criterion: its reliability as a service provider to the real economy. Bankers and regulators should use this understanding to work together towards making the financial system more stable.
Dr Andreas Dombret is member of the board of Deutsche Bundesbank, the German central bank, responsible for the department of banking and financial supervision, risk controlling and the Bundesbank's representative offices abroad.
