Transparency, cross-border cooperation, and stronger macro and micro prudential supervision key to financial recovery.

The President of the Deutshe Bundesbank, Professor Dr Axel Weber, spoke to a distinguished audience at the Institute of International and European Affairs in Dublin this week about the reform of financial supervision and regulation in Europe in what is now the third year of the current crisis.

While the background to the crisis is largely attributable to regulatory failure and, in the case of Ireland, the utter fecklessness on the part of banks operating here, the genesis of the crisis internationally can be traced to a myriad of complex causes – although the vast majority of these relate to commercial and residential property. 

These include regulatory gaps, incentives that focused on short-term goals, the shortcomings of supervision in a transnational context and ignorance of systemic risk. 

There are, for example, no 100% residential mortgages in Germany as was the case in Ireland.  The maximum loan-to-value ration tolerated is 60-80% with only the more affluent mortgage holders qualifying for the higher figure.  Off balance sheet transactions, through special purpose vehicles, reduced levels of regulatory capital.  A mindset that tolerated a ‘too big to fail’ or ‘too interconnected to fail’ mentality led to a lack of awareness of systemic risk.  The system of financial supervision did not keep pace with the internationalisation and globalisation of the financial sector causing a severe weakness in resilience.  Structural problems of this scale cannot be simply outgrown, or ignored. 

The process of credit transfer that arises when an asset is securitised means that the connection between the originator of risk and the ultimate bearer of risk is ruptured giving rise to moral hazard because there is no incentive for the originator to monitor the debtor and a lack of transparency arises in the marketplace.  The consequence is the erosion of credit standards, as occurred in the US sub-prime market.  If transparency is compromised so is market discipline and  there is less scope to adjust investment decisions.

Weber’s recipe for rehabilitation includes improved regulation and prudential supervision at both the macro and micro level; closer attention to the threat of systemic risk at the macroeconomic level.  An example of an improvement at the micro level would be that those elements of banks deemed systemically important would be required to maintain a higher level of regulatory capital.  Mortgage holders might, for example, be granted a five to ten year period of fixed interest.

There needs to be stronger interplay between the prudential supervision at both levels and the implications of this on price stability, or inflation.  All the new initiatives require a greater level of international cooperation.

Initiatives at an EU level is pursuing two goals – stronger macro prudential supervision and greater cooperation between Member States in prudential supervision. 

The goal of the European Systemic Risk Board is to avert and mitigate systemic risks to financial stability. An early earning system is intended to identify threats and warnings and recommendations will be issued.  The link between macro and micro prudential supervision will be strengthened through the European System of Financial Supervision and cooperation between national supervisory authorities.  A network of three new authorities will be inaugurated.  The European Banking Authority will be responsible for the supervision of the banking sector.  The European Securities and Markets Authority will supervise financial markets.  The European Insurance and Occupational Pensions Authority will be mainly responsible for the supervision of the insurance industry.

The role of central banks in these new arrangements will be to safeguarding financial stability – guarding against inflation.  Their expertise in monitoring macroeconomic developments that could impact financial stability will also be crucial.  When a crisis occurs central banks have a vital role in restoring financial stability. 

The instruments of monetary policy and those of financial regulation are discrete but they relate to each other.  Initiatives to deal with macro prudential supervision at both the national and EU level can impact the goal of price stability.  Safeguarding price stability in the medium terms remains the primary goal of monetary policy.

A stronger process of macro prudential supervision integrated with micro prudential supervision that takes account of the cross-border implications of modern financial services will be the bedrock of recovery and reform.  Economic growth, post recovery, will be significantly less than before the crisis.  Not all banks are systemically important.  Components of the business of some banks maybe systemically important and the minimum capital levels of these must increase to reflect this position.  While some see evidence of some recovery there could be a brake on this caused by the challenge of repairing the financial system and credit flow issues.