The role of regulation, implementation and research in promoting financial stability

Keynote address by Mr Agustín Carstens, General Manager of the BIS, at the Bank of Spain and CEMFI Second Conference on Financial Stability, Madrid, 3 June 2019.

Introduction

Good afternoon. Let me start by thanking the Bank of Spain and CEMFI for inviting me to deliver the keynote address for this conference.

I would also like to applaud the scientific committee, as the agenda for the next two days covers a range of very interesting and highly topical financial stability issues. These include the macroeconomic impact of post-crisis reforms, the use and governance of macroprudential policy, the interactions between monetary policy and financial stability, and the implications of climate-related risks.

Many of these topics relate to the so-called "regulatory cycle". In my remarks today, I will refer repeatedly to this cycle. What is it? The regulatory cycle is somewhat akin to, but distinct from, the better known business and financial cycles. It operates as follows:

• The first phase is about regulatory design. It is typically set in motion by a financial crisis, when there is a strong impetus, both domestically and globally, to address areas of regulatory and supervisory deficiency. This impetus helps authorities to develop and agree reforms that strengthen the resilience of financial markets and institutions. As the scars and costs of the crisis are clearly  evident, vested interests are weak.
• The second phase is about implementation. Full, timely and consistent implementation of the reforms is necessary to ensure that societies can reap the financial stability benefits. But implementation may be put on hold while international standards are being adapted to national realities. The longer the delays, the more time vested interests have to recover.
• The third phase is about assessment. Once the reforms are finalised and start to be implemented, accountability calls for a thorough evaluation of their impact. It is crucial to review how far the reforms have achieved their objectives and mitigated the risks in question. These evaluations also allow policymakers to assess the broader impact of reforms and the extent to which there may be unintended consequences.
• We are currently in this third phase, in which memories of the crisis gradually fade. It is characterised by a weakening in the will to persevere with the ambition and implementation of the reforms. Vested interests gain momentum, promoting the fallacy that "this time is different", and that delaying, diluting or rolling back post-crisis reforms is the convenient path to promote jobs and growth.
• The third phase is key, as it will shape the financial regulatory framework and its effectiveness in mitigating the impact of future crises. How the post-crisis reforms are assessed will determine whether any potential adjustments are likely to accommodate private vested interests - thereby undermining financial stability - or whether any adjustments are truly evidence-based and thus serve the public good.

Rigorous academic research plays an important role at each phase of the regulatory cycle. Indeed, the Basel Committee on Banking Supervision has always relied extensively on academic research when designing international standards. In turn, member jurisdictions draw on the academic literature when putting in place and calibrating national policies. The Committee also engages with academics as part of its formal consultation periods and the evaluation of reforms. Throughout the regulatory cycle, the policy community relies on rigorous forward-looking analyses to monitor and assess financial vulnerabilities.

In my remarks today I will focus on the link between research and the various phases of the regulatory cycle.

First, I will discuss the post-crisis reforms and how academic research helped to shape them. In this part, I will start by reviewing the post-crisis regulatory framework, essentially reviewing the design phase of the regulatory cycle. I will then turn to the ongoing second phase of implementing the reforms. And since we are in Europe, I will zoom in on challenges that the region faces in agreeing and implementing a common set of prudential policies.

Second, I will ask how academic research can contribute to our understanding of financial stability. With many of the key regulatory reforms already implemented, research can provide an objective view of their effects, thus contributing to the evaluation phase of the regulatory cycle. Furthermore, academic analysis can identify and assess financial vulnerabilities of both a structural and cyclical nature. Such work will help policymakers in their efforts to build a more robust financial system.

The post-crisis regulatory framework: Enhancing robustness

The Basel Committee's post-crisis reforms are comprehensive and wide-ranging. They have strengthened global bank regulatory standards by addressing the main fault-lines exposed in the banking system by the Great Financial Crisis (GFC). These fault-lines include unsustainable growth in leverage and credit, inadequate loss-absorbing capital, and excessive exposure to liquidity risk.

The regulatory framework that has emerged following the crisis is one with multiple metrics. Compared with the pre-crisis framework, which relied only on the risk-weighted capital ratio, the revised international regulatory framework now features a leverage ratio, large exposure limits, liquidity standards, macroprudential instruments, such as the countercyclical capital buffer, and higher loss-absorbing requirements for systemically important banks.

The shift to multiple metrics in Basel III, and greater reliance on stress testing on the part of national authorities, reflect the importance of using a range of complementary and mutually reinforcing regulatory standards together with supervisory judgment. By definition, tail risks are hard to measure. Relying on a single regulatory standard to maintain financial stability is therefore likely to be insufficient. An approach based on multiple metrics is more resistant to arbitrage and erosion over time, as each metric offsets the shortcomings and adverse incentives of the others. And their disclosure enhances market discipline by providing market participants with more information about a bank's risk profile.

Industries where the cost of failure is high commonly rely on multiple safeguards. For example, aerospace uses a "triple modular redundancy" system: some aircraft have three systems performing the same process, so that a failure in one can be corrected by the others.¹ Similarly, in software engineering, "n-version programming" seeks to increase software reliability by developing and executing multiple versions of the same application in parallel to compare their outputs.²

In addition, prudential authorities have significantly strengthened their supervision of non-financial risks. A range of non-financial factors, such as conduct, culture and a broad array of technology-related risks have increased in importance in recent years, and are being addressed through stress testing and the supervisory process.

The Basel Committee relied extensively on academic research in shaping the design and calibration phase of the post-crisis reform. Let me give two concrete examples. First, the Committee drew on an extensive review of the literature for its study on the calibration of capital requirements and their long-term economic impact.³ The analytical framework developed by the Committee and the BIS has formed the basis of numerous subsequent academic papers on the macroeconomic impact of post-crisis reforms and optimal capital requirements.⁴

A second example of the role of research in the design of Basel III is the macroprudential framework, including the countercyclical capital buffer.⁵ This aims to protect the banking sector from the type of prolonged excess aggregate credit growth that often characterises the build-up of systemic risk. To help authorities decide on the appropriate level for this buffer in each jurisdiction, the Basel Committee developed a methodology for calculating an internationally consistent buffer guide, drawing on the rich literature on early warning indicators. This guide is based on the credit-to-GDP ratio, which serves as a common reference point for taking buffer decisions.

The regulatory cycle and the fallacy of "this time is different"

With the Basel III reforms finalised, the Committee's focus has naturally shifted to implementation and evaluation. The Committee has been monitoring this implementation as part of its Regulatory Consistency Assessment Programme. In the process, it is promoting full, timely and consistent implementation by member jurisdictions, as repeatedly agreed by the G20 Leaders.

As we approach the peak of the implementation phase and move to the evaluation phase, there is an increased risk of complacency and backsliding on enacting the globally agreed standards. For example, the Basel Committee's periodic assessments of the adoption of the Basel III reforms show growing evidence of delayed or inconsistent implementation.⁶ There is always merit in undertaking detailed evaluations and considering whether changes are warranted based upon strong empirical evidence. However, changes based solely on the lobbying of vested interests will weaken financial stability. While the process of reaching international agreement was critical, putting the rules in place is now the crucial next step. Failure will undermine the progress made so far to enhance global financial stability.

The financial stability benefits of implementing global standards

The financial stability benefits of implementing globally agreed standards in a full, timely and consistent manner are not just theoretical; they can deliver real economic benefits. Let me highlight three channels through which they will take effect.

First, implementing post-crisis reforms in a timely manner helps build the resilience of the banking system while there is still the capacity to do so. There are many imbalances and risks at the current juncture. These stem, for example, from high debt levels, changing dynamics in the financial system, the growing threat of cyber attacks and geopolitical tensions. As we do not know if or when these or other risks may crystallise, it is in our collective interest to lock in the benefits of enhanced financial system resilience by implementing regulatory reforms. This is especially the case as the public sector may lack the capacity, including the monetary and fiscal space, or the political will, to respond to a future crisis with the same speed and force as during the GFC. Indeed, the costs of future financial crises may be greater than those of previous ones, in that the scope for offsetting policy responses could be more limited.

Second, full implementation of the post-crisis reforms brings clarity and certainty to all stakeholders. A stable post-crisis regulatory framework provides a clear roadmap for supervisors, banks and market participants. It helps build trust and restore confidence in the banking system's resilience, as it eliminates speculation about potential future revisions or watering-down of reforms.

Third, implementing post-crisis reforms in a consistent manner across jurisdictions reduces the risk of regulatory fragmentation and minimises potential cross-border competitive distortions. In this context, we witness some clearly inconsistent arguments. Some stress the need for a level playing field in regulation while simultaneously lobbying for national discretions and exemptions to suit local "specificities". This suggests a "financial trilemma" where, at most, you can only have only two of (i) global financial stability, (ii) financial integration and (iii) national financial policies. But we do not even need to go that far, given that growing regulatory divergences across jurisdictions could potentially undermine global financial stability or financial integration.⁷

An example from Europe

The financial trilemma manifests itself strongly within currency unions, such as the European one.⁸

Financial integration is a prerequisite for a well-functioning economic and monetary union. It is generally agreed that such integration is crucial for ensuring sufficient risk-sharing among member countries. Thus, the policy fragmentation that stands in the way of financial integration in the EMU is likely to exact a particularly high cost.

Of course, EMU member countries have made progress towards region-wide financial policies. In particular, they have moved to put in place an effective single rulebook. And they have set up common supervisory and resolution mechanisms.

Despite this progress, a number of important barriers to further banking integration persist. For one, European legislation provides scope for national discretion. Second, the host authorities of pan-European banks can impose prudential and resolution requirements at the subsidiary level. This can give rise to the ring-fencing of loss-absorbing capacity. Third, we still do not have a European deposit-guarantee scheme. These elements of the European financial landscape reduce the incentives for European banks to expand their businesses to other member countries.

A key reason why the convergence of Europe's financial policies is incomplete is the lack of economic integration, which explains why economic and financial cycles vary across countries. This fact leads some to argue for a suite of regulatory powers at the domestic level. Proponents of this argument go on to stress that EMU countries have only limited macroeconomic policy tools at the domestic level. They add that there are still no common fiscal mechanisms which could help country-idiosyncratic shocks to be smoothly absorbed within the euro zone.

Another, more technical, reason behind policy fragmentation has to do with legacy issues in bank balance sheets. Non-performing loans have been a common topic in this context, but their relevance is set to diminish as banks and supervisors work together to repair balance sheets. A second legacy issue relates to the concentration of banks' exposures to domestic sovereigns. The resulting risks have hindered the establishment of a common deposit guarantee scheme.

In sum, incomplete economic integration and banks' riskiness have made it possible to argue that financial stability is a domestic responsibility, at least in part.

Yet, the task of financial integration is not complete. We see this in the limited share of cross-border loans and deposits, and in the predominantly domestic focus of the most significant banks. We also see it in the low number of mergers between entities located in different European jurisdictions.

Incomplete banking integration is a major vulnerability of the EMU project. It implies the lack of an effective private risk-sharing mechanism that could help break the potentially destabilising link between national economic developments and the banking system's solvency. Therefore, if European leaders are to avoid getting trapped in what game theorists would call a prisoners' dilemma, they might collectively agree to remove the existing barriers to further integration. Implementing the internationally agreed reforms in a timely and consistent fashion across the euro zone would also be an important step towards freeing themselves from this situation - by helping to resolve the financial trilemma, so that financial stability would go hand in hand with EMU-wide financial integration.

Research on financial stability

Let me now turn to themes that are of more direct relevance to you, as researchers. For research to serve prudential policymaking, it should reflect each phase of the regulatory cycle. In the third phase of this cycle, for instance, academic research can enlighten and discipline the assessment of regulatory reforms by providing the necessary analytical rigour and by delivering evidence-based policy messages. In addition, research can serve the public interest by continuously helping policymakers to identify and study vulnerabilities. It need not be limited to specific phases of the cycle.

As the papers in this conference and BIS research testify, much progress has been made on both these counts. Of course, more can always be done. Let me highlight some areas where future research would be highly valuable for policymakers.

The research agenda going forward

One cyclical vulnerability that has received some attention stems from the rapid growth of corporate debt over the last few years. In a search-for-yield environment, volumes in high yield markets shoot up, investors tend to under-price risks and, in the process, assume excessive risk exposures.

Could this market segment destabilise the system? Those who want to be reassuring stress that - unlike the pre-crisis period - the risky exposures appear to be held mainly outside the banking sector. What concerns me, however, is that we know rather little about the capacity and - more importantly - the willingness of non-bank investors to absorb credit losses. If an event triggers a reassessment of risks, these investors could join a selling spree and amplify destabilising market dynamics.

Policymakers would highly value research that sheds light on how the repricing of risks and these market dynamics could play out. And the sooner we see such research the better, so that events do not get ahead of us.

A second topic relates to how regulatory reform and financial innovation have changed the financial landscape. We need to understand the new players much better, as well as their risk exposures, their effect on incumbents and the resulting imbalances.

Third, we also need to identify and study new pockets of risk concentration, including CCP risk management. Central clearing, a highly concentrated business, has been promoted by design, based on the resilience of CCPs during the crisis period. However, the recent case of Nasdaq Clearing AB in Sweden, where the CCP had to pass on losses to its members, highlights the importance of further research into CCP resilience. With the continuing shift towards central clearing, it is imperative that CCPs act as shock absorbers rather than risk amplifiers.

Finally, we need to do our best to anticipate how the reconfigured financial system might react at a time of stress. There will always be events that we cannot predict or transmission channels that we do not fully appreciate until they materialise. But research can highlight optimal policy responses and also warn against suboptimal policy responses during stress periods. Such research will be highly appreciated by the policymakers responsible for dealing with future stress.

To undertake high-quality research, you need good data. And here is where policymakers might help you. The BIS compiles data sets that have proved their worth to researchers everywhere. The continuously enhanced international banking statistics,⁹ for instance, can be useful in analysing the resilience of international bank operations¹⁰ and the underlying role of macroprudential tools.¹¹ The BIS also compiles and improves statistics on global OTC derivatives and international debt securities.¹² Our new medium-term strategic plan - Innovation BIS 2025 - envisages a new data management platform that will greatly facilitate the use of information and collaborative research. I very much hope that you will find these developments useful.

Conclusion

Research that serves policy well is challenging to design and execute. So, while applauding your efforts, I also want to stress that financial stability-related research follows a cycle of its own. Economic crises foster new efforts. Then the "good times" blunt the edge of academic and policy interest, opening the door to the build-up of imbalances, sowing the seeds for the next crisis. But, this time, I hope that it will indeed be different!